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© Kenneth Clark, David Forst, James Fuller, Adam Halpern, Andrew Kim, Larissa Neumann, William Skinner & Michael Solomon 2017

FENWICK & WEST

U.S. INTERNATIONAL TAX DEVELOPMENTS

April 26, 2017

by

Kenneth Clark David Forst James Fuller

Adam Halpern Andrew Kim

Larissa Neumann William Skinner Michael Solomon

Fenwick & West LLP Mountain View, California

I. Section 482............................................................................................... 1 II. European Commission: U.S. Concerns ................................................... 31

III. Subpart F .................................................................................................. 39 IV. Partnerships .............................................................................................. 53 V. Section 385............................................................................................... 65

VI. Foreign Tax Credits ................................................................................. 82 VII. Section 367............................................................................................... 116

VIII. Section 987............................................................................................... 135 IX. Other Developments ................................................................................ 165 X. Treaties ..................................................................................................... 178

XI. Inversions ................................................................................................. 196 XII. Country-by-Country Reporting ................................................................ 200

XIII. Other Recent BEPS Developments .......................................................... 214

I. SECTION 482.

A. Amazon.

1. The Tax Court decision in Amazon.com Inc. v. Commissioner, 148 T.C. No. 8 (2017), is another transfer pricing taxpayer victory. Judge Lauber rejected the IRS’s attempt to relitigate the same cost sharing transfer pricing issues the IRS lost on in Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009).

2. The IRS claimed that Amazon undervalued the buy-in intangibles contributed to Luxembourg by more than $3 billion when it entered into a cost share arrangement (“CSA”) with its Luxembourg subsidiary.

3. As part of its cost sharing arrangement (“CSA”), Amazon US transferred three groups of intangible assets: (1) software and other technology

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required to operate the European websites, fulfillment centers, and related business activities; (2) marketing intangibles, including trademarks, tradenames, and domain names relevant to the European business; and (3) customer lists and other information relating to the European clientele. The IRS claimed that the transferred property had an indeterminate useful life, and that it had to be valued, not as three distinct groups of assets, but as integrated components of an operating business and taking into account all projected cash flows of the European business in perpetuity to value the preexisting intangibles.

4. Facts.

(a) The Tax Court stated that due to differing cultural preferences, retail traditions, and national regulations, the details of Amazon’s operations – and the technology required to make them happen – often varied from country to country. Local Amazon employees in each country identified and recruited vendors. Pricing in Europe was also local. Customers’ payment preferences differed geographically. The idiosyncrasies of local markets tripped up many U.S. retailers seeking to expand into Europe. Each European Subsidiary had a distinct website employing its own national language. Each European Subsidiary had its own fulfillment centers, often processing country-specific inventory, and a distinct universe of customers residing chiefly within its own borders.

(b) Amazon’s management decided to establish a European headquarters in Luxembourg. Beginning in 2004 Amazon undertook a series of transactions, dubbed “Project Goldcrest,” to implement this plan. (“Goldcrest” refers to Luxembourg’s national bird.) Amazon US formed AEHT, the Luxembourg headquarters entity that would serve as the holding company for all of the European businesses. AEHT performs various functions essential to the operation of the European businesses including holding title to the inventory sold in Europe, licensing Amazon’s intellectual property, housing the servers, and maintaining call centers. The Tax Court stated that Amazon Luxembourg was by no means a shell company.

(c) Another important fact the Tax Court focused on was the rate of innovation and technology development. The Tax Court stated that because Amazon operates in a competitive environment, constant innovation is essential to ensure survival. Technological failure damages profitability; a late delivery or damaged product may also alienate a customer permanently. Innovative technology underlies every aspect of Amazon’s retail business. Amazon made massive continuous investments to ensure a rapid pace of technological innovation. Respondent’s principal valuation expert,

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Daniel Frisch, even agreed that Amazon operated in a highly competitive, rapidly changing industry that also required substantial innovation all the time. Rapid technological innovation was required to overcome the scale challenges posed by rapid growth. Amazon’s engineers estimated that the software was no longer material within six years. Deloitte determined that the intangible assets had a seven-year useful life.

5. Opinion.

(a) The Tax Court stated that by definition, compensation for subsequently developed intangible property is not covered by the buy-in payment. Rather, it is covered by future cost sharing payments, whereby each participant pays its ratable share of ongoing IDCs. The Tax Court held that AEHT, by making cost sharing payments, became a genuine co-owner of the subsequently developed intangibles that the IDCs financed.

(b) The Tax Court stated that in Veritas the useful life of the trademarks, brand names, and other marketing intangibles was seven years. It is unreasonable, the Tax Court concluded, to determine the buy-in payment by assuming that a third party, acting at arm’s length, would pay royalties in perpetuity for the use of short-lived assets.

(c) The Tax Court stated that one does not need a Ph.D. in economics to appreciate the essential similarity between the DCF methodology that Dr. Hatch employed in Veritas and the DCF methodology that Dr. Frisch employed here. Both assumed that the preexisting intangibles transferred had a perpetual useful life; both determined the buy-in payment by valuing into perpetuity the cash flows supposedly attributable to these pre-existing intangibles; and both in effect treated the transfer of pre-existing intangibles as economically equivalent to the sale of an entire business.

(d) The Tax Court held that an enterprise valuation of a business includes many items of value that are not intangibles. These include workforce in place, going concern value, goodwill, and what trial witnesses described as growth options and corporate resources or opportunities. The Tax Court stated that unlike the intangibles listed in the statutory and regulatory definitions, these items cannot be bought and sold independently; they are an inseparable component of an enterprise’s residual business value. These items often do not have substantial value independent of the services of any individual. And these contributors to value are not similar to the enumerated intangibles because they do not derive

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their value from their intellectual content or other intangible properties. Thus, the Tax Court stated that as concluded in Veritas, there was no explicit authorization in the cost sharing regulations for the akin to a sale theory or the inclusion of workforce in place, goodwill, or going-concern value in determining the buy-in payment for pre-existing intangibles.

(e) The Tax Court rejected the Service’s aggregation argument in Veritas and it rejected it in Amazon as well. The Tax Court stated the type of aggregation proposed does not yield a reasonable means, much less the most reliable means, of determining an arm’s-length buy-in payment for at least two reasons. First, it improperly aggregates pre-existing intangibles (which are subject to the buy-in payment) and subsequently developed intangibles (which are not). Second, it improperly aggregates compensable intangibles (such as software programs and trademarks) and residual business assets (such as workforce in place and growth options) that do not constitute pre-existing intangible property under the cost sharing regulations in effect during 2005-2006.

(f) The IRS contended that Amazon US had a realistic alternative available to it, namely, continued ownership of all the intangibles in the United States. The Tax Court stated that it found this argument unpersuasive for many reasons. First, the Tax Court stated that the argument proves too much. Whenever related parties enter into a QCSA, they presumably have the realistic alternative of not entering into a QCSA. This would make the cost sharing election, which the regulations explicitly make available to taxpayers, altogether meaningless. Second, as noted in Veritas, the regulation enunciating the realistic alternatives principle also states that the IRS “will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance.” Treas. Reg. § 1.482-1(f)(2)(ii)(A). Thus, even where a realistic alternative exists, the Commissioner will not restructure the transaction as if the alternative had been adopted by the taxpayer, so long as the taxpayer’s actual structure has economic substance.

(g) The Tax Court stated that AEHT was not an empty cash box. The European Subsidiaries, of which AEHT became the parent, had been in business for approximately six years. They had a skilled workforce; they owned tangible and intangible assets; and they had goodwill and going-concern value.

(h) The Service urged the Tax Court to overrule Veritas if it could not be distinguished on the facts. The Tax Court stated “We decline his invitation to overrule that Opinion.”

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(i) The parties agreed that the Target arrangement was the most comparable transaction for purposes of implementing the CUT approach. Target was contractually entitled to receive from Amazon US all technology updates as they occurred. The Tax Court held that the Target agreement was not comparable in one major respect: It included a variety of ancillary services, such as fulfillment and customer service, that Amazon US did not provide to AEHT. However, the Tax Court found that the Target agreements bracketed the range of acceptable royalty rates. The Tax Court also stated that some volume adjustment was required and concluded that a 25-basis-point adjustment was appropriate.

(j) In terms of useful life, Amazon’s experts testified that a substantial portion of the source code remaining after six years is dormant or commoditized. The technology experts were generally consistent with the testimony of software engineers. The Tax Court held that the evidence clearly establishes that Amazon’s website technology did not have a perpetual or indefinite useful life. The Tax Court concluded that Amazon’s website technology, ignoring the tail, had on average a useful life of seven years.

(k) The Tax Court also held that unless AEHT’s royalty rate were ramped down to reflect decay in the value of the original technology, AEHT would be required to pay for the subsequently developed intangibles twice, once through cost sharing and again through an artificially inflated buy-in payment.

(l) The Tax Court determined that Amazon’s discount rate of 18% was correct.

(m) The Tax Court held that because the going-forward value of the marketing intangibles would increasingly be attributable to marketing investments by AEHT, an unrelated party in its position would not agree to pay royalties forever. A trademark is, at any specific moment, the product of investments of the past. Future investments can replace those made in the past, and therefore the value of a trademark built by investments of the past will diminish. The Tax Court cited Nestle Holdings, Inc. v. Commissioner, T.C. Memo. 1995-441, 70 T.C.M. (CCH) 682, 696 (“Trademarks lose substantial value without adequate investment, management, marketing, advertising, and sales organization.”), rev’d in part and remanded on other grounds, 152 F.3d 83 (2d Cir. 1998). If consumers were dissatisfied with their shopping experience, Amazon’s marketing intangibles would rapidly decline in value. Any profits attributable to these intangibles after a period of 15 to 20 years would reflect the quality of AEHT’s ongoing business execution and the effectiveness of supporting technology and

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subsequently developed intangibles for which AEHT had paid. The Tax Court found that the marketing intangibles had a useful life of 20 years.

(n) The IRS contended that Amazon US was the true equitable owner of any marketing intangibles legally owned by the European Subsidiaries. The Tax Court did not find this argument persuasive. Because of differing cultural preferences, retail traditions, and national regulations, the details of these operations often varied from country to country. Local teams were thus integral to Amazon’s success in Europe. On these facts, the Tax Court held that the European Subsidiaries were not mere agents of Amazon US.

(o) The Tax Court concluded that any value associated with the customer information in excess of the value of customer referral was short-lived and immaterial or was adequately accounted for in the valuation of the marketing intangibles.

(p) The Tax Court also agreed with Amazon that the IRS abused his discretion in determining that 100% of the costs accumulated in the T&C cost centers constitute IDCs.

(q) The Tax Court stated that since Altera remains pending on appeal, the CSA stock based compensation and clawback provision is not yet operative.

B. Altera.

1. Altera Corporation v. Commissioner, 145 T.C. No. 3 (2015), is a follow-on to the Xilinx v. Commissioner case, 125 T.C. 37 (2005), aff’d, 598 F.3d 1191 (9th Cir. 2010).

2. In Xilinx, the Tax Court held that, under the § 1995 cost-sharing regulations, controlled entities entering into qualified cost-sharing agreements (“QCSAs”) need not share stock-based compensation costs because parties operating at arm’s length would not do so. In an effort to overrule Xilinx, Treasury and the IRS in 2003 issued Treas. Reg. § 1.482-7(d)(2). The 2003 regulation requires controlled parties entering into QCSAs to share stock-based compensation costs. Altera v. Commissioner addressed that regulation, and held that it was invalid.

3. The § 482 regulations provide that in determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm’s length within another uncontrolled taxpayer. The arm’s length standard also is incorporated into numerous income tax treaties between the United States and foreign countries. In Xilinx, as noted, the Tax Court held that unrelated parties

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would not share the value of stock-based compensation in a cost-sharing arrangement. The Ninth Circuit, in affirming, held that the “all costs” requirement of the 1995 cost-sharing regulations was irreconcilable with the arm’s length standard.

4. In issuing the new regulations, Treasury and the IRS first published a proposed version of the regulations with a notice of proposed rulemaking and a notice of public hearing. At the hearing a number of persons testified, and many written comments were submitted.

5. Several of the commentators informed Treasury that they knew of no transactions between unrelated parties, including any cost-sharing arrangement, service agreement, or other contract, that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation. Some comments were based on a survey of an association’s members. Some commentators represented that they had conducted multiple searches of electronic data gathering and found no cost-sharing agreements between unrelated parties in which the parties agreed to share either the exercise spread or grant date value of stock-based compensation.

6. Several commentators identified arms-length agreements in which stock-based compensation was not shared or reimbursed. Some cited the practice of the federal government, which regularly enters into cost-reimbursement contracts at arm’s length. They noted that federal acquisition regulations prohibit reimbursement of amounts attributed to stock-based compensation.

7. Treasury and the IRS nonetheless issued the regulation as a final regulation. The final rule explicitly required parties to QCSAs to share stock-based compensation costs. Treasury and the IRS also added sections to Treas. Reg. §§ 1.482-1(b)(2)(i) through 1.482-7(a)(3) to provide that a QCSA produces an arm’s-length result only if the parties’ costs are determined in accordance with the final rule.

8. When Treasury and the IRS issued the final regulation, the government’s files relating to the final rule did not contain any expert opinions, empirical data or published or unpublished articles, papers, surveys, or reports supporting a determination that the amounts attributable to stock-based compensation must be included in the cost rule of QCSAs to achieve an arm’s-length result. Those files also did not contain any record that Treasury searched any data base that could have contained agreements between unrelated parties relating to joint undertakings with the provision of services. Treasury was also unaware of any written contract between unrelated parties that required one party to pay or reimburse the other party for amounts attributable to stock-based compensation.

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9. The Court considered the applicable principles of Administrative Law, including especially the Administrative Procedure Act (“APA”). Pursuant to APA § 553, in promulgating regulations through informal rulemaking, an agency must (1) publish a notice of proposed rulemaking in the Federal Register; (2) provide interested parties an opportunity to participate in the rulemaking through submission of written data, views, or arguments with or without the opportunity for oral presentation; and (3) after consideration of the relevant matter presented incorporate in the rules adopted a concise general statement of their basis and purpose.

10. The Court stated that these requirements do not apply to interpretive rules (those which merely explain pre-existing substantive law), or when an agency for good cause finds--and incorporates its findings in the rules issued--that the notice and public procedure thereon are impracticable, unnecessary or contrary to the public interest. The regulations at issue, however, were legislative (substantive) regulations, i.e., those that create rights, impose obligations, or effect a change in existing law.

11. The notice and comment requirements of APA § 553 are intended to assist judicial review as well as to provide fair treatment for persons affected by a rule. There must be an exchange of views, information, and criticism between interested parties and the agency. The opportunity to comment is meaningless unless the agency responds to significant points raised by the public. The failure to respond to comments is significant only insofar as it demonstrates that the agency’s decision was not based on a consideration of the relevant factors.

12. Pursuant to APA § 706(2)(A), a court must hold unlawful and set aside agency action, findings and conclusions that it finds to be arbitrary, capricious and an abusive discretion or otherwise not in accordance with the law. A court’s review under this standard is narrow and a court is not to substitute its judgment for that of the agency. Motor Vehicle Mfrs. Ass’n of the U.S. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983). A reviewing court, however, must ensure that the agency “engaged in reasoned decision making.” Under State Farm, normally an agency rule would be arbitrary and capricious if the agency has relied on factors which Congress has not intended it to consider, entirely failed to consider an important aspect of the problem, offered an explanation for its decision that runs counter to the evidence before the agency, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise.

13. The standard to be applied in every case under § 482 is that of an uncontrolled taxpayer dealing at arm’s length with another uncontrolled taxpayer. Commissioner v. First Sec. Bank of Utah, 405 U.S. 394 (1972) (quoting Treas. Reg. § 1.482-1(b)(1)); accord Treas. Reg. §§ 1.482-

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1(a)(1), (b)(1) and Treasury Department technical explanations of a number treaties.

14. The IRS countered that Treasury should be permitted to issue regulations modifying--or even abandoning--the arm’s-length standard. But the preamble to the final rule, stated the Court, did not justify the final rule on the basis of any modification or abandonment of the arm’s-length standard, and the IRS conceded that the purpose of § 482 is to achieve tax parody. The preamble to the regulation also did not dismiss any of the evidence submitted by commentators regarding unrelated party conduct as addressing an irrelevant or inconsequential factor. The Court stated that it did not decide whether Treasury would be free to modify or abandon the arm’s-length standard because it had not done so here.

15. The taxpayer contended that the final regulation is invalid because (1) it lacks a basis in fact, (2) Treasury failed rationally to connect the choice it made with the facts it found, (3) Treasury failed to respond to significant comments and (4) the final rule is contrary to the evidence before Treasury.

16. A court will generally not override an agency’s “reasoned judgment about what conclusions to draw from technical evidence or how to adjudicate between rival scientific or economic theories.” Treasury, however, failed to provide a reasoned basis for reaching the conclusions that support the regulation from any evidence in the administrative record. Indeed, every indication in the record pointed the other way. The Court concluded that by failing to engage in any fact finding, Treasury failed to examine the relevant data and it failed to support its belief that unrelated parties would share stock-based compensation with any evidence in the record. The Court also stated that the final rule was contrary to the evidence before Treasury when it issued the final rule.

17. Because the final regulation lacks a basis in fact, the Court held that Treasury failed to rationally connect the choice it made with the facts found, Treasury failed to respond to significant comments when it issued the final rule, and Treasury’s conclusion that the final rule is consistent with the arm’s-length standard was contrary to all of the evidence before it. Thus, the Court concluded that the final rule failed to satisfy the State Farm’s reasoned decision making standard and therefore is invalid.

18. The Court closed with the statement that Treasury’s ipse dixit conclusion coupled with its failure to respond to contrary arguments resting on solid data, epitomizes arbitrary and capricious decision making.

19. The decision was “reviewed by the Court,” which means that all of the Tax Court’s judges considered whether to join in with the Court’s opinion,

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file concurring opinions, or dissent. All of the judges who participated agreed with the opinion of the Court. There were no dissenting opinions.

20. The term ipse dixit refers to an unsupported statement that rests solely on the authority of the individual who made it. The term describes a dogmatic statement that the speaker expects the listener to accept as valid.

21. In this regard, we cannot resist quoting a high-ranking government official as stating in 2008 “we can simply interpret arm’s-length to mean what we think it should mean, and if we say it correctly, that is what it means.” See Lee Sheppard, Tax Notes Int’l. Sept. 22, 2008, p. 970.

22. Unfortunately, this is the very issue that raises serious problems in BEPS. For example, the “special measures” exceptions to the arm’s-length standard in BEPS has the U.S. government and taxpayers both concerned that it will lead to many ipse dixit pronouncements by foreign taxing authorities. Perhaps, these BEPS exceptions from the arm’s length standard, instead of being referred to “special measures,” should be called ipse dixit pronouncements. That’s what they will be.

23. The IRS filed an appeal in Altera to the Ninth Circuit, the circuit that affirmed Xilinx.

24. The Department of Justice (DoJ) filed its appellate brief with the Ninth Circuit on June 27, 2016. The DoJ’s brief largely makes the same arguments the government made, and lost on, in Xilinx.

25. The Government’s brief asserts that the changes made to the cost sharing regulation in 2003 overcome the regulatory deficiencies that the Ninth Circuit determined in its Xilinx decision. The Government asserts that Xilinx therefore is not controlling.

26. The Government makes three arguments for the validity of the 2003 cost sharing regulation (1) the commensurate with income sentence in § 482, (2) the 1986 legislative history, and (3) an economic reality/implicit cost argument. These arguments were made by the Commissioner and, on appeal, the Government in Xilinx regarding years before the regulation was in effect. The Tax Court and the Ninth Circuit rejected them there.

27. An amicus brief supporting the Government in Altera asserts that “the question of comparability was not fully considered in the Xilinx case” and “[i]f the Xilinx litigation had included the question of whether the controlled and uncontrolled party joint development costs were comparable, perhaps that question would have influenced the Xilinx outcome.”

28. Such assertions as those are incorrect, and we filed an amicus brief.

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(a) Xilinx submitted thirteen opening expert reports. The Commissioner submitted five. There also were numerous rebuttal reports. These expert reports (over 30 of them in total) are not listed on the Xilinx docket sheet, so the amici clearly did not read these expert reports or see the attached comparable cost sharing agreements. The amici also appear not to have read the parties’ four post-trial briefs or reviewed the 2,500+ pages of the transcript. The IRS consistently asserted that all of the dozens of cost sharing agreements presented by Xilinx were not comparable to Xilinx’s CSA agreement. The comparability of the transactions was a matter that was addressed extensively in examinations, cross examination and in post-trial briefs.

(b) We point this out as counsel to Xilinx in its case and in filing the Altera amicus brief.

(c) We also state that including a statement in the regulation that the IRS’s litigating position in Xilinx produces an arm’s length result does not make it an arm’s length result.

(d) The regulation cannot change the Xilinx decision that: “If unrelated parties operating at arm’s length would not share the employee stock option cost, requiring controlled parties to share it is simply not an arm’s length result.”

(e) Moreover, the Ninth Circuit’s Xilinx opinion states that “[i]f the standard of arm’s length is trumped, the purpose of the statute is frustrated” and that the arm’s length standard is the touchstone for § 482.”

(f) Furthermore, Xilinx was a case designated for litigation, which also diminishes the government’s argument that the Xilinx decision does not control.

(g) We also point out that apart from the Xilinx decision, the 2003 cost sharing regulation is not a reasonable implementation of § 482. The Commissioner is given the authority to do only two things: clearly reflect income and prevent evasion of tax. Because stock options are not shared in uncontrolled transactions, there is no evasion of taxes and the income is clearly reflected. Although the IRS asserted that unrelated parties would include stock options in cost sharing agreements, the IRS presented no agreements of any kind that actually included stock option amounts. Consequently, a § 482 regulation that requires a result that is demonstrably contrary to the arm’s length standard exceeds the authority granted to the Commissioner in § 482. The regulation is, therefore, not a reasonable implementation of the statute.

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29. Interestingly, the government addressed our amicus brief in its Reply Brief filed in the Ninth Circuit at p. 39, asserting that the new regulation governs the matter, not Xilinx.

30. Thus, the government seems to assert that the IRS can define what “arm’s length” means in a regulation without regard to what the term really means. (See #21.)

C. Medtronic: § 482/367.

1. Medtronic is an important case involving § 482 and § 367(d). In previous motions, Medtronic sought to reduce the prices used on its tax return to pre-agreement numbers because the IRS reneged on an agreement and put the issue in play and the IRS unsuccessfully moved for partial summary judgment on an issue involving product risk.

2. The IRS’s first examination of Medtronic’s 2005 and 2006 tax returns began in May 2007. During the course of the examination IRS Exam proposed an initial $84 million adjustment as a result of revised calculations under a Memorandum of Understanding (“MOU”) agreed to in a prior cycle. The MOU reflected an agreement that royalty rates of 44% for devices and 26% for leads would be used by Medtronic for royalties from its Puerto Rico subsidiary. (The “Puerto Rico subsidiary” or “Puerto Rico company,” as we use those terms, more specifically refers to Medtronic’s wholly-owned Cayman Islands subsidiary that manufactures through a branch in Puerto Rico.)

3. The prior cycle also involved the IRS’s assertion that Medtronic had contributed to the Puerto Rico company workforce-in-place, goodwill and going concern value with a fair market value of $23 million. The IRS asserted that the gain should rateably be included in Medtronic’s income over a 20-year period pursuant to § 367(d). Medtronic accepted the IRS’s prior-cycle § 367(d) adjustment and in 2003-2006 included additional amounts totaling about $2 million in income each year.

4. In March 2009 after completing its initial examination of Medtronic’s 2005-2006 returns, the IRS proposed to increase Medtronic’s royalty income by an additional $455 million for 2005 and 2006. Medtronic filed a protest later in 2009. Appeals, at IRS Exam’s request, subsequently returned the case to IRS Exam, which reexamined Medtronic’s 2005 and 2006 tax returns. On December 23, 2010, the IRS issued Medtronic a Notice of Deficiency determining deficiencies totaling $198 million and $759 million for 2005 and 2006, respectively. These were based on IRS Exam’s use of the comparable profits method.

5. On July 10 2014, the IRS amended its Answer in Tax Court to exclude royalty amounts paid by the Puerto Rico company for non-U.S. sales, and

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asserting that the adjustments were understated by $51 million for 2005 and $60 million for 2006.

6. Thus, the proposed deficiencies related to the royalties in issue were increased to approximately $550 million for 2005 and $810 million for 2006, or roughly a total of $1.4 billion.

7. As noted above, since the IRS reneged on the earlier-year’s MOU and put the taxpayer’s transfer pricing in issue, Medtronic sought a refund by using its pre-MOU prices.

8. The Notice of Deficiency also provided for alternative income inclusions under § 367(d). The IRS contended that Medtronic should include these amounts in income if the Tax Court did not sustain the IRS’s § 482 allocations. The Notice of Deficiency stated “that significant value had been transferred to [the Puerto Rico company] [and] it is determined that such value transferred (exclusive of tangible assets transferred) is taxable under I.R.C. [section] 367(d)).” The Notice of Deficiency stated that, accordingly, Medtronic must include in income amounts not to exceed $497 million for 2005 and $751 million for 2006.

9. Opinion.

(a) The IRS’s contended that the CPM was the best method to determine the arm’s-length royalty rates on the intercompany sales of devices and leads and that making the § 482 adjustments did not result in an abuse of discretion. Medtronic, as noted, contended that the MOU royalty rates on the intercompany sales of devices and leads were greater than arm’s-length.

(b) The companies had entered into four separate intercompany agreements that the court considered. They were (1) the components supply agreement, (2) the distribution agreement, (3) the trademark license, and (4) the devices and leads licenses (collectively covered transactions).

(c) The taxpayer met its burden of showing that the IRS’s allocations were arbitrary, capricious or unreasonable. Medtronic argued that (1) the IRS abandoned a prior position and (2) the IRS’s adjustments were unreasonable because they gave inadequate consideration to the importance of quality at the Puerto Rican operation.

(d) First, the court concluded that the IRS did not abandon its position taken in the Notice of Deficiency. The court then considered the IRS’s adjustments, which were made based on a Heimert report. Heimert used CPM and opined that this method would provide the Puerto Rico company with a return for its finished-product

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manufacturing that was consistent with the returns earned by comparable manufactures in the medical-device industry. Heimert subtracted the operating profits attributed to the Puerto Rico company from the overall value-chain operating profits and allocated the remainder to Medtronic U.S.

(e) Heimert performed an economic analysis of the functions performed, assets used, and risks assumed by the Puerto Rico company and Medtronic U.S. The only function assigned to the Puerto Rico company was finished-product manufacturing. His analysis assumed that all of the intangibles that the Puerto Rico company needed to perform the finished manufacturing, other than assembled workforce-in-place and incremental process intangibles that the Puerto Rico company may have developed, were licensed from Medtronic U.S.

(f) This approach treated the Puerto Rico company as equivalent to many other third-party medical-device manufacturers that do not create nonroutine assets and that do not bear additional risks that would require the assignment of additional profits.

(g) Medtronic stressed that quality is critical in the medical-device industry and, in particular, to the Puerto Rico company. Numerous witnesses testified on the taxpayer’s behalf about the importance of quality. Medtronic’s chief executive officer during the years in issue testified that product quality is the “single greatest factor in terms of market share.” Medtronic argued that the Puerto Rico company’s role in quality was unique because it bore the greatest economic risk. It was exposed to being sued if there was a defect in the manufactured device.

(h) The parties disputed the level of risk attributed to the Puerto Rico company, but the court felt there was no dispute that the Puerto Rico company bore some of the risk. The court, however, specifically declined to consider which company was responsible under federal products liability law.

(i) The IRS argued that the Puerto Rico company was similar to a manufacturer of components and that it was replaceable in the process. The taxpayer contended that since the Puerto Rico company was responsible for assembling the final product, the importance of quality was vital. The court found that the Puerto Rico company not only assembled the product but that it leveraged its systems-engineering expertise to make manufacturing process design improvements to the finished medical devices, enabling a safe product to be made.

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(j) The Puerto Rico company contributed throughout the design process and had a role in product development. The court found the Puerto Rico company was an integral part of the taxpayer’s operations. The Puerto Rico company’s role was not only to make a safe product, but to make a product that would stand the test of time.

(k) The court found that Heimert’s approach ignored valuable intangible assets that were obtained through the devices and leads licenses because the assets were not recorded on the Puerto Rico company’s balance sheet. The court agreed that his approach was misleading because it ignored the value of the licensed intangibles.

10. Aggregation.

(a) Medtronic contended that the transactions in issue should not be aggregated and that aggregation would treat the Puerto Rico company more like a contract manufacturer, failing to take into account its full role. The IRS contended that aggregating transactions was required.

(b) The court held that the functions at issue in the current transactions can exist independently and that the regulations do not require that the transactions be aggregated. Transections may be aggregated under the regulations if an aggregated approach produces the “most reliable means of determining the arm’s length consideration for the controlled transactions.” Here, the covered transactions are accounted for and priced separately in the marketplace.

(c) Whether the IRS abused its discretion by aggregating transactions involving intangibles, tangible goods, and provision of services is a question of fact. Here, aggregating the transactions did not result in a reasonable determination of true taxable income.

11. Commensurate with Income.

(a) The court stated that the commensurate with income standard under § 482 does not replace the arm’s-length standard. It cited Altera Corp. v. Commissioner, 145 T.C. ___ (2016), and Xilinx, Inc. v. Commissioner, 125 T.C. 37 (2005), aff’d, 598 F.3d 1191 (9th Cir. 2010). Thus, the court held that the IRS’s use of CPM is not required under the § 482 commensurate with income standard and the IRS’s arguments regarding that standard did not change the court’s view that the IRS’s allocations were unreasonable.

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12. Medtronic’s Method.

(a) Medtronic still had to prove that its royalties met the arm’s-length standard. Otherwise, the court would need to determine the proper royalty rates.

(b) Using the comparable uncontrolled transaction (“CUT”) method, Medtronic contended that royalties of 29% of net device intercompany sales and 15% of net leads intercompany sales were arm’s-length. Medtronic contended that a Pacesetter agreement was the best comparable, and had an expert testify in support of those royalty rates.

(c) The court found that those royalty rates were not arm’s length because appropriate adjustments had not been made to the third-party rates to account for variations in profit potential. However, the court did accept Medtronic’s trademark royalty rate.

13. The Court Determines the Royalty Rates.

(a) The court stated that the IRS took an all-or-nothing approach by advocating a result based on CPM using its value-chain method and by refusing to suggest adjustments to Medtronic’s CUT method for the devices and leads royalties. Because of the IRS’s approach, and because the court concluded that neither party’s transfer pricing analysis was reasonable, the court stated that it was left with little help from the parties to determine the proper transfer prices.

(b) The court agreed with Medtronic that the Pacesetter agreement could serve as an appropriate CUT because it involved some of the same intangibles and involved comparable circumstances. However, that agreement’s rate had to be modified because it included a narrower group of intangibles.

(c) The court calculated the royalty rates and determined that an appropriate arm’s-length royalty rate for devices was 44%.1 It concluded that a reasonable royalty rate for the leads was 22%, half of the 44% that it determined for the devices royalties.

1 Medtronic is interestingly similar to Eli Lilly v. Commissioner, 856 F.3rd 855 (7th Cir 1988), in this regard. Both

cases involved a prior cycle transfer-pricing agreement which the IRS sought not to follow in a later audit cycle by increasing the taxpayer’s prices even further. At the end of the day, both courts seemed to have adjusted the taxpayer’s pricing in a matter similar to that which the IRS and the taxpayer had previously agreed, with some tweaking.

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14. Transfer of Intangible Property.

(a) As stated above, the Notice of Deficiency also asserted that alternative income inclusions would be necessary under § 367(d) if the court did not sustain the IRS’s § 482 allocations in their entirety.

(b) Section 367(a) provides general rules for the taxation of outbound transfers of property by U.S. persons to foreign corporate transferees in transactions that would otherwise qualify as nonrecognition transactions, such as § 351 transfers.

(c) The IRS contended that intangible property subject to § 367(d) “must have been” transferred to the Puerto Rico company in 2002 when it was formed. Intangible property subject to § 367(d) is defined in the statute. The court quoted the statutory definition.2

(d) The court stated that the IRS did not identify or allege any specific intangibles that were transferred to the Puerto Rico company. An IRS witness who was a member of the IRS’s 2000-2002 Exam Team stated they did not find that any statutorily-defined intangibles were transferred to the Puerto Rico company in the relevant reorganization transaction. It was during that period that the Puerto Rico company was established in the reorganization of a § 936 subsidiary.

(e) The court stated that the gist of the IRS’s argument seems to be that the Puerto Rico company could not possibly be as profitable as it was unless intangibles were transferred to it. The court was not persuaded by this argument. The court also stated that it was unclear which intangibles the IRS believes are subject to § 367(d).

(f) Thus, the court concluded that it was not persuaded that intangibles were transferred that should be subject to § 367(d).

D. Guidant.

1. Guidant v. Commissioner, 146 T.C. No. 5 (2016), involves a group of U.S. corporations that filed consolidated federal income tax returns during the years in issue (collectively, the “taxpayer”). During those years, the taxpayer consummated transactions with its foreign affiliates. The transactions included the licensing of intangibles, the purchase and sale of manufactured property, and services.

2 The statutory definition does not include goodwill, going concern value and workforce in place. Presumably,

Medtronic agreed to an inclusion in the prior audit cycle because the amounts were quite small.

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2. The IRS utilized § 482 to adjust the reported prices at which items were transferred between the taxpayer and its foreign affiliates. The IRS posted all of the adjustments to the taxpayer’s group parent company without making specific adjustments to any of the subsidiaries’ separate taxable incomes. The IRS also did not determine any portion of the adjustments that related solely to tangibles, intangibles, or services.

3. The taxpayer filed a motion for partial summary judgment asserting that the IRS adjustments were arbitrary, capricious, and unreasonable as a matter of law. The IRS did not determine “true taxable income” of each controlled taxpayer within the group as required under Treas. Reg. § 1.482-1(f)(iv), and did not make specific adjustments with respect to each transaction involving an intangible, a purchase and sale of property, or a provision of services.

4. The court denied the taxpayer’s motion stating that neither § 482 nor the regulations thereunder requires that the IRS must always determine true taxable income of each separate controlled taxpayer within a consolidated group contemporaneously with the making of a § 482 adjustment. The court also held that the IRS is permitted to aggregate one or more related transactions instead of making specific adjustments with respect to each type of transaction.

5. During the examination, the IRS did not spend time or resources to determine member-specific adjustments for each of the taxpayer’s U.S. controlled group members. The Service did not believe that it could independently make reliable member-specific adjustments on the basis of the information available to it. The activities of each group member and the group member’s relationship with the activities of other group members were complex.

6. The court read Treas. Reg. § 1.482-1(f)(1)(iv) to require the IRS to determine both consolidated taxable income and separate taxable income when making a § 482 adjustment with respect to income reported on a consolidated return, but also giving the IRS a certain latitude to decide when the determination of separate taxable income becomes necessary. The court stated that the regulation does not preclude the IRS from deferring making the separate taxable income determinations for each member until the time when such a determination is actually required.

7. According to the court, its reading was consistent with the underlying purpose of both the transfer pricing regulations and the consolidated return regime. The court stated that the taxpayer’s suggested interpretation could completely eliminate the IRS’s ability to make § 482 adjustments when the taxpayer consciously withholds or fails to maintain records or information necessary for separate-company taxable income adjustments:

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“While using the ‘bottom to top’ approach could theoretically yield the most reliable results, we cannot require the Commissioner to use it in cases when taxpayers cannot provide the Commissioner with reliable information for member-specific adjustments. The determination of whether the Commissioner abused his discretion by making ‘top to bottom’ § 482 adjustments beginning at the [consolidated taxable income] level thus depends on the facts and circumstances of a given case.”

8. On the basis of the record before the court, which the court said it must construe favorably to the IRS as the party opposing the motion for partial summary judgment, the IRS’s revenue agents concluded that they were unable to make reliable member-specific adjustments on the basis of the available information.

9. The court stated that while taxpayer argued that it maintained all the necessary information and records to make the separate-company taxable income determinations, it would have been too costly or otherwise difficult for the IRS to extract that information at the time of the audit from the taxpayer’s accounting databases.

10. The court added that whether the IRS’s decision to delay the separate-company taxable income computations constitutes an abuse of discretion under these circumstances is still in dispute and remains to be determined on the basis of the full record as developed at trial.

11. Thus, the court did not conclusively hold that the IRS’s § 482 adjustments were not arbitrary, capricious or unreasonable as a matter of fact. It only held that the IRS’s § 482 adjustments were not arbitrary, capricious, or unreasonable as a matter of law.

12. The taxpayer also argued that the IRS’s § 482 adjustments were arbitrary, capricious and unreasonable because the Service did not make separate adjustments for each transfer of intangible property, transfer of tangible property and provision of services. The applicable regulations in determining the arm’s length consideration lets the IRS aggregate two or more separate transactions to the extent that aggregation serves as the most reliable means of determining the arm’s length consideration for the transactions: Treas. Reg. § 1.482-1(f)(2)(i) provides that the combined effect of two or more transactions may be considered if the transactions, taken as a whole, are so interrelated that the consideration of multiple transactions is the most reliable means of determining the arm’s-length consideration for the controlled transactions.

13. Thus, the court denied the taxpayer’s motion regarding this argument as well. The court closed by stating “Whether respondent abused his discretion by aggregating transactions involving intangibles, tangible

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goods, and provision of services, thus, is a question of fact that should be resolved on the basis of the trial record.”

14. The parties settled their dispute by agreeing to adjustments of $975 million for the 2001-2007 tax years. The IRS agreed to concede alternative adjustments under § 367(d). The case appears to have been resolved for approximately 25% of the total amount asserted, and the settlement likely was motivated by the Tax Court’s decision in Medtronic, discussed above.

E. Other Pending Cases.

1. 3M Company v. Commissioner, T.C. Dkt. No. 5816-13, filed March 11, 2013, involves the IRS’s allocation of royalty income from a Brazilian subsidiary. The taxpayer asserts that the royalties in issue are not permitted under Brazilian law. First Security Bank of Utah v. Commissioner, 405 U.S. 394 (1972) held that if the law prevents the taxpayer from earning certain income, the taxpayer did not have the necessary control that § 482 requires, and an allocation under § 482 would be inappropriate. Subsequently, Proctor & Gamble v. Commissioner, 961 F.2d 1255 (6th Cir. 1992), held that this applies where foreign law is involved, as well. Exxon Corp. v. Commissioner, 66 TCM 1707 (1993), aff’d, Texaco v. Commissioner, 98 F.3d 825 (5th Cir. 1996), followed these cases with respect to Saudi Arabian crude pricing. Treasury and the IRS have tried to reverse these decisions with a regulation issued in 1994: Treas. Reg. § 1.482-1(h). We have long wondered how Treasury and the IRS could write a regulation under § 482 to overrule the Supreme Court’s holding that § 482 does not apply in the first case.

F. New § 482 Regulations. Treasury and the IRS issued temporary and proposed regulations under § 482 at the same time they proposed the § 367 regulations discussed below. They state the new regulation is to coordinate the application of the arm’s length standard and the best method rule under § 482 with other Code provisions. The coordination rules apply to controlled transactions, including those subject in whole or in part to both §§ 367 and 482.

1. Consistent Valuation of Controlled Transactions.

(a) Section 482 authorizes Treasury and the IRS to adjust the results of controlled transactions to clearly reflect the income of commonly controlled taxpayers in accordance with the arm’s-length standard and, in the case of transfers of intangible property (within the meaning of § 936(h)(3)(B)), so as to be commensurate with the income attributable to the intangible.

(b) While the determinations of arm’s-length prices for controlled transactions is governed by § 482, the tax treatment of controlled

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transactions is also governed by other Code and regulatory rules applicable to both controlled and uncontrolled transactions. Controlled transactions always remain subject to § 482 in addition to these generally applicable provisions.

(c) The new temporary regulations provide for the coordination of § 482 with those other Code and regulatory provisions. The new coordination rules thus apply to controlled transactions including controlled transactions that are subject in whole or in part to §§ 367 and 482. Transfers of property subject to § 367 that occur between controlled taxpayers require a consistent and coordinated application of both sections to the controlled transfer of property. The controlled transactions may include transfers of property subject to § 367(a) or (e), transfers of intangible property subject to § 367(d) or (e), and the provision of services that contribute significantly to maintaining, exploiting or further developing the transferred properties.

(d) Treasury and the IRS say the consistent analysis and valuation of transactions subject to multiple Code and regulatory provisions is required under the best method rule described in Treas. Reg. § 1.482-1(c). A best method analysis under § 482 begins with a consideration of the facts and circumstances related to the functions performed, the resources employed, and the risks assumed in the actual transaction or transactions among the controlled taxpayers, as well as in any uncontrolled transactions used as comparables.

(e) For example, states the preamble, if consideration of the facts and circumstances reveals synergies among interrelated transactions, an aggregate evaluation under § 482 may provide a more reliable measure of an arm’s length result than a separate valuation of the transactions. In contrast, an inconsistent or uncoordinated application of § 482 to interrelated controlled transactions that are subject to tax under different Code and regulatory provisions may lead to inappropriate conclusions.

(f) The best method rule requires the determination of the arm’s-length result on controlled transactions under the method, and particular application of that method, that provides the most reliable measure of an arm’s-length result. The preamble also refers to the “realistic alternative transactions” rule and states that “on a risk-adjusted basis” this may provide the basis for application of unspecified methods to determining the most reliable measure of an arm’s length result.

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(g) Based on taxpayer positions that the IRS has encountered in examinations and controversy, Treasury and the IRS are concerned that certain results reported by taxpayers reflect an asserted form or character of the parties’ arrangement that involves an incomplete assessment of relevant functions, resources, and risks and an inappropriately narrow analysis of the scope of the transfer pricing rules. In particular, Treasury and the IRS are concerned about situations in which controlled groups evaluate economically integrated transactions involving economically integrated contributions, synergies, and interrelated value on a separate basis in a manner that results in a misapplication of the best method rule and fails to reflect an arm’s length result.

(h) Taxpayers may assert that, for purposes of § 482, separately evaluating interrelated transactions is appropriate simply because different statutes or regulations apply to the transactions (for example, with § 367 and the regulations thereunder applying to one transaction and the general recognition rules of the Code applying to another related transaction). Treasury and the IRS believe these positions are often combined with inappropriately narrow interpretations of Treas. Reg. § 1.482-4(b)(6), which provides guidance on when an item is considered similar to the other items identified as constituting intangibles for purposes of § 482. The interpretations purport to have the effect, contrary to the arm’s length standard, of requiring no compensation for some value provided in controlled transactions despite the fact that compensation would be paid if the same value were provided in uncontrolled transactions.

2. Compensation Independent of the Form or Character of Controlled Transaction.

(a) New Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(A) provides that arm’s-length compensation must be consistent with, and must account for all of, the value provided between parties in a controlled transaction, without regard to the form or character of the transaction. For this purpose, it is necessary to consider the entire arrangement between the parties, as determined by the contractual terms, whether written or imputed in accordance with the economic substance of the arrangement, in light of the actual conduct of the parties.

(b) Is this not the very BEPS proposal the U.S. fought (is fighting) against? We’re not sure we can reconcile the two U.S. positions here and in BEPS.

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(c) The preamble says this requirement is consistent with the principles underlying the arm’s length standard, which require that arm’s length compensation in controlled transactions equal the compensation that would have occurred if a similar transaction had occurred between similarly situated uncontrolled taxpayers.

(d) This is the very position of the pro-BEPS countries in regard to this provision. There, the U.S. disagrees. Here, Treasury and the IRS like the argument.

3. Aggregate or Separate Analysis.

(a) Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(B) changes (the preamble asserts this is a “clarification”) Treas. Reg. § 1.482-1(f)(2)(i)(A), which provided that the combined effect of two or more separate transactions (whether before, during, or after the year under review) may be considered if the transactions, taken as a whole, are so interrelated that an aggregate analysis of these transactions provides the most reliable measure of an arm’s-length result determined under the best method rule of Treas. Reg. § 1.482-1(c).

(b) Specifically, a new clause was added to provide that this aggregation principle also applies for purposes of an analysis under multiple provisions of the Code or regulations. A new sentence also elaborates on the aggregation principle by noting that consideration of the combined effect of two or more transactions may be appropriate to determine whether the overall compensation is consistent with the value provided, including any synergies among items and services provided.

(c) The temporary regulation does not retain the statement in Treas. Reg. § 1.482-1(f)(2)(i)(A) that transactions generally will be aggregated only when they involve “related products or services.”

(d) Curiously, the Obama Administration proposed a change in the statute to permit this type of aggregation (a “clarification” of the law said the explanation), but that proposal was never enacted. This would seem to raise some questions about Treasury and the IRS’s changing the law by regulations when Congress has declined to act.

4. Aggregation and Allocation for Purposes of Coordinated Analysis.

(a) Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(C) provides that, for one or more controlled transactions governed by one or more provision of the Code and regulations, a coordinated best method analysis and evaluation of the transactions may be necessary to ensure that the overall value provided (including any synergies) is properly taken

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into account. A coordinated best method analysis of the transactions includes a consistent consideration of the facts and circumstances of the functions performed, resources employed, and risks assumed, and a consistent measure of the arm’s length results, for purposes of all relevant Code and regulatory provisions.

(b) For example, situations in which a coordinated best method analysis and evaluation may be necessary include: (1) two or more interrelated transactions when either all of the transactions are governed by one regulation under § 482 or all are governed by one subsection of § 367, (2) two or more interrelated transactions governed by two or more regulations under § 482, (3) a transfer of property subject to § 367(a) and an interrelated transfer of property subject to § 367(d), (4) two or more interrelated transactions when § 367(d) applies to one transaction and the general recognition rules of the Code apply to another interrelated transaction, and (5) other circumstances in which controlled transactions require analysis under multiple Code and regulatory provisions.

(c) Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(D) provides that it may be necessary to allocate the arm’s length result that was properly determined under a coordinated best method analysis described in Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(C) among the interrelated transactions. An allocation must be made using the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result for each allocated amount.

5. Examples of Coordinated Best Method Analysis.

(a) Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(E) provides 11 examples to illustrate the new guidance. Examples 1 through 4 are materially the same as the examples in Treas. Reg. § 1.482-1(f)(2)(i)(B). Treasury and the IRS do not intend for the revisions to those examples to be interpreted as substantive. The rest of the examples are new.

(b) Example 1 is titled “Aggregation of Interrelated Licensing, Manufacturing and Selling Activities.” Example 2 describes an aggregation of interrelated manufacturing, marketing and services activities. Example 3 is titled “Aggregation and Reliability of Comparable Uncontrolled Transactions,” and Example 4 is described as covering non-aggregation of transactions that are not interrelated.

(c) The first new example, Example 5, is titled “Aggregation of Interrelated Patents.” In the example, P owns 10 individual patents that in combination, can be used to manufacture and sell a

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successful product. P anticipates that it can earn $25 from the patents based on a discounted cash flow analysis that provides a more reliable measure of the value of the patents exploited as a bundle rather than separately.

(d) P licenses all 10 patents to S-1 to be exploited as a bundle. Evidence of uncontrolled licenses of similar individual patents indicates that, exploited separately, each license of each patent would warrant a price of $1, implying a total value for the patents of $10. The example states that it would not be appropriate to use the uncontrolled licenses as comparables for the license of the bundle of patents, because, unlike the discounted cash flow analysis, the uncontrolled licenses considered separately do not reasonable reflect the enhancement to value resulting from the interrelatedness of the 10 patents exploited as a bundle.

(e) Example 6, “Consideration of Entire Arrangement, Including Imputed Contractual Terms,” states that P contributes the foreign rights to conduct a business, including foreign rights to certain IP, to newly incorporated S-1. P treats the transaction as a transfer described in §§ 351 and 367. Subsequently, P and S-1 enter into a cost sharing arrangement. P takes the position that the only platform contribution transactions (“PCTs”) in connection with the second transaction (the cost sharing agreement) consist of P’s contribution of the U.S. business IP rights and S-1’s contribution of the rest-of-the-world rights of which S-1 had become the owner due to the prior transaction.

(f) The example states that the IRS may consider the economic substance of the entire arrangement between P and S-1, including the parties’ actual conduct throughout their relationship, regardless of the form or character of the contractual arrangement that the parties have expressly adopted. In the example, the IRS determines that the parties’ formal arrangement fails to reflect the full scope of the value provided between the parties in accordance with the economic substance of their arrangement. Therefore, the IRS may impute one or more agreements between P and S, consistent with the economic substance of their arrangement.

(g) Example 7 is titled “Distinguishing Provision of Value from Characterization.” P developed a collection of resources, capabilities and rights (“Collection”) that it uses on an interrelated basis in ongoing R&D. Under § 351, P transfers certain IP to S-1 related to the Collection. P claims a portion of the property (Portion 1) is subject to § 367(d), and that another portion (Portion 2) is not taxable under § 367. The new temporary regulations are applied to determine the value to P. Whether

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Portion 2 is characterized as “property” under § 367 is irrelevant because any value in Portion 2 must be compensated by S-1 in a manner that is consistent with the new rules.

(h) Examples 8 and 9 also involve multiple transactions regarding § 351 and a cost sharing agreement.

(i) Example 10, “Services Provided Using Intangibles,” states that P’s worldwide group produces and markets product X and subsequent generations of products that result from research and development activity performed by P’s R&D team. Through this collaboration with respect to P’s proprietary products, the members of the R&D team have individually and as a group acquired specialized knowledge and expertise subject to non-disclosure agreements.

(j) P arranges for the R&D team to provide research and development services to create a new line of products, building on the product X platform to be owned and exploited by S-1 in the overseas market. P asserts that the arm’s-length charge for the services is only a reimbursement to P of its associated R&D team compensation costs.

(k) Even though P did not transfer the platform or the R&D team to S-1, P is providing value associated with the use of the platform, along with the value associated with the use of the know-how, to S-1 by way of the services performed by the R&D team for S-1 using the platform and the know-how.

(l) The example states that the R&D team’s use of the intangible property, and any other valuable resources, in P’s provision of services must be evaluated under the § 482 regulations, including the regulations specifically applicable to the controlled services transactions in Treas. Reg. § 1.482-9.

(m) Example 11 deals with “Allocating Arm’s-Length Compensation Determined Under an Aggregate Analysis.” P provides services to S-1. P licenses intellectual property to S-2 and S-2 sublicenses the intellectual property to S-1. The example states that if an aggregate analysis of the service and license transactions provides the most reliable measure of an arm’s-length result, then an aggregate analysis must be performed. If an allocation of the value that results from the aggregate analysis is necessary, for example, for purposes of sourcing the service income that P receives from S-1 or to determine the deductible expenses incurred by S-1, then the value determined under the aggregate analysis must be allocated using the method that provides the most reliable measure of the services income and the deductible expenses.

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6. Effective/Applicability Dates. The regulations apply to taxable years ending on or after September 14, 2015. The preamble contains the usual caveat: No inference is intended regarding the application of the provisions amended by the temporary regulations under current law. The IRS may, when appropriate, challenge transactions, including those described in the temporary regulations, under currently applicable Code or regulatory provisions or judicial doctrines.

G. Annual APA Report.

1. In Announcement 2017-3, 2017-15 I.R.B. 1, the IRS released its annual report on APAs for calendar year 2016. Fewer APAs were executed in 2016 than in 2015 and it took slightly more time to complete them. The IRS executed 86 APAs in 2016 compared with 110 in 2015, 49 were renewals and 37 were new APAs. Of the renewals, 32 were bilateral and 17 were unilateral. Of the new APAs, 33 were bilateral and 4 unilateral.

2. Perhaps even more interesting: APA applications filed in 2016 (98) were almost 50% less than APA applications filed in the prior year (183). We wonder whether this might be a result of European state aid assertions, Eaton’s APA revocation or BEPS.

3. APAs executed with Japan constituted 54% of bilateral APAs. Canada accounted for another 20%. Thus, nearly three quarters of the total number of bilateral APAs executed in 2016 involved the U.S. entering into mutual agreements with either Japan or Canada. Interestingly, only 9% of identified-country APAs were with EU countries.

4. Of the bilateral APAs filed in 2016, 31% of involved Japan and 34% involved India. It’s interesting that India jumped to number 1. No other country accounted for more than 8%. Interestingly, only 11% were filed regarding identified EU countries.

5. There was a surprising number of withdrawn APAs during 2016: 24. This was the most since 2002 when 26 were withdrawn. In 2015, only 10 APA requests were withdrawn, and in 2014 only 1 request was withdrawn.

6. The number of pending APAs dropped slightly. Japan and Canada continued to account for more than half of the pending bilateral APA requests in 2016.

7. Inbound APAs (non-U.S. parent and U.S. subsidiary) accounted for 65% of the APAs executed in 2016 and outbound APAs (U.S. parent and non-U.S. subsidiary) accounted for 20%, excluding the categories of “sister companies.”

8. The majority of APAs executed in 2016 involved the sale of tangible goods and the provision of services. The Announcement states that

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transactions involving intangibles may be more challenging and represent a smaller percentage of the covered transactions in 2016 (20 percent), the IRS continues to seek opportunities to work with taxpayers and treaty partners to provide prospective certainty for such transactions wherever appropriate.

9. New unilateral APAs in 2016 took on average nearly three years to be issued, and new bilateral APAs took over four years on average to be issued. Renewal APAs in each case took a somewhat shorter time. Unilateral APA renewals took slightly short of two years and bilateral renewals took slightly short of three years.

H. Analog Devices: Section 482.

1. Analog Devices, Inc. (“ADI”) repatriated cash dividends from one of its foreign subsidiaries, a controlled foreign corporation, (the “CFC”) and claimed an 85% § 965 dividends received deduction for 2005. ADI reported no related party indebtedness during its testing period pursuant to § 965(b)(3).

2. The IRS determined that the annual 2% royalty received by ADI from CFC should be increased to 6% for 2001 – 2005. ADI agreed with the proposed adjustment. In 2009, ADI and the IRS executed a closing agreement pursuant to Rev. Proc. 99-32, 1999-2 C.B. 296, to effect the secondary adjustments required after a primary § 482 allocation. The closing agreement established accounts receivable pursuant to the revenue procedure and deemed them created as of the last day of the taxable year to which they relate. The IRS subsequently determined that the accounts receivable constituted an increase in related party indebtedness under § 965(b)(3) during ADI’s testing period, which the IRS determined decreased ADI’s § 965 DRD.

3. The Tax Court held that the parties did not reach an agreement in the closing agreement regarding the treatment of the accounts receivable under § 965. The court further held a § 965(b)(3) does not provide that the accounts receivable constituted related party indebtedness arising during ADI’s testing period. Thus, the accounts receivable did not increase CFC’s related party indebtedness during the testing period.

4. Previously, the Tax Court had determined in BMC Software Inc. v. Commissioner, 141 T.C. 224 (2013), (“BMC I”) that in such a situation taxpayer’s DRD was reduced. The Fifth Circuit reversed at 780 F.3d 669 (5th Cir. 2015) (“BMC II”). The Tax Court stated that BMC II is not binding in the instant case in which an appeal would lie to the First Circuit. However, the Tax Court stated that given the reversal and the parties’ arguments, the instant case required the court to revisit its analysis in BMC I.

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5. The court concluded that the important goals of stare decisis to ensure that “evenhanded, predictable, and consistent development of legal principles” and to “foster reliance on judicial decisions” are not served by the court’s continued adherence to its previous opinion. The court stated there has been no predictable or consistent development of the legal principles affecting the current case.

6. On balance, the Tax Court concluded that the importance of reaching the right result in ADI outweighed the importance of following the court’s precedent. The decision in favor of ADI was “reviewed by the court” with the judges voting 13-4 to reverse BMC I.

7. The parties entered into a closing agreement against the backdrop of longstanding caselaw holding that “a court may not include as part of the agreement matters other than the matters specifically agreed upon and mentioned in the closing agreement.”

8. A caption taken verbatim from the IRS’s pattern agreement regarding Rev. Proc. 99-32 is not a matter to which the parties specifically agreed. It is not a determined clause that binds the parties, but rather an introductory clause that signals the transition from the recitals to the determined clauses. Therefore, giving the phrase “for all federal income tax purposes” a literal application would be to ignore the court’s mandate to interpret a contract in context and would broaden the scope of the closing agreement beyond that which the parties intended.

9. That the closing agreement provided in a recital that it applied “for all federal income tax purposes” was the focus of the four dissenting judges who felt that this language meant that § 965 was included within the parties’ agreement.

10. The majority, however, held that when the parties signed the closing agreement they did not manifest an intent with respect to § 965(b)(3). The court’s opinion states that the dissent would have the court give the phrase “for all federal income tax purposes” a literal interpretation and ignore the intent of the parties. The parties signed a closing agreement that enumerated specific tax consequences, and § 965 was not specifically enumerated. A literal interpretation of the boilerplate “for all federal income tax purposes” would render surplusage the provisions of the closing agreement that listed the transaction’s tax implications in considerable detail.

11. The court also read the holding in Schering Corp. v. Commissioner, 69 T.C. 579 (1978), to be consistent with its holding in ADI. In Schering, a U.S. corporation entered into a Rev. Proc. 65-17 closing agreement that established accounts receivable to effect secondary adjustments between the corporation and its Swiss CFC. The taxing authority in Switzerland

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considered the CFC’s payment of the accounts receivable to be a taxable dividend, and the CFC paid Swiss tax as a withholding agent for its U.S. parent corporation.

12. Although Schering’s closing agreement stated that the repatriation would be free of federal income tax consequences, the Tax Court allowed the taxpayer in that case to claim a § 901 foreign tax credit with respect to the Swiss withholding tax. In doing so, the court looked to the structure and context of the closing agreement as a whole and held that the phrase “free of further federal income tax consequences” showed only the parties’ intent that the taxpayer would not have gross income upon receipt of the CFC’s payment of the account “and that it was not intended to determine any collateral tax consequences disadvantageous to the [taxpayer] which might ensue upon the payment of that sum.” The Tax Court read the disputed phrase in Shering in context rather than applying a literal interpretation that would expand the closing agreement past its intended scope. This is the same approach the court took in ADI.

13. The IRS contended that if the closing agreement is ambiguous, the taxpayer had reason to know of the IRS’s intent to treat the accounts receivable as related party indebtedness because the IRS stated that position (1) in Notice 2005-64, § 10.06, 2005-2 C.B. 471,3 and (2) to the taxpayer orally in the Service’s notice of proposed adjustment.

14. Assuming arguendo that the taxpayer knew or had reason to know of the IRS’s position, the court disagreed that the taxpayer should be bound to the IRS’s interpretation of the closing agreement. Under the Internal Revenue Manual, “unless the taxpayer’s agreement to an issue is fully documented by the signing of Form 870, the issue will be treated as unagreed.” ADI did not agree to the adjustments, which put the IRS on notice that ADI did not agree with the Service’s position regarding § 965.

15. Even assuming that the taxpayer knew of the IRS’s interpretation of the closing agreement, the court stated the IRS had reason to know of the taxpayer’s understanding as well. Both parties were aware before the execution of the closing agreement that § 965(b)(3) was an issue, yet the closing agreement did not include any provision addressing it. The extrinsic evidence shows that the parties did not reach an agreement with respect to § 965(b)(3). The court stated that it would not read a term into the closing agreement to which the parties did not agree.

16. In BMC II, the Fifth Circuit also held that the closing agreement did not alter the application of § 965 due to the timing requirement of that

3 Notice 2005-64 § 10.06 includes one sentence stating the “[a]ccounts payable” established under Rev. Proc. 99-

32 are treated as related party indebtedness for purpose of § 965(b)(3). The court noted that the notice does not include any analysis of this statement.

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provision. The Fifth Circuit stated that § 965(b)(3) specifically requires that the determination of the final amount of indebtedness be made “as of the close of the taxable year for which the [§ 965] election . . . is in effect.” The Fifth Circuit held that “as of” 2006 the account receivable did not exist and indeed could not have existed until the signing of the closing agreement in 2007, after the testing period had closed.

17. The Tax Court in ADI agreed with the Fifth Circuit that the indebtedness must have existed “as of” the close of the election year. ADI’s testing period closed long before the execution of its Rev. Proc. 99-32 closing agreement, and the account receivable did not exist before the closing agreement. Therefore, the only way in which the accounts receivable could have been established “as of” the close of ADI’s election year is if the closing agreement’s deemed established date applied to the application of § 965(b)(3). The court had already held that the parties did not reach an agreement in their Rev. Proc. 99-32 closing agreement with respect to § 965(b)(3).

18. The court also noted that a representative from CFC did not sign the Rev. Proc. 99-32 closing agreement and that CFC was not a party to the agreement. Parties are not contractually bound until they mutually assent to bind themselves to an agreement. Section 965(b)(3) addresses only related party “indebtedness of the controlled foreign corporation.” Because the Rev. Proc. 99-32 closing agreement established the accounts receivable and the CFC was not a party to that agreement, the accounts receivable also cannot be indebtedness “of the controlled foreign corporation.”

19. The parties also briefed the issue regarding the “trade payables” exception, that is, if there were such an account payable, whether the “trade payables” exception under § 965(b)(3) would apply. The court stated that it did not reach the parties arguments regarding the trade payables exception.

II. EUROPEAN COMMISSION: U.S. CONCERNS.

A. Apple.

1. Apple was ordered to pay a record 13 billion Euros ($14.5 billion) in purportedly unpaid taxes plus interest as a result of a European Commission assertion that the company had received state aid from Ireland. State aid requires “selective tax treatment” that would provide the beneficiary with a “significant advantage over other businesses.”

2. Apple had entered into an advance pricing agreement (APA) with Ireland to provide tax certainty. This is a contract between the taxing authority and the taxpayer. A similar APA would seem to have been available to

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others on similar facts. Apple U.S. and the subsidiary in issue had also cost-shared development of the relevant intangibles for 30 years. The subsidiary owned the foreign rights to those intangibles. The OCED Transfer Pricing Guidelines recognized, and recognize, cost-sharing regimes. Cost-sharing, of course, also is available to others. The Commission seemingly ignored these very important facts, and has left chaos in its wake.

3. Apple and the Irish government both vowed to fight the decision, which also risks a U.S-Europe fight over taxation policies.

4. The U.S. Treasury Department has pushed against the European Commission’s state aid probes, most recently with a white paper that said the European Commission had overextended its legal authority and threatened global tax reforms. The white paper states that the Commission’s approach is new and departs from prior EU caselaw and Commission decisions. It states that the Commission also should not seek retroactive recoveries under its new approach. Further, the Commission’s new approach is inconsistent with international norms and undermines the international tax system. We agree.

5. The white paper discusses the Apple situation. It states the Commission initiated an investigation of advanced pricing agreements provided by the Irish tax authorities regarding the attribution of profits to the Irish branch of an Irish company that under Irish law was treated as a non-resident for Irish tax purposes because it was not managed or controlled in Ireland. The white paper also discusses the EC’s attacks on certain other companies. In each case, the company had an APA with the relevant taxing authority.

6. Treasury states that the Commission’s actions undermine the United States’ efforts in developing transfer pricing norms and implementing the BEPS project. The Commission’s actions also call into question the ability of EU member states to honor their bilateral tax treaties with the United States.

7. The white paper further states there is the possibility that any repayments ordered by the Commission will be considered foreign income taxes that are creditable against U.S. taxes owed by Apple and other U.S.-parented companies under attack. If so, the companies’ U.S. tax liability would be reduced dollar for dollar by these recoveries when their offshore earnings are repatriated or treated as repatriated as part of possible U.S. tax reform. To the extent that these foreign taxes are imposed on income that should not have been attributable to a relevant EU member state, this outcome is deeply troubling, as it would effectively constitute a transfer of revenue to the EU from the U.S. government and its taxpayers.

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8. Further, the white paper states that although currently there are only three cases involving transfer pricing arrangements obtained by U.S.-headquartered companies, the Commission has suggested that it is still evaluating other tax rulings and may initiate more cases. A substantial number of additional cases against U.S. companies may lead to a growing chilling effect on U.S.-EU cross-border investment.

9. Treasury states that the U.S. Congress has made similar assessments regarding the effect the Commission’s investigations may have on U.S. interests. In one letter, the chairman, ranking member and other members of the U.S. Senate Committee on Finance stated that “the United States has a stake in these cases and has serious concerns about their fairness and potential impact on the U.S. fisc.” They also stated that “these investigations raise serious questions about our ability to rely on bilateral tax treaties negotiated with EU member states.”

10. The EC departed from its past practice of examining whether an advantage has been given and the selective nature of the measure. In the opening decisions in Apple and Amazon, the Commission found that selectivity was met simply because the ruling deviated from the arm’s-length principle. In the Starbucks and Fiat final decisions, the Commission was even more explicit, stating that “where a tax measure results in an unjustified reduction of the tax liability of the beneficiary who would otherwise be subject to a higher level of tax under the reference system, that reduction constitutes both the advantage granted by the tax measure and the derogation from the system of reference.”

11. Treasury states that previously, selectivity was often considered the “decisive criterion.” In the context of individual transfer pricing rulings, the selectivity is a key hurdle for the Commission to overcome because individual rulings are generally available to any taxpayer and are granted based on an application of member state tax law.

12. In these recent state aid cases, the Commission challenges neither the member states’ practice of granting transfer pricing rulings or the substance of member states’ actual transfer pricing laws. Rather, the Commission challenges the substance of particular member state rulings; specifically, whether the arm’s-lengths prices described in the rulings were accurately determined. The Commission’s challenge is based not on the arm’s-length standard as enshrined in member state law, but on the Commission’s own arm’s-length standard, which has never before been articulated. Not only is this application of state aid law new, but taxpayers and member states could not have foreseen that the Commission would apply this new standard.

13. It seems reasonably clear that Apple did not receive special and favorable treatment compared to other multinational businesses in Europe. Many

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observers believe that the real purpose why these investigations started was not because there was a concern about distortion of competition in the EU market, but because the Commission wanted to take on tax avoidance as its mantra. We believe this. State aid, however, requires the Commission to separately consider if a business received an advantage and if that advantage was granted on a selective basis.

14. In our view, European Competition Commissioner Margrethe Vestager does not understand cost-sharing, or know or care about the OECD Transfer Pricing Guidelines. After all, she is the EU Competition Commissioner, not a tax expert. She also probably has no idea about the thousands of APAs that exist in the world, or their importance to tax certainty and tax transparency. Her actions may have destroyed the worldwide APA system, at least in the EU. Certainly no one in Europe can safely rely on an APA anymore.

15. As an Apple spokesperson said, the Commission is “effectively proposing to replace Irish tax laws with a view of what the Commission thinks the law should have been.”

16. US House and Senate members have voiced frustration and concern about the European Commission’s announcement. In a report by Dylan Moroses, at 206 TNT 169-2, he quotes House Ways and Means Committee Chair, Kevin Brady (R-Texas), calling the ruling “a predatory and naked tax grab.” Senate Finance Committee Chair, Orrin Hatch (R-Utah), called the ruling “inherently unfair.” House Speaker Paul Ryan (R-Wis) called the ruling “awful” and “in direct violation of many European countries’ treaty obligations.” He added that what the Commission has done “sends exactly the wrong message to job creators on both sides of the Atlantic.”

17. In the past, some members of Congress urged the U.S. government to consider retaliatory action under § 891 (below). The EC’s Apple decision only makes matters worse.

B. EC State-Aid Assertions.

1. A bipartisan group of U.S. senators urged the U.S. Treasury on May 23 to put pressure on the European Commission (“EC”) to keep it from issuing rulings that would target U.S. multinational companies in its ongoing state-aid investigations. The text of the letter can be found at 2016 TNT 100-24.

2. The four Senate Finance Committee Members expressed disappointment that EC officials have dismissed their concerns. They specifically criticized EU Competition Commissioner Margrethe Vestager, who stated that the European Commission is now using state-aid as one if its “tools”

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to achieve a “reform agenda.” The senators’ letter states that this “confirms our [the U.S. senators’] suspicion that these cases are about more than objectively enforcing existing competition policies. The retroactive effect of the state aid investigations contradicts the notion of reform, and any retroactive application of a ‘reform agenda’ is improper and plainly undermines legal certainty and the rule of law.”

3. The Senators also accused the EC of establishing its own transfer pricing rules and of ignoring the national practice and law of its member states. As a result, the Senators said that they believe the U.S. needs to determine for itself the implications of the EC being the final arbiter of how its member states apply international tax standards as part of their own tax laws and what actions should be taken in response.

4. An EC policy document on state aid specifically refers to the collection of “back taxes as to be eligible for foreign tax credits” in non-EU countries. The senators’ letter states that this demonstrates the EC’s intended result is to have U.S. taxpayers “foot the bill.” This helps form the basis for the Senators’ view that the EC’s actions are a direct threat against U.S. interests.

5. Stephanie Soong Johnston (TNI Dec. 21, 2015, p. 1020) quoted Bob Stack of the U.S. Treasury Department discussing the European Commission’s other ongoing state aid investigations in one of her reports. Stack expressed concern that in these investigations the European Commission is effectively saying, “We are the final arbiter in the EU whether the transfer pricing judgments of the member states are correct or not.” Stack added, “And if that’s true, it has much broader implications for [the U.S.’s] dealings with [its] treaty partners in the EU.”

6. Stack pointed out that 4 of 5 companies involved in these ongoing investigations are U.S. taxpayers. He said that when the EU is applying the law, “It just seems to defy mathematics that the only people who run afoul of it happen to be U.S. taxpayers.” Stack said the U.S. government has expressed its concerns to the Commission and continues to advocate for U.S. companies. American taxpayers may end up footing the bill for any state aid the Commission orders countries to recover from the companies in question.

7. Johnston quoted Stack as saying he wasn’t aware of any auditor, attorney, tax advisor, or government that would have said a few years ago that if the transfer pricing is wrong in a tax ruling, it’s considered state aid. He asked, “Does it meet our notions of fairness?”

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C. More on EU State Aid Assertions.

1. A bipartisan group of Senators, including the chairman and ranking member of the Senate Finance Committee wrote to the U.S. Department of Treasury urging the Administration to consider retaliatory tax hikes in response to the European Commission’s state aid assertions. They stated “It alarms us that the EU Commission is using a non-tax forum to target U.S. firms essentially to force its member states to impose taxes, looking back as far as 10 years, in a manner inconsistent with internationally accepted standards in place at the time. By all accounts, these cases have taken the member states, companies, and their advisors by surprise.” They urge the Administration to consider retaliatory action under § 891.

2. Mindy Herzfeld reported on the EU Commission’s newest state-aid attack, “Belgian Excess Profits, the Commission Strikes Again.” Tax Notes International Jan. 25, 2016. She notes that the Commission’s Belgian decision differs from earlier Commission’s attacks finding illegal state aid in other tax rulings. In contrast to its earlier actions, the EU Commission’s latest decision invalidates a key provision of the Belgian corporate income tax law, implemented via ruling practice.

3. The Commission’s attack on the Belgian excess profits ruling system raises yet additional serious concerns. The EC communique states: “The Commission’s in-depth investigation showed that by discounting ‘excess profits’ from a company’s actual tax base, the scheme derogated from … the arm’s-length principle under EU state aid rules.” This has caused some practitioners to ask, “Can there be several arm’s-length principles? Or is this just the way the European Commission would like the arm’s-length principle to be applied?” There certainly shouldn’t be more than one arm’s-length standard.

4. Bob Stack met with EU officials in Brussels to personally deliver the message that recent European Commission state aid investigations unfairly target American companies. EU Competition Commissioner Margrethe Vestager stated that she is not singling out American companies. However, most multinational enterprises that have been targeted are American.

D. More on EC State Aid Assertions: Treaties.

1. In another report by Herzfeld (TNI Dec. 14, 2015, p. 879), she discussed the Commission’s investigation regarding whether certain rulings granted by Luxembourg concerning finance branches constitute illegal state aid. In this investigation, the Commission apparently believes that it has the power to overrule a country’s interpretation of internationally agreed upon tax rules. Bob Stack suggested in testimony to the House Ways & Means Tax Policy Subcommittee that the U.S. needs to question the value of its

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bilateral tax treaties with EU members if those agreements can seemingly be overturned by an administrative commission with supranational authority.

2. The structure in question involves a Luxembourg company allocating assets to a U.S. branch that Luxembourg deems to constitute a permanent establishment in the U.S. but which the U.S. does not recognize as subject to U.S. tax. This would seem to us more like an issue the two countries should resolve than one on which the overarching European Commission should be focused.

E. More on EC and Treaties.

1. In November, the European Commission found that the limitation on benefits article in the Netherlands treaty with Japan violated (infringes on) the fundamental freedoms of the Treaty on the Functioning of the European Union. The case may find its way to the EU Court of Justice.

2. As discussed in an excellent report by Mindy Herzfeld (TNI Jan. 4, 2016, p. 13), the decision could have implications for the United States. The Japan-U.S. treaty is similar to virtually all U.S. treaties with EU countries. The LOB article in the Japan-Netherlands treaty contains a derivative benefits clause that EU members thought might protect them from EU challenges.

3. According to the Commission, an EU state cannot, under a treaty with a third country, agree to more favorable treatment for companies held by shareholders resident in its own territory than for comparable companies held by shareholders who are resident elsewhere in the EU and the European Economic Area (“EEA”). An EU state also cannot agree to provide better conditions for companies traded on its own stock exchange than for companies traded on stock exchanges located elsewhere in the EU and the EEA.

4. The Commission’s holding not only affects all U.S. treaties with EU member countries but conceivably also could implicate BEPS Action #6, which states that treaties should have a limitation on benefits provision or a more general anti-abuse rule based on the principal purpose of transactions or arrangements (the “PPT” rule). The U.S. Senate has already rejected proposed treaties containing PPT rules.

5. More likely, however, the U.S.’s treaties with EU countries can be amended to satisfy the Commission’s decision if it is upheld in the Court of Justice, or if the Netherlands agrees to renegotiate its treaty with Japan and others follow this course of action. The U.S.’s treaties with EU countries would remain in effect. They simply would need to be renegotiated.

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F. EU Anti-Tax Avoidance Directive.

1. The EU Council approved the EU Anti-Tax Avoidance Directive (“ATAD”). This is a significant development. It contains a number of BEPS-related provisions.

2. The European Commission’s original proposals covered six key areas, including controlled foreign company (CFC) rules, a switchover clause, exit taxation, interest limitation rules, hybrid mismatches and a general anti-avoidance rule (“GAAR”). The Directive also defines terms such as permanent establishment, tax havens and minimum economic substance.

3. The switchover clause was removed as a part of a compromise agreement. The rule would have required member states to apply a credit system instead of offering an exemption for certain types of foreign income that originate from third countries.

4. Other compromises move the proposal nearer to the final BEPS Reports. For example, the hybrid rule, which previously required the primary response to be inclusion in income rather than denial of a deduction, has been resolved in favor of the BEPS approach.

5. The interest deductibility provision in the ATAD became controversial. BEPS recommends implementing a fixed-ratio approach that can be supplemented by a worldwide group ratio, which allows an entity to exceed the fixed ratio in certain circumstances.

6. To resolve concerns and reach consensus on ATAD, the Directive provides a transition period of five years to implement Article 4 of the ATAD. This means that EU member states would be able to incorporate the interest-deduction limitation rules in national legislation effective 2024, rather than the general 2019 deadline. The compromise also permits member states to implement a grandfather clause to facilitate the transition to the new interest limitation rules.

7. Member states will have until December 31, 2018 to incorporate the directive into their national laws and regulations, except for the exit taxation rules. They will have until December 31, 2019 to implement those rules.

8. Certain U.S. congresspersons were concerned that the EU was moving full speed ahead to implement the OECD’s BEPS recommendations and that this will make it more difficult for American companies to compete in the global market. One Congressman said that “we must be doing more to ensure that American companies are able to compete in the global marketplace and not suffer a slanting of the playing field against them.”

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G. Further U.S. Comments on the European Commission.

1. Bob Stack of the U.S. Treasury was quoted on December 6, 2016 as stating that the European Commission’s (“EC”) state aid decisions and policies have done “immeasurable damage” to multilateral cooperation in taxation, report by Ryan Finley at 2016 TNT 234-5. Stack also stated the EC and EU member state officials have used carefully negotiated standards on country-by-country (CbC) reporting, permanent establishment, and the continued use of the arm’s-length principle as a minimum baseline only. This undermines the creditability of EU member states’ commitments and will make future multilateral action more difficult.

2. Stack said that “the ink wasn’t dry” on our agreement to exchange country-by-country data among tax authorities when folks in the EU decided, “You know what? Let’s take that one better and do that on a public basis.” Stack asked “Why would you show up in that atmosphere and agree to anything if you knew that your hard-fought agreement and compromises are simply going to be used as a floor?”

3. Stack also criticized the EC’s state aid decisions for retroactively applying a new rule and applying the arm’s-length principle in a way that differs from OECD guidance. He said this is particularly troubling given EU member states’ disproportionate representation on the OECD’s Committee for Fiscal Affairs. (“CFA”).

4. Stack said the CFA is a European-dominated institution. They have 22 of the 35 members and they are the largest block in this new inclusive framework that we have to implement BEPS. Yet, they’ve sat there in utter silence as the EC has eviscerated the arm’s-length standard and imposed retroactive rules on multinationals, and they continue to argue that the CFA should have a role in shaping tax policies.

III. SUBPART F.

A. Final Section 956 Regulations: Anti-Avoidance Rules.

1. Treasury and the IRS finalized the anti-avoidance regulation, generally as proposed. However, the final rules are located at Treas. Reg. § 1.956-1(b)(1)(ii) and (iii). These rules have their origin in temporary regulations issued in 1988. Previously, the temporary regulations provided that at the IRS’s discretion, a controlled foreign corporation (“CFC”) will be considered to hold indirectly investments in U.S. property acquired by any other foreign corporation that is controlled by the CFC if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) the other foreign corporation is to avoid the application of § 956 with respect to the CFC.

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2. As finalized, the anti-avoidance rules can also apply when a foreign corporation controlled by a CFC is funded by any means, including through capital contributions or debt. They also can apply in a partnership context. The regulations provide that for purposes of § 956, U.S. property held indirectly by a CFC includes:

(a) United States property acquired by any other foreign corporation that is controlled by the CFC if a principal purpose of creating, organizing or funding by any means (including through capital contributions or debt) the other foreign corporation is to avoid the application of § 956 with respect to the CFC; and

(b) Property acquired by a partnership that is controlled by the CFC if the property would be U.S. property if held directly by the CFC, and a principal purpose of creating, organizing or funding by any means (including through capital contributions or debt) the partnership is to avoid the application of § 956 with respect to the CFC.

3. Example No. 3 in the final regulations illustrates that the CFCs’ relative tax attributes associated with the § 956 inclusion (such as total earnings and profits, previously taxed earnings and profits, and foreign tax pools) can be taken into account in determining whether a principal purpose of the funding was to avoid the application of § 956 with respect to the funding CFC. The example also clarifies that if the funding CFC is considered to indirectly hold U.S. property pursuant to Treas. Reg. § 1.956-1(b)(4), then the CFC that actually holds the U.S. property, the funded CFC, will not considered to hold the property for purposes of § 956.

4. Treasury and the IRS expressed the view that the “tax avoidance” requirement ensures that ordinary course business transactions are not subject to the anti-avoidance rules. However, they also added two new examples to illustrate that the anti-avoidance rule should not apply to certain common business transactions, because those transactions are not considered to constitute a “funding” of the related foreign corporation. Examples 5 and 6 illustrate this point with a sale of property for cash in the ordinary course of business and the repayment of a loan, respectively, to which the anti-avoidance rules do not apply. Each example states that the transaction in question does not constitute a funding.

5. New Example 4, on the other hand, incorporates the holding in Situation 3 of Rev. Rul. 87-89, 1987-2 C.B. 195. A CFC could be treated as holding U.S. property as a result of a deposit with an unrelated bank if the unrelated bank would not have made a loan to a person related to the CFC (the U.S. parent company or a second CFC) on the same terms absent the

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first CFC’s deposit. The addition of Example 4 would not seem to be a change of substance in the regulations.

6. The provision requiring an exercise of the IRS’s discretion was eliminated. The regulations are now self-executing. This was in the 2015 proposed regulations, as well.

7. A commenter expressed a concern that a CFC could be treated as holding duplicative amounts of U.S. property by an application of both the anti-avoidance rule and the new partnership obligation rules of Treas. Reg. § 1.956-4(c) (discussed below). In response, the coordination rules were expanded in final Treas. Reg. § 1.956-1(b)(3) to prevent a CFC from being treated as holding duplicative amounts of U.S. property. A new example (Example 8) illustrates this rule.

8. The § 956 anti-avoidance rules in Treas. Reg. § 1.956-1(b) apply to taxable years of CFCs ending on or after September 1, 2015, and to taxable years of U.S. shareholders in which or with which those taxable years end, with respect to property acquired, including property treated as acquired as a result of a deemed exchange of property pursuant to § 1001, on or after September 1, 2015.

B. Final Section 956 Regulations: Factoring. In 1988, Treasury and the IRS proposed Treas. Reg. § 1.956-3 to address the application of § 956 to property acquired by a CFC in certain related-party factoring transactions. The regulation was also issued as a temporary regulation. The 2015 proposed regulations proposed certain, relatively minor revisions to the proposed/temporary rules in § 1.956-3(b)(2)(ii) regarding the use of a nominee, pass-through entity or related foreign corporation. No comments were received, and the 1988 and 2015 proposed regulations were adopted as final. The 1988 proposals are effective back to 1984. However, these rules were already effective back to 1984 as temporary regulations.

C. Final Section 956 Regulations: Partnerships. In 2015, Treasury and the IRS proposed a number of regulatory changes addressing § 956 in the context of partnerships. These proposed regulations were finalized generally as proposed, but with some substantive changes.

1. Partnership Property. Under Treas. Reg. § 1.956-4(b)(2), a CFC partner’s attributable share of partnership property is determined in accordance with the partner’s liquidation-value percentage with respect to the partnership, unless the partnership agreement contains a special allocation of income (or, where appropriate, gain) regarding a particular item or items of partnership property that differs from the partner’s liquidation-value percentage in that particular taxable year. In that case, the partner’s attributable share of the property is determined solely by reference to the partner’s special allocation regarding the property, provided the special

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allocation does not have a principal purpose of avoiding the purposes of § 956. This special allocation rule will be changed, however, by a newly proposed regulation when that regulation is adopted as final. This is discussed below.

2. Partnership Obligations.

(a) New Treas. Reg. § 1.956-4(c) generally treats an obligation of a foreign partnership as an obligation of its partners for purposes of § 956. This is perhaps the most important part of the new § 956 partnership regulations. If a CFC lends funds to a foreign partnership in which the CFC’s U.S. parent company is a partner, the CFC will be treated as holding an obligation of a U.S. person, and thus as having made a § 956 investment.

(b) More specifically, Treas. Reg. § 1.956-4(c)(1) generally treats an obligation of a foreign partnership as an obligation of its partners to the extent of each partner’s relative share of the obligation as determined in accordance with the partner’s liquidation-value percentage. The proposed regulations would have determined a partner’s share of a partnership obligation in accordance with the partner’s interest in partnership profits. Liquidation value was used in the proposed regulations for partnership property; the rule for partnership obligations was conformed to that rule.

(c) This rule raises interesting issues. Section 956 requires that a CFC must hold an “obligation of a U.S. person.” If the entity is a corporate-type limited-liability entity checked for U.S. tax purposes into partnership status, how can a U.S. partner be an obligor on the obligation? There would not seem to be an obligation of a U.S. person. Obviously, the regulation’s writers ignored this detail.

3. Partnership Obligations: The Funded-Distribution Rule.

(a) Treasury and the IRS also finalized the special funded-distribution rule The rule will operate to increase the amount of a foreign partnership obligation that is treated as U.S. property (and a lending CFC’s § 956 investment as a result of a loan to that partnership) when the following requirements are satisfied: (i) the CFC lends funds (or is a pledgor or guarantor regarding a loan) to a foreign partnership whose obligation is, in whole or in part, U.S. property regarding the CFC pursuant to Treas. Reg. § 1.956-4(c)(1); (ii) the partnership distributes an amount of money or property to a partner that is related to the CFC and whose obligation would be U.S. property if held (or treated as held) by the CFC; (iii) the foreign partnership would not have made the

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distribution but for a funding of the partnership through the obligation held (or treated as held) by the CFC; and (iv) the distribution exceeds the partner’s share of the partnership obligation as determined in accordance with the partner’s interest in the partnership.

(b) Comments suggested that taxpayers might take the position that the “but for” requirement is not satisfied in certain situations in which a CFC’s earnings are effectively repatriated to a partner that is related U.S. person. For example, taxpayers might take the position that a partnership distribution could have been made without the funding by the CFC merely by establishing that a third party would have loaned the funds needed for the partnership to make the distribution.

(c) The preamble states that such a position would be inconsistent with the purposes of the rule. Accordingly, the final regulations clarify the funded-distribution rule by providing that the “but for” requirement in Treas. Reg. § 1.956-4(c)(3) will be treated as satisfied to the extent the partnership did not have sufficient liquid assets to make the distribution immediately prior to the distribution, without taking into account the obligation.

(d) When a CFC holds (or is treated as holding) multiple obligations of the foreign partnership to which this rule would potentially apply, its applicability is determined first with respect to the obligation acquired (or treated as acquired) closest in time to the distribution, and then successively to other obligations further in time from the distribution until the distribution is fully accounted for.

4. Determining the Partner’s Liquidation-Value Percentage.

(a) A comment recommended that a partner’s liquidation-value percentage in a partnership should be determined on an annual basis, rather than upon formation and upon the occurrence of the relevant § 704 events (“revaluation events”) as proposed in § 1.956-4(b)(2)(i).

(b) Treasury and the IRS state that it is appropriate for a partner’s liquidation-value percentage to be determined upon a revaluation event, which may result in a significant change in the partner’s relative economic interest in the partnership. Accordingly, upon a revaluation event, the partnership is required to determine the partnership’s capital accounts resulting from a hypothetical book-up at that point in time even if the partnership did not actually book-up capital accounts in connection with the event.

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(c) However, in light of a commenter’s observation that partners’ relative economic interests in the partnership may change significantly as a result of allocations of income or other items under the partnership agreement even in the absence of a revaluation event, Treas. Reg. § 1.956-4(b)(2)(i) provides that a partner’s liquidation-value percentage must be determined in certain additional circumstances.

(d) Specifically, if the liquidation-value percentage determined for any partner on the first day of the partnership’s taxable year would differ from the most recently determined liquidation-value percentage of that partner by more than 10 percentage points, then the partner’s liquidation-value percentage must be redetermined on that day even in the absence of a revaluation event. For example, if the partner’s liquidation-value percentage was determined upon a revaluation event to be 40% and, on the first day of a subsequent year before occurrence of another revaluation event, would be less than 30% or more than 50% if redetermined on that date, then the liquidation-value percentage must be redetermined on that day.

5. Rev. Rul. 90-112.

(a) Another rule was changed by the Service’s withdrawal of Rev. Rul. 90-112, 1990-2 C.B. 186. The ruling addressed the treatment under § 956 of U.S. property held by a CFC indirectly through a partnership and generally is consistent with the new regulations. However, the ruling also included a limitation on the measurement of U.S. property that is not in the final, and was not in the proposed, § 956 regulations. Specifically, the ruling provided that amount of U.S. property taken into account for purpose of § 956 when a CFC partner indirectly owns property through a partnership is limited by the CFC’s adjusted basis in its partnership interest. A commenter requested that the proposed § 956 regulations be revised to include this outside-basis limitation.

(b) Treasury and the IRS stated that including an outside-basis limitation in the regulations would be inappropriate. The rule in the regulations is based on an aggregate approach to partnerships and measures the amount of U.S. property indirectly held by a CFC partner on a property-by-property basis. An overall limitation on the amount of U.S. property a CFC partner is considered to hold indirectly through a partnership would be inconsistent with this property-by-property aggregate approach to U.S. property held by the partnership.

(c) Additionally, Treasury and the IRS expressed the view that a limitation determined by reference to a CFC partner’s basis in its

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partnership interest would be inconsistent with § 956(a), which provides that the amount of U.S. property directly or indirectly held by a CFC is determined by reference to the adjusted basis of the U.S. property itself.

(d) They also were concerned that, under the rules of Subchapter K, adjustments may be made to outside basis through the allocation of liabilities pursuant to the regulations under § 752 that are inconsistent with the policy of § 956.

(e) Accordingly, an outside-basis limitation was not incorporated in the final § 956 regulations. Rev. Rul. 90-112 also was withdrawn/obsoleted. For tax years ending prior to the obsolescence of the revenue ruling, taxpayers may rely on the outside-basis limitation provided in that ruling.

6. Special Allocations.

(a) The effect of special allocations also can present important issues in the context of determining liquidation value. The proposed § 956 regulations defined a special allocation as an allocation of income (or, where appropriate, gain) from partnership property to a partner under a partnership agreement that differs from the partner’s liquidation-value percentage in a particular taxable year.

(b) Questions arose as to whether allocations pursuant to § 704(c) and the regulations thereunder constitute special allocations. In response to these questions, Treasury and the IRS revised the definition of special allocations in Treas. Reg. § 1.956-4(b)(2)(ii) to clarify that a special allocation is an allocation of book income or gain, rather than a tax allocation such as the allocations required under § 704(c). The final regulations also clarify that, for purposes of these regulations, a special allocation means only an allocation of income (or, where appropriate, gain) from a subset of property of the partnership to a partner other than in accordance with the partner’s liquidation value percentage in a particular taxable year.

(c) As noted above, the new § 956 regulations provide that a partner’s attributable share of an item of partnership property is not determined by reference to a special allocation with respect to the property if the special allocation has a principal purpose of avoiding the purposes of § 956.

(d) A comment requested that the final regulations provide guidance on the circumstances in which special allocations are treated as having a principal purpose of avoiding § 956. Specifically, the comment requested that the § 956 regulations be revised to include

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a presumption that a transaction does not have a principal purpose of avoiding § 956 if the allocation is respected under § 704(b) and is reasonable taking into account the facts and circumstances relating to the economic arrangement of the partners and the characteristics of the property at issue.

(e) Treasury and the IRS believe that the determination of whether a special allocation has a principal purpose of avoiding the purposes of § 956 must take into account all of the relevant facts and circumstances, which include factors set forth in the comment letter. However, an allocation adopted with a principal purpose of avoiding the purposes of § 956 could nonetheless be respected under § 704(b), which is not based on, and does not take into account, § 956 policy considerations. Thus, Treasury and the IRS determined that the presumption requested by that commenter would not be appropriate.

(f) Another comment noted that determining a partner’s attributable share of an item of property by reference to a special allocation of income or gain regarding that property could produce results that are inconsistent with the liquidation-value percentage approach because of the forward-looking nature of special allocations. The commenter described, but did not explicitly recommend, an alternative approach that would limit the effect of a special allocation to the portion of the liquidation value that represents actual appreciation, as opposed to initial book value. Treasury and the IRS recognize the conceptual issue highlighted by the comment but determined that such an alternative approach would entail substantial administrative complexity.

(g) Additionally, Treasury and the IRS continue to consider it appropriate, in cases in which special allocations are economically meaningful, to determine a partner’s attributable share of property in accordance with the special allocations, since the allocations replicate the effect of owning, outside of the partnership, an interest in the property that is proportional to the special allocation.

(h) However, the preamble states that special allocations regarding a partnership controlled by a U.S. multinational group (an 80%-controlled partnership) and its CFCs are unlikely to have economic significance for the group as a whole and can facilitate inappropriate tax planning. Accordingly, a new rule was proposed under which a partner’s attributable share of property of a controlled partnership is determined solely in accordance with the partner's liquidation-value percentage, without regard to any special allocations. This is discussed further below.

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7. Disregarded Entities.

(a) The final regulation adopted without change the proposed regulations’ provision that for purposes of § 956, an obligation of a business entity that is disregarded under the check-the-box rules as an entity separate from its owner is treated as an obligation of its owner.

(b) The preamble to the proposed regulations suggested that this rule follows from an application of the check-the-box rules and thus does not represent a change in the law, despite its prospective effective date.

(c) Here, too, we make the observation that § 956 requires an “obligation of a U.S. person.” There is no such obligation at law if the disregarded entity is a foreign corporation-type limited-liability entity. Nonetheless, the regulation now seems to deem into existence such an obligation.

8. Multiple Inclusions Problem. Comments were received in response to a request concerning whether Treasury and the IRS should exercise their authority under § 956(e) to prescribe regulations addressing situations in which multiple CFCs serve, or are treated, as pledgors or guarantors of a single obligation in order to limit the aggregate inclusion of a U.S. shareholder with respect to a CFC under § 951(a)(1)(B) and § 956 to the unpaid principal amount of the obligation. Treasury and the IRS state that they continue to study the comments concerning multiple inclusions under § 956(d), which do not impact any of the regulations adopted. We’re not sure what there is to study. Multiple inclusions of the same loan amount are simply wrong.

9. Effective Dates.

(a) The new regulations generally are effective for taxable years of CFCs ending on or after November 3, 2016, and to taxable years of U.S. shareholders in which or with which those regulations end. Most of the rules apply to property acquired or pledges or guarantees entered into on or after September 1, 2015, including property considered acquired, or pledges or guarantees considered entered into, on or after September 1, 2015, as a result of a deemed exchange pursuant to § 1001.

(b) Some of the new rules, however, only apply to obligations held on or after Nov. 3, 2016. See Treas. Reg. §§ 1.956-2(a)(3) and 1.956-4(e) (dealing with obligations of disregarded entities and domestic partnerships); and Treas. Reg. § 1.956-4(b) (liquidation value

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measurement rules for determining amount of U.S. property held by CFC partners).

(c) The preamble states that no inference is intended as to the application of the provisions amended by the final regulations under prior law, including in transactions involving obligations of foreign partnerships. The IRS may, where appropriate, challenge transactions under the Code, regulatory provisions under prior law, or judicial doctrines.

D. Proposed Section 956 Regulations: Partnership Special Allocations.

1. As discussed above, new Treas. Reg. §1. 956-4(b) provides that a CFC that is a partner in a partnership generally is treated as holding its share of U.S. property held by the partnership in accordance with the CFC partner’s liquidation-value percentage in the partnership. However, if there is a special allocation of income (or, where appropriate, a gain) that does not have a principal purpose of avoiding the purposes of § 956, the partner’s attributable share of that property is determined solely by reference to the special allocation. See Treas. Reg. § 1.956-4(b)(2)(ii).

2. The preamble states that, in general, these rules provide a reasonable means of determining a partner’s interest in property held by a partnership for purposes of § 956 because they generally result in an allocation of specific items of property that corresponds with each partner’s economic interest in that property, including any income or gain that may be subject to special allocations.

3. Treasury and the IRS are concerned, however, that special allocations regarding a partnership that is controlled by a single multinational group are unlikely to have economic significance for the group as a whole and can facilitate tax planning that is inconsistent with the purposes of § 956. Accordingly, the proposed regulations would revise Treas. Reg. § 1.956-4(b) so that such a partner’s attributable share of each item of property of a partnership controlled by the partner would be determined solely in accordance with the partner’s liquidation-value percentage, even if income or gain from the property is subject to a special allocation.

4. Specifically, under Prop. Treas. Reg. § 1.956-4(b)(2)(iii), the rule in Treas. Reg. § 1.956-4(b)(2)(ii) requiring a partner’s attributable share of partnership property to be determined by reference to special allocations regarding the property would not apply in the case of a partnership controlled by the partner. For this purpose, a partner is treated as controlling a partnership if the partner and the partnership are related within the meaning of § 267(b) or § 707(b), substituting “at least 80%” for “more than 50%.”

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5. The regulations are proposed to be effective for taxable years of CFCs ending on or after the date of publication in the Federal Register of the Treasury Decision adopting them as final regulations, and for tax years of U.S. shareholders in which or with which such taxable years end, with respect to property acquired on or after the date the regulations are published in the Federal Register as final regulations. The preamble states that the IRS may, where appropriate, challenge transactions under currently applicable Code or regulatory provisions or judicial doctrines.

6. This proposed regulation raises some serious and interesting issues. We will illustrate them in context of LTR 200832024, which was discussed in our column of August 25, 2008.

7. LTR 200832024 describes a U.S. parent company that owns three relevant subsidiaries: US-1, F-1, and F-2. (See Doc. 2008-17337 or 2008 WTD 156-16). The foreign subsidiaries are country B entities. US-1 conducts a U.S. business, and F-1 conducts a foreign business. FP, an unrelated foreign corporation, will form a joint venture with US-1 and F-2. An LLP in country A will be formed. It will be a partnership for U.S. tax purposes. The three partners will contribute cash, and LLP will purchase from US-1 the U.S. business and from F-1 the foreign business.

8. The U.S. business and the non-U.S. business will be maintained in separate foreign legal entities (“FDEs”) owned by LLP that will constitute disregarded entities for U.S. tax purposes. The FDEs are LLC-1 and LLC-2. They will maintain separate books and records, and funds will not be loaned or transferred between these entities. LLC-1 will own and conduct the U.S. business, and LLC-2 will own and conduct the non-U.S. business.

9. The LLP agreement specifies that F-2 will share only in the income, gains, deductions, and losses of the non-U.S. business and will have liquidation rights only in assets of the non-U.S. business. F-2 will not share in any income, gains, deductions, or losses from the U.S. business and will not have any rights to assets of the U.S. business upon the liquidation of LLP.

10. Then Treas. Reg. § 1.956-2(a)(3) said that if a CFC is a partner in a partnership that owns property that would be U.S. property if owned directly by the CFC, the CFC will be treated as owning an interest in the property equal to its interest in the partnership and that interest will be treated as an investment in U.S. property. Accordingly, the letter ruling says that a CFC that has an economic interest in U.S. property through a partnership will be considered to have an interest in U.S. property for purposes of § 956. On the other hand, a CFC that does not have any economic interest in U.S. property through a partnership, including a profits interest, a capital interest, a liquidation right, or any other interest, does not have an interest in U.S. property for purposes of § 956.

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11. In the ruling, the U.S. business will be conducted in the same manner as before the formation of LLP. F-2 will not have an economic interest in the U.S. business conducted by LLC-1, including a profits or capital interest, liquidation rights, or any other interest. As part of the LLP arrangement, LLC-1 will continue the preexisting U.S. business in which F-1 did not have an economic interest before the formation of LLP.

12. Therefore, the ruling states, because F-2 will not have any economic interest in the U.S. business after the formation of LLP, no economic interest in U.S. property is being shifted from a CFC to a non-CFC. LLC-1 will not receive any loans, other funds, or credit support from LLC-2. Thus, F-2’s status as a partner in LLP will not cause F-2 to be treated as holding an interest in U.S. property under Treas. Reg. § 1.956-2(a)(3).

13. This ruling would appear to be overruled by the proposed regulation, at least if (1) it’s viewed as a special allocation (instead of an “economic interest” issue), and (2) the partnership is 80% controlled under §§ 267(b) or 707(b).

14. Even if the partnership is not a controlled partnership, the special allocation, if it is such, will only be respected if it does not have a principal purpose to avoid the purposes of § 956. In this case, it might be asked what other purpose does the structure have? Is avoiding an inappropriate result under § 956 one of its principal purposes? Is avoiding an inappropriate result under § 956 really bad? Perhaps that would not be “avoiding the purposes” of § 956.

E. Section 956: “Obligation.”

1. The IRS issued temporary § 956 regulations in the same regulations package as certain § 7874 temporary inversion regulations. These § 956 regulations adopted the rules described in Notice 88-108 and related notices concerning the short-term obligation exception from United States property for purposes of § 956. These § 956 notices and the related new temporary regulations would seem to have nothing at all to do with inversions.

2. The new regulation states that for purposes of § 956 the term “obligation” does not include any obligation of the United States person that is collected within 30 days from the time it is incurred (a 30-day obligation), unless the controlled foreign corporation that holds the 30-day obligation holds for 60 or more calendar days during the taxable year in which it holds the 30-day obligation any obligation which, without regard to the exclusion, would constitute United States property within the meaning of § 956 and § 1.956-2(a).

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F. Section 954(c): Active Rents And Royalties Exception.

1. Treasury and the IRS adopted the 2015 proposed § 954(c) regulations without change. They address the active rents and royalties rules, and were also issued in 2015 as temporary regulations.

2. Rents and royalties generally are included in a CFC’s foreign personal holding company income (“Subpart F income”). Rents and royalties derived in the active conduct of a trade or business and received from a person that is not a related person, however, are excluded from Subpart F income. The § 954 regulations provide rules for determining whether rents and royalties are derived in the active conduct of a trade or business for purposes of § 954(c)(2)(A).

3. Specifically, Treas. Reg. § 1.954-2(c) provides four alternative ways for rents to be derived in the active conduct of a trade or business, and Treas. Reg. § 1.954-2(d) provides two alternative ways for royalties to be derived in the active conduct of a trade or business. One way for a CFC to derive rents and royalties in the active conduct of a trade or business is to satisfy an “active development” test which, among other things, requires the CFC to be regularly engaged either in the “manufacture or production of, or in the acquisition and addition of substantial value to,” certain property (regarding rents); or in the “development, creation or production of, or in the acquisition of and the addition of substantial value to,” certain property (regarding royalties) (collectively, the “active development” tests).

4. Certain of the alternative ways (specifically, the active management and marketing tests) in which a CFC can satisfy the active rents and royalties exception require the relevant activities be performed by the CFC’s own offices or staff of employees. The active-development tests did not expressly contain this requirement.

5. In addition to the active-development test, another way for a CFC to derive active rents and royalties in the active conduct of a trade or business is to satisfy an “active marketing” test. The test, among other things, requires the CFC to operate in a foreign country an organization that is regularly engaged in the business of marketing, or marketing and servicing, the leased or licensed property, and that is “substantial” in relation to the amount of rents and royalties derived from the leased or licensed property. Pursuant to a safe harbor, an organization is “substantial” if the active-leasing or active-licensing expenses equal or exceed 25% of the adjusted-leasing or adjusted-licensing profits. The regulations generally define active-leasing expenses and active-licensing expenses to mean, subject to certain exceptions, deductions that are properly allocable to rental or royalty income and that would be so allowable under § 162 if the CFC were a domestic corporation.

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6. The active rents and royalties exception is intended to distinguish between a CFC that passively receives investment income and a CFC that derives income from the active conduct of a trade or business. Accordingly, the policy underlying the active-rents and active-royalties exceptions requires that the CFC itself actively conduct the business that generates the rents or royalties. The preamble to the 2015 temporary and proposed regulations stated that, consistent with this policy, the CFC must perform the relevant active development activities (that is, activities related to the manufacturing, production, development, or creation of, or, in the case of an acquisition, the addition to substantial value to, the property at issue) through its own officers or staff of employees in order to satisfy the active-development test. Thus, new Treas. Reg. § 1.954-2(c)(1)(i) and (d)(1)(i) expressly provide that the CFC lessor or licensor must perform the required functions through its own officers or staff of employees.

7. Treasury and the IRS state that the policy of the active-rents and active-royalties exceptions allows the relevant activities undertaken by a CFC through its officers or staff of employees to be performed in more than one foreign country. Thus, new Treas. Reg. § 1.954-2(c)(1)(iv) and (d)(1)(ii) provide that a CFC’s officers or staff of employees may be located in one or more foreign countries, and an organization that meets the requirements of the active-marketing test can be maintained and operated by the officers or a staff of employees either in a single foreign country or in multiple foreign countries collectively. An organization also can be in a single foreign country or in multiple foreign countries collectively for purposes of determining the substantiality of the foreign organization.

8. The preamble to the 2015 temporary and proposed regulations stated that in applying the active-development tests and the active-marketing tests, questions arose as to the treatment of cost sharing arrangements under which a person other than a CFC actually conducts relevant activities. Consistent with the policy underlying the active rents and royalties exceptions that require the CFC itself to conduct the relevant activities, the final regulations clarify that cost sharing payments and PCT (buy-in) payments made by a CFC will not cause the CFC’s officers and employees to be treated as undertaking the activities of the controlled participant to which the payments are made. This clarification applies for purposes of the active-development tests and the active-marketing tests, including for purposes of determining whether an organization that engages in marketing is substantial.

9. Similarly, the new regulations also provide that deductions for cost-sharing payments and PCT payments are excluded from the definition of active-leasing expenses and active-licensing expenses. Thus, cost-sharing payments and PCT payments are not active-leasing expenses or active-licensing expenses for purposes of determining whether an organization is “substantial” under the safe harbor test.

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10. The rules relating to the active-development test apply to rents and royalties received or accrued during taxable years of CFCs ending on or after September 1, 2015, and to taxable years of U.S. shareholders in which or with which such taxable years end, but only with respect to property manufactured, produced, developed, or created, or, in the case of acquired property, property to which substantial value has been added, on or after September 1, 2015.

11. The rules regarding the active-marketing test, as well as the rules regarding cost-sharing arrangements, apply to rents or royalties received or accrued during taxable years of CFCs ending on or after September 1, 2015, and to taxable years of U.S. shareholders in which or with which those taxable years end, to the extent that these rents or royalties are received or accrued on or after September 1, 2015.

IV. PARTNERSHIPS.

A. Transfers to Partnerships: New Regulations.

1. Notice 2015-54, 2015-34 I.R.B. 210 (the “Notice”) described regulations to be issued under § 721(c). The regulations are intended to ensure that, when a U.S. person transfers certain property to a partnership that has foreign partners related to the U.S. person, income or gain attributable to the appreciation in the property at the time of the contribution will be taken into account by the transferor either immediately or over time. To prevent immediate gain recognition, the regulations require use of the partnership income remedial allocation method under the so-called gain deferral method.

2. The new temporary regulations adopt the rules that were described in the Notice, with certain modifications. The Notice also stated that regulations would be issued under §§ 482 and 6662 to ensure the appropriate valuation of controlled transactions involving partnerships. These regulations were not issued, but will be in the future. Section 482, however, continues to apply to controlled transactions (within the meaning of Treas. Reg. § 1.482-1(i)(8)) that are also subject to the new § 721(c) regulations below.

3. Statutory Authority. Some comments questioned whether the regulations described in the Notice would be within the scope of Treasury’s and the IRS’ authority under § 721(c). Specifically, the comments asserted that pre-contribution gain could not be taxed under § 721(c) until it is recognized in a sale or exchange by the partnership. Treasury and the IRS obviously disagreed since the regulations were issued. The preamble discusses their statutory authority at length.

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4. The New Regulations. Temp. Treas. Res. § 1.721(c)-1T provides definitions and rules of general application for purposes of all sections of the temporary regulations. Temp. Treas. Reg. § 1.721(c)-2T provides the general operative rules that override § 721(a) nonrecognition upon a contribution of § 721(c) property to a partnership. Temp. Treas. Reg. § 1.721(c)-3T describes the gain deferral method, which, if adopted, avoids the immediate recognition of gain upon a contribution of § 721(c) property. Temp. Treas. Reg. § 1.721(c)-4T provides rules regarding events that accelerate the recognition of gain that previously was deferred under the gain deferral method. Temp. Treas. Reg. § 1.721(c)-5T identifies exceptions to the acceleration events provided in Temp. Treas. Reg. § 1.721(c)-4T, the result of which, generally, is that the gain deferral method either ends (termination events) or continues to apply without immediate gain recognition (successor events) or continues to apply with partial gain recognition (partial acceleration events). Temp. Treas. Reg. § 1.721(c)-6T provides procedural and reporting requirements. Temp. Treas. Reg. § 1.721(c)-7T provides examples illustrating the application of the temporary regulations.

5. General Scope.

(a) Unlike the Notice, the temporary regulations apply on a property-by-property basis. They apply to all contributions, actual or deemed, of property to a partnership, including, for example, a contribution of property that occurs as a result of (i) a partnership merger, consolidation, or division in the assets-over form, (ii) a change in entity classification that occurs pursuant to Treas. Reg. § 301.7701-3, or (iii) a transaction described in Rev. Rul. 99-5, 1999-1 C.B. 434 (change from a disregarded entity to a partnership).

(b) However, a contribution in a technical termination of a partnership described in § 708(b)(1)(B) (technical termination) will not, by itself, cause a partnership to become a § 721(c) partnership subject to the temporary regulations. This exception does not apply to a technical termination of a § 721(c) partnership already applying the gain deferral method.

(c) The regulations provide that a mere change in identity, form, or place of organization of a partnership or a recapitalization of a partnership will not cause the partnership to become a § 721(c) partnership. See Temp. Treas. Reg. § 1.721(c)-1T(c).

(d) Finally, the regulations contain rules for transactions involving tiered partnerships, as well as a general anti-abuse rule (see Temp. Treas. Reg. § 1.721(c)-1T(d)) that applies for all purposes of the § 721(c) temporary regulations.

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6. Definitions.

(a) The Notice stated the regulations would provide that a partnership is a § 721(c) partnership if a U.S. transferor contributes § 721(c) property to the partnership, and, after the contribution and any transactions related to the contribution, (i) a related foreign person is a direct or indirect partner, and (ii) the U.S. transferor and related persons own (directly or indirectly) more than 50 percent of the interests in partnership capital, profits, deductions, or losses.

(b) After considering taxpayer comments suggesting that a higher level of related-party ownership would be more appropriate, the new regulations increase the ownership threshold for their application from a “more than 50 percent” test to an “80 percent or more” test (ownership requirement). See § 1.721(c)-1T(b)(14)(i) for the general definition of a § 721(c) partnership. This 80% threshold level, while helpful, however, can be tricky: “Related party” is defined by reference to §§ 267(b) and 707(b)(1) and thus to a “more than 50%” standard. Temp. Treas. Reg. § 1.721(c)-1T(b)(12). The temporary regulations also provide rules that deem certain controlled partnerships in a tiered-partnership structure to be § 721(c) partnerships in order to apply the gain deferral method. See Temp. Treas. Reg. § 1.721(c)-1T(b)(14)(ii).

(c) Section 721(c) property is property, other than excluded property, with built-in gain that is contributed to a partnership by a U.S. transferor, including pursuant to a contribution described in Temp. Treas. Reg. § 1.721(c)-2T(d) (partnership look-through rule). Temp. Treas. Reg. § 1.721(c)-1T(b)(15).

(d) Temp. Treas. Reg. § 1.721(c)-1T(b)(6) defines excluded property as (i) a cash equivalent; (ii) a security within the meaning of § 475(c)(2), without regard to § 475(c)(4); (iii) tangible property with a book value exceeding tax basis by no more than $20,000 or with an adjusted tax basis in excess of book value (built-in loss); and (iv) an interest in a partnership that holds (directly, or indirectly through interests in one or more partnerships that are not excluded property under this clause (iv)) property of which 90 percent or more of the value consists of property described in clauses (i) through (iii) (partnership interest exclusion).

(e) The Notice announced the first three categories of excluded property. The temporary regulations include tangible property with a built-in loss in the third exclusion. Treasury and the IRS determined that it was appropriate to add the partnership interest exclusion. Thus, the regulations will not apply to transfers of partnership interests when only a small portion of the partnership’s

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property is § 721(c) property. If a partnership interest fails the 90-percent threshold test for the partnership interest exclusion and does not qualify under the exclusion for securities, the interest is § 721(c) property.

(f) Comments recommended that property that gives rise to income effectively connected with a U.S. trade or business (ECI property) be excluded from the definition of § 721(c) property. The comments stated that the income will be subject to U.S. tax even if it is allocated to a related foreign person. Treasury and the IRS agreed with the reasoning behind this comment, and determined that the temporary regulations should also address the situation when the property ceases to be ECI property and still has built-in gain. Accordingly, the temporary regulations continue to include ECI property in the definition of § 721(c) property but modify the application of the gain deferral method to ECI property.

(g) Finally, the temporary regulations, consistent with the Notice, define (i) a related person (as noted above) as a person that is related (within the meaning of § 267(b) or § 707(b)(1)) to a U.S. transferor; (ii) a related foreign person as a person that is a related person (other than a partnership) that is not a U.S. person; and (iii) a direct or indirect partner as a person (other than a partnership) that owns an interest in a partnership directly or indirectly through one or more partnerships. See Temp. Treas. Reg. § 1.721(c)-1T(b)(12), (b)(11), and (b)(5), respectively.

7. General Rule of Gain Recognition.

(a) Temp. Treas. Reg. § 1.721(c)-2T provides the general operative rules that override § 721(a) nonrecognition of gain upon a contribution of § 721(c) property to a partnership. Temp. Treas. Reg. § 1.721(c)-2T(b) provides the general rule that nonrecognition under § 721(a) will not apply to gain realized upon a contribution of § 721(c) property to a § 721(c) partnership. In contrast to the Notice, Temp. Treas. Reg. § 1.721(c)-2T(b) provides that this general rule does not apply -- and therefore that nonrecognition under § 721(a) continues to apply -- to a direct contribution of § 721(c) property by an "unrelated" U.S. transferor (in other words, a U.S. transferor that does not, together with related persons with respect to it, satisfy the ownership requirement). This is consistent with the intent of the temporary regulations to address the shifting of income among related persons. Because this carve-out for an unrelated U.S. transferor is limited to direct contributions of § 721(c) property, it does not apply to a contribution that occurs pursuant to the tiered-

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partnership look-through rule in Temp. Treas. Reg. § 1.721(c)-2T(d)(1).

(b) Temp. Treas. Reg. § 1.721(c)-2T(c) provides a de minimis exception. The temporary regulations modify the de minimis exception described in the Notice -- which focused on contributions made by a U.S. transferor (and all related U.S. transferors) during the U.S. transferor’s taxable year -- to focus instead on contributions during the partnership’s taxable year, in order to align the rule with the reporting required under Temp. Treas. Reg. § 1.721(c)-6T. Under the de minimis exception in the temporary regulations, contributions of § 721(c) property will not be subject to immediate gain recognition if the sum of all built-in gain for all § 721(c) property contributed to a § 721(c) partnership during the partnership's taxable year does not exceed $1 million.

(c) Temp. Treas. Reg. § 1.721(c)-2T(d)(1) provides a look-through rule for identifying a § 721(c) partnership when an upper-tier partnership in which a U.S. transferor is a direct or indirect partner contributes property to a lower-tier partnership. For purposes of determining if the lower-tier partnership is a § 721(c) partnership, the U.S. transferor will be treated as contributing to the lower-tier partnership its share of the property actually contributed by the upper-tier partnership to the lower-tier partnership. If the lower-tier partnership is a § 721(c) partnership, absent application of the gain deferral method by the lower-tier partnership to the entire property and by the upper-tier partnership to the partnership interest in the lower-tier partnership, the upper-tier partnership will recognize the entire built-in gain in the § 721(c) property under the general gain recognition rule, because the entire property will be § 721(c) property (see the general definition of § 721(c) property in Temp. Treas. Reg. § 1.721(c)-1T(b)(15)(i)).

8. Gain Deferral Method.

(a) Temp. Treas. Reg. § 1.721(c)-3T describes the gain deferral method, which as discussed above, generally must be applied in order to avoid the immediate recognition of gain upon a contribution of § 721(c) property to a § 721(c) partnership. The regulations’ gain deferral method requirements are somewhat different from those in the Notice. Temp. Treas. Reg. § 1.721(c)-3T(b) provides the five general requirements for applying the gain deferral method to an item of § 721(c) property: (i) the § 721(c) partnership adopts the remedial allocation method with respect to the § 721(c) property and applies the consistent allocation method; (ii) the U.S. transferor recognizes gain equal to the remaining built-in gain with respect to the § 721(c) property upon an acceleration

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event, or an amount of gain equal to a portion of the remaining built-in gain upon a partial acceleration event or certain transfers to foreign corporations described in § 367; (iii) procedural and reporting requirements are satisfied; (iv) the U.S. transferor extends the period of limitations on assessment of tax; and (v) the rules for tiered partnerships are satisfied if either the § 721(c) property is an interest in a partnership or the § 721(c) property is described in the tiered-partnership look-through rule in Temp. Treas. Reg. § 1.721(c)-2T(d)(1).

(b) As noted above, the temporary regulations did not adopt the comment recommending that ECI property be excluded from the definition of § 721(c) property. Instead, the temporary regulations continue to provide that a contribution of § 721(c) property that is ECI property is subject to immediate gain recognition if the gain deferral method is not applied. However, the regulations modify the gain deferral method so that ECI property is not subject to the remedial allocation method or the consistent allocation method (requirement (i) above). This special exception for ECI property applies for as long as, beginning on the date of the contribution and ending when there is no remaining built-in gain with respect to the § 721(c) property, all distributive shares of income and gain with respect to the property for all direct and indirect partners that are related foreign persons will be subject to taxation as effectively connected with a trade or business within the United States (under § 871 or 882), and neither the § 721(c) partnership nor a direct or indirect partner that is a related foreign person claims benefits under an income tax treaty that would exempt the income or gain from tax or reduce the rate of taxation to which the income or gain is subject. See Temp. Treas. Reg. § 1.721(c)-3T(b)(1)(ii).

(c) All the other requirements of the gain deferral method apply with respect to ECI property. Thus, a U.S. transferor must recognize gain upon an acceleration event with respect to ECI property, including when property ceases to be ECI property, and satisfy the procedural and reporting requirements with respect to ECI property. See Temp. Treas. Reg. § 1.721(c)-6T(b)(2)(iii), (b)(3)(vii), and (c)(1).

(d) The temporary regulations revise the remedial allocation method in Temp. Treas. Reg. § 1.704-3T(d) as to related partners when a § 721(c) partnership is applying the gain deferral method with respect to § 197(f)(9) anti-churning intangible property. The revised rule requires the partnership to amortize the portion of the partnership’s book value in the § 197(f)(9) intangible property that exceeds its adjusted tax basis in the property. Accordingly, the allocation of book amortization to a noncontributing partner will

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result in a ceiling rule limitation to the extent of this allocation of book amortization. If a noncontributing partner is a related person with respect to the U.S. transferor, the regulations provide that, solely with respect to the related noncontributing partner, the partnership must increase the adjusted tax basis of the property by the amount of the difference between the book allocation of the item to the related person and the tax allocation of the same item to the related person and allocate remedial income in the same amount to the U.S. transferor. See Temp. Treas. Reg. § 1.704-3T(d)(5)(iii).

9. Consistent Allocation Method.

(a) Temp. Treas. Reg. § 1.721(c)-3T(c)(1) describes the consistent allocation method, which, like the gain deferral method, applies on a property-by-property basis. The consistent allocation method requires a § 721(c) partnership in which there is remaining built-in gain in the § 721(c) property to allocate each book item of income, gain, deduction, and loss with respect to the § 721(c) property to the U.S. transferor in the same percentage.

(b) Comments questioned the need to apply the consistent allocation method. Some comments said the consistent allocation method is unnecessary because the built-in gain in § 721(c) property will be preserved in the difference between the book and tax capital accounts of a U.S. transferor. In response, the temporary regulations provide exceptions from the requirement to apply the consistent allocation method with respect to certain book items of a § 721(c) partnership.

(c) The new regulations thus provide that a regulatory allocation (below) of book income, gain, deduction, or loss with respect to § 721(c) property that otherwise would fail to satisfy the requirements of the consistent allocation method nevertheless will satisfy the method if the allocation is of income or gain to the U.S. transferor or a member of its consolidated group, or an allocation of deduction or loss to a partner other than the U.S. transferor or a member of its consolidated group. It also can qualify if it is treated as a partial acceleration pursuant to Temp. Treas. Reg. § 1.721(c)-5T(d)(2).

(d) A regulatory allocation is (i) an allocation pursuant to a minimum gain chargeback, as defined in Treas. Reg. § 1.704-2(b)(2), (ii) a partner nonrecourse deduction, as determined in Treas. Reg. § 1.704-2(i)(2), (iii) an allocation pursuant to a partner minimum gain chargeback, as described in Treas. Reg. § 1.704-2(i)(4), (iv) an allocation pursuant to a qualified income offset, as defined

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in Treas. Reg. § 1.704-1(b)(2)(ii)(d), (v) an allocation with respect to the exercise of a noncompensatory option described in Treas. Reg. § 1.704-1(b)(2)(iv)(s), and (vi) an allocation of partnership level ordinary income or loss described in Treas. Reg. § 1.751-1(a)(3).

(e) Treasury and the IRS have determined that relief is appropriate for these regulatory allocations because, in general, partners do not have discretion regarding their application and, when necessary, treating them as a partial acceleration event will result in the appropriate amount of gain being recognized for purposes of the gain deferral method. Treasury and the IRS also have determined that relief is not appropriate for a nonrecourse deduction as defined in Treas. Reg. § 1.704-2(b)(1) because, unlike the other types of regulatory allocations, partners have significant discretion regarding the allocation of a nonrecourse deduction.

(f) The temporary regulations also provide that allocations of creditable foreign tax expenditures (as defined in Treas. Reg. § 1.704-1(b)(4)(viii)(b)) (CFTEs) are not subject to the consistent allocation method. See Temp. Treas. Reg. § 1.721(c)-3T(c)(4)(ii). The regulations governing the allocation of CFTEs take into account § 704(c) income and gain and are not based strictly on the allocation of book items. As a result, it would be difficult to apply the consistent allocation method with respect to CFTEs.

10. Acceleration Events.

(a) Temp. Treas. Reg. § 1.721(c)-4T provides rules regarding acceleration events, which, like the gain deferral method, apply on a property-by-property basis. When an acceleration event occurs with respect to § 721(c) property, remaining built-in gain in the property must be recognized and the gain deferral method no longer applies.

(b) An acceleration event is any event that would reduce the amount of remaining built-in gain that a U.S. transferor would have recognized under the gain deferral method if the event had not occurred or that could defer the recognition of the remaining built-in gain. The temporary regulations clarity that an acceleration event includes the transfer of § 721(c) property via a contribution of the property itself or through a contribution of a partnership interest.

(c) An acceleration event can result from a failure to comply with one of the requirements of the gain deferral method with respect to that property, i.e., the rules apply on a property-by-property basis. An

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acceleration event will not occur solely as a result of a failure to comply with a procedural or reporting requirement of the gain deferral method if that failure is not willful and relief is sought under the prescribed procedures.

(d) A U.S. transferor also may affirmatively treat an acceleration event as having occurred with respect to §721(c) property by recognizing the remaining built-in gain with respect to that property and satisfying the reporting requirements.

(e) Treas. Reg. § 1.721(c)-5T(d) identifies partial acceleration events, and, in each case, the amount of gain that a U.S. transferor must recognize.

11. Acceleration Event Exceptions. Temp. Treas. Reg. § 1.721(c)-5T identifies the following categories of exceptions to acceleration events, which, like acceleration events, apply on a property-by-property basis: (i) termination events, in which case, the gain deferral method ceases to apply to the § 721(c) property; (ii) successor events, in which case, the gain deferral method continues to apply to the § 721(c) property but with respect to a successor U.S. transferor or a successor § 721(c) partnership, as applicable; (iii) partial acceleration events, in which case, a U.S. transferor recognizes an amount of gain that is less than the full amount of remaining built-in gain in the § 721(c) property and the gain deferral method continues to apply; (iv) transfers described in § 367 of § 721(c) property to a foreign corporation, in which case, the gain deferral method ceases to apply and a U.S. transferor recognizes an amount of gain equal to the remaining built-in gain attributable to the portion of the § 721(c) property that is not subject to tax under § 367; and (v) fully taxable dispositions of a portion of an interest in a § 721(c) partnership, in which case, the gain deferral method continues to apply for the retained portion of the interest.

12. Termination Events.

(a) Temp. Treas. Reg. § 1.721(c)-5T(b) identifies the events that cause the gain deferral method to no longer apply. A termination event does not constitute an acceleration event. Rather, the gain deferral method terminates with respect to the affected § 721(c) property in these cases. This is because the potential to shift gain or income to a related foreign person that is a direct or indirect partner in the § 721(c) partnership has been eliminated. Termination events are:

i. If a § 721(c) partnership transfers § 721(c) property other than a partnership interest to a domestic corporation in a transaction to which § 351 applies. See Temp. Treas. Reg. § 1.721(c)-5T(b)(2).

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ii. An incorporation of a § 721(c) partnership into a domestic corporation by any method of incorporation other than a method involving an actual distribution of partnership property to the partners, followed by a contribution of that property to a corporation, provided that the § 721(c) partnership is liquidated as part of the incorporation transaction. See Temp. Treas. Reg. § 1.721(c)-5T(b)(3).

iii. If a § 721(c) partnership distributes § 721(c) property either to the U.S. transferor or, if the U.S. transferor is a member of a consolidated U.S. tax group at the time of the distribution and the distribution occurs outside the § 704(c)(1)(B) seven-year period, to a member of the consolidated group.

A comment questioned whether an acceleration event should occur as a result of a distribution of § 721(c) property to a partner other than a U.S. transferor outside of the seven-year period described in §§ 704(c)(1)(B) and 737 (rules that address certain distributions of property within seven years of a contribution).

While §§ 704(c)(1)(B) and 737 also are intended to ensure that gain on contributed property is not inappropriately transferred to a partner other than the contributor, in the context of contributions to partnerships with related foreign partners, Treasury and the IRS are of the view that concerns about the erosion of the U.S. tax base remain as long as there is remaining built-in gain in the § 721(c) property. Accordingly, they have determined that it is inappropriate to provide a termination event exception for all distributions of § 721(c) property after seven years.

Thus, the temporary regulations provide that a termination event occurs if a § 721(c) partnership distributes § 721(c) property to the U.S. transferor. A termination event will also occur if a § 721(c) partnership distributes § 721(c) property to a member of a U.S. transferor’s consolidated group and the distribution occurs more than seven years after the contribution. See Temp. Treas. Reg. § 1.721(c)-5T(b)(4).

iv. The § 721(c) partnership ceases to have a related foreign person partner. A termination event occurs when a § 721(c) partnership ceases to have any direct or indirect partners that are related foreign persons, provided there is no plan for a related foreign person to subsequently become

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a direct or indirect partner in the partnership (or a successor). See Temp. Treas. Reg. § 1.721(c)-5T(b)(5). The no-plan requirement applies independently of the general anti-abuse rule under Temp. Treas. Reg. § 1.721(c)-1T(d). An acceleration event, however, occurs upon a distribution of § 721(c) property in redemption of a related foreign person’s interest in a § 721(c) partnership.

v. Fully taxable dispositions of § 721(c) property or of an entire interest in a § 721(c) partnership. The Notice treated a taxable disposition of § 721(c) property by a § 721(c) partnership, or an indirect disposition of § 721(c) property through a taxable disposition of an interest in a § 721(c) partnership interest, as an acceleration event. Treasury and the IRS have determined that it is appropriate instead to treat a fully taxable disposition of § 721(c) property or of an entire interest in a § 721(c) partnership as a termination event because other sections of the Code require gain to be recognized.

Accordingly, the temporary regulations provide that a termination event occurs if a § 721(c) partnership disposes of § 721(c) property in a transaction in which all gain or loss, if any, is recognized. See Temp. Treas. Reg. § 1.721(c)-5T(b)(6). In addition, a termination event occurs if either a U.S. transferor or a partnership in which a U.S. transferor is a direct or indirect partner disposes of an entire interest in a § 721(c) partnership that owns § 721(c) property in a transaction in which all gain or loss, if any, is recognized. This rule does not apply if a U.S. transferor is a member of a consolidated group and the interest in the § 721(c) partnership is transferred to another member in an intercompany transaction (as defined in Treas. Reg. § 1.1502-13(b)(1)). See Temp. Treas. Reg. § 1.721(c)-5T(b)(7). (However, Treas. Reg. § 1.721(c)-5T(c)(3) provides that such a transaction may be a successor event.)

13. Successor Events. Temp. Treas. Reg. § 1.721(c)-5T(c) identifies the successor events that allow for the continued application of the gain deferral method. Successor events do not constitute acceleration events. Successor events are: (1) transfers of an interest in a § 721(c) partnership by a U.S. transferor or upper-tier partnership to a domestic corporation in certain nonrecognition transactions; (2) transfers of an interest in a § 721(c) partnership in an intercompany transaction; (3) a technical termination of a § 721(c) partnership; and (4) a partnership becomes a successor § 721(c) partnership in a tiered-partnership structure.

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14. Reporting and Procedural Requirements.

(a) Temp. Treas. Reg. § 1.721(c)-6T implements the rules described in the Notice in a manner consistent with the approach in the 2014 GRA regulations. For a U.S. transferor, the reporting requirements include, among other information, the information required to be filed under § 6038B. The regulations also adopt procedural requirements in order to seek relief for a failure to meet the reporting requirements of the gain deferral method, which mirror the approach in the 2014 GRA regulations, including procedures relating to the manner by which a transferor can establish the lack of willfulness and that a failure was due to reasonable cause.

(b) For purposes of the U.S. transferor’s reporting requirements under Temp. Treas. Reg. § 1.721(c)-6T with respect to a gain deferral contribution to a domestic § 721(c) partnership, a domestic § 721(c) partnership will generally be treated as foreign under § 7701(a)(4) for reporting purposes. See Temp. Treas. Reg. §§ 1.721(c)-6T(b)(4) and 1.6038B-2T(a)(1)(iii). As a result, a U.S. transferor that contributes § 721(c) property to a domestic § 721(c) partnership in a gain deferral contribution must file a Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships (including Form 8865, Schedule O, Transfer of Property to a Foreign Partnership), with its return for the taxable year that includes the date of the gain deferral contribution.

(c) Also as a requirement of the gain deferral method, the temporary regulations require that the U.S. transferor agree to extend the period of limitations on the assessment of tax for eight full taxable years with respect to the gain realized but not recognized on a gain deferral contribution, and for six full taxable years with respect to the U.S. transferor’s distributive share of all items with respect to the § 721(c) property for the year of contribution and two subsequent years.

(d) The temporary regulations also require the U.S. transferor to provide certain information on an annual basis with respect to § 721(c) property subject to the gain deferral method.

15. Effective/Applicability Dates. The applicability dates of the temporary regulations generally relate back to the issuance of the Notice. Accordingly, in general, the temporary regulations apply to contributions occurring on or after August 6, 2015, and to contributions occurring before August 6, 2015, resulting from an entity classification election that is filed on or after August 6, 2015 (referred to in this preamble as the “general applicability date”). However, new rules, including any substantive changes to the rules described in the notice, apply to

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contributions occurring on or after January 18, 2017, or to contributions occurring before January 18, 2017, resulting from an entity classification elections that are filed on or after January 18, 2017. Taxpayers may, however, elect to apply those new rules and substantive changes to the rules described in the notice to a contribution occurring on or after the general applicability date. The election is made by reflecting the application of the relevant rule on a timely filed or amended return.

V. SECTION 385 REGULATIONS

A. Treasury and the IRS finalized the § 385 regulations, and included certain of the § 385 rules in temporary regulations. The final regulation package, including the preamble and a lengthy cost-benefit analysis, is 518 pages. The text of the regulation alone is 139 pages.

B. Not only is the regulatory package long, the final rules are exceedingly complex. Apparently chastened by the unanimous Tax Court decision in Altera, Treasury and the IRS went to great lengths to respond to the numerous comments they received on the proposed regulations. The preamble includes lengthy explanations of many comments and the government’s responses and decisions with respect thereto. While the government’s responsiveness is a welcome change from certain previous regulatory processes, it has resulted in a monster of a regulatory package. There are a dizzying number of exceptions, exclusions, exceptions to exceptions, and special rules. Even a seasoned international tax practitioner will find these regulations challenging.

C. Treasury and the IRS have also gone to great lengths to attempt to insulate the regulations from the inevitable court challenges they will face. In addition to the recitation of comments and the government’s responses, the preamble repeatedly refers to the new rules as “factors.” The required elements of documentation to avoid automatic stock treatment are “factors.” The blacklisted transaction rules are justified by the assertion that relatedness and the lack of new investment in the issuer’s operations are “determinative factors.”

D. The big news internationally is that the regulations reserve on all aspects of their application to foreign debt issuers. Thus, they do not apply in an outbound context, such as when a U.S. parent company makes a loan to its foreign subsidiary. It was this area that caused the most problems from an international tax perspective. Foreign tax credits could have been lost and other serious collateral damage would have resulted from an outbound application of the § 385 regulations. Adam Halpern testified at the Treasury/IRS hearings specifically on these points. Treasury and the IRS stated that they reserved the issue for further study.

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E. Other major highlights of the regulations (applicable internationally primarily in an inbound context):

1. The general bifurcation rule is removed. That rule would have permitted the IRS during an examination to bifurcate a debt instrument so that it would constitute part equity and part debt. There were no rules on how this would be done and it seemed to have been left to the discretion of an IRS examining agent. Treasury and the IRS stated that they also reserved this issue for further study.

2. The documentation requirements will be implemented on a delayed basis. They apply only to debt instruments issued on or after January 1, 2018.

3. Once the documentation rules take effect, they will treat the required documentation and financial analysis as timely if it is prepared by the due date of the issuer’s federal income tax return (including applicable extensions) for the year in which the relevant event occurs.

4. The blacklisted transaction rules are generally retained, including the per se funding rule for distributions or acquisitions within 3 years of a debt issuance.

5. However, the E&P exception is expanded to include all of an issuer’s E&P accumulated after the proposed regulations were issued (April 4, 2016) and while it was a member of the same expanded group. This is a very helpful rule.

6. The “cliff effect” of the $50 million threshold exception is removed. Taxpayers can exclude the first $50 million of debt that otherwise would be recharacterized under the blacklisted transaction rules.

7. The 90-day delay in implementation of the blacklisted transaction rules is expanded so that any debt instrument that is subject to recharacterization but that is issued on or before January 19, 2017—the date 90 days after publication of the final regulations in the Federal Register—will not be recharacterized until January 20, 2017.

F. Documentation Requirements

1. Under the final regulations, documentation and information must be prepared and maintained with respect to each expanded group instrument, or EGI, within the scope of the rules. If the documentation and information are not prepared and maintained as required, and if no exception applies, the EGI will be treated as stock for all federal tax purposes.

2. An EGI generally means a debt instrument issued on or after January 1, 2018, with respect to which the issuer and the holder are both members of

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the same expanded group. Certain definitions are provided in Section I below.

3. The documentation rules apply to EGIs issued by a covered member (i.e., a domestic corporation that is a member of an expanded group, see definitions in Section I below) or by a disregarded entity whose regarded owner is a covered member.

4. The documentation rules only apply to expanded groups of a certain material size. An EGI is subject to the rules only if, on the date that an applicable interest first becomes an EGI—

The stock of any member of the expanded group is traded on (or subject to the rules of) an established financial market within the meaning of § 1.1092(d)-1(b);

Total assets exceed $100 million on any applicable financial statement or combination of applicable financial statements; or

Annual total revenue exceeds $50 million on any applicable financial statement or combination of applicable financial statements.

5. EGIs issued by certain regulated financial companies and regulated insurance companies are excluded from the rules. However, these entities must prepare and maintain documentation establishing that the EGI fits within the exclusion.

6. Documentation used to satisfy the documentation requirements must include complete copies of all instruments, agreements, and other documents evidencing the material rights and obligations of the issuer and the holder, and any associated rights of other parties, such as guarantees. For documents that are executed, such copies must be the executed copies.

7. Four categories of documentation must be prepared and maintained. These are the same categories as under the proposed regulations.

(a) Unconditional Obligation to Pay a Sum Certain. There must be written documentation establishing that the issuer has entered into an unconditional and legally binding obligation to pay a sum certain on demand or at one or more fixed dates. Documentation of a kind customarily used in comparable third-party transactions treated as debt for federal tax purposes may be used to satisfy this requirement. For example, documentation of a kind that a taxpayer uses for trade payables with unrelated parties will generally satisfy this requirement for documenting trade payables with members of the expanded group.

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(b) Creditor’s Rights. There must be written documentation establishing that the holder has the rights of a creditor to enforce the obligation. The regulation states that the rights of a creditor include, but are not limited to, the right to trigger an event of default or acceleration (when the event of default or acceleration is not automatic) for non-payment of interest or principal when due and the right to sue the issuer to enforce payment. Creditor’s rights must include a superior right to shareholders to receive the issuer’s assets in case of dissolution. An EGI that is nonrecourse has creditor’s rights for this purpose if it provides sufficient remedies against a specified subset of the issuer’s assets. As with the first requirement, documentation of a kind customarily used in comparable third-party transactions treated as debt for federal tax purposes may be used to satisfy this requirement.

(c) Reasonable Expectation of Repayment.

i. There must be written documentation establishing that, as of the date the applicable interest is issued and taking into account all relevant circumstances (including other obligations incurred by the issuer as of that date or reasonably anticipated to be incurred thereafter), the issuer’s financial position supported a reasonable expectation that the issuer intended to, and would be able to, meet its obligations pursuant to the applicable interest. Documentation in respect of an EGI that is nonrecourse must include information on any cash and property that secures the EGI, including the fair market value of publicly traded property, and any appraisal of other property, if one was prepared pursuant to the issuance of the EGI or within the three preceding years.

ii. If any member of an expanded group relied on any report or analysis prepared by a third party in analyzing whether the issuer would be able to meet its obligations, the documentation must include that report or analysis. If privilege is properly asserted, neither the existence nor the content of the report or analysis is taken into account in determining whether the reasonable expectation of repayment requirement is satisfied.

iii. Special rules apply in the case of written documentation that applies with respect to more than one EGI issued by a single issuer. In such a case, the documentation for this requirement may be prepared on an annual basis (an “annual credit analysis”). An annual credit analysis can be used to support the reasonable expectation of repayment of

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all EGIs issued within the 12-month period beginning on the date on which the analysis is based (the “analysis date”). However, if there is a material event with respect to the issuer within the 12-month period, new documentation must be prepared with an analysis date after the date of the material event.

iv. The documentation used to satisfy this requirement may include cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity ratios and other relevant financial ratios of the issuer in relation to industry averages, and other information regarding the sources of funds enabling the issuer to meet its obligations. The documentation may assume that the principal amount of an EGI may be satisfied with the proceeds of another borrowing, if that assumption is reasonable.

(d) Actions Evidencing Debtor-Creditor Relationship.

i. If an issuer made any payment of interest or principal with respect to the EGI and such payment is claimed to support the treatment of the EGI as debt, documentation under this requirement must include evidence of the payment. This evidence could include, for example, a wire transfer record or bank statement, or a netting of payables or receivables or journal entries in a centralized cash management system or in the expanded group’s accounting system.

ii. If the issuer did not make a payment of interest or principal due and payable under the EGI, or if any other event of default has occurred, there must be written documentation evidencing the holder’s reasonable exercise of the diligence and judgment of a creditor. This could include evidence of the holder’s efforts to assert its rights, the parties’ efforts to renegotiate the terms of the EGI or mitigate the breach of an obligation under the EGI. If the holder does not enforce its rights, there must be documentation that supports the holder’s decision to refrain from pursuing any actions to enforce payment as being consistent with the reasonable exercise of the diligence and judgment of a creditor.

8. Special documentation rules apply to arrangements in which an EGI is not evidenced by a separate note or other writing executed with respect to the initial principal balance or any increase in principal balance, such as a revolving credit agreement, a cash pool agreement, an omnibus or umbrella agreement that governs open account obligations or any other

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identified set of payables or receivables, or a master agreement that sets forth general terms of an EGI with an associated schedule or ticket that sets forth the specific terms of the EGI.

9. Under the special documentation rules, the first two documentation requirements (relating to requirement to pay a sum certain and creditor’s rights) are satisfied only if the material documentation associated with the EGI, including all relevant enabling documents, is prepared and maintained in accordance with the documentation rules. The third requirement (relating to reasonable expectation of repayment) is satisfied only if written documentation is prepared at least annually. The annual credit analysis must contain information establishing that, as of the analysis date and taking into account all relevant circumstances (including all other obligations incurred or reasonably anticipated to be incurred by the issuer), the issuer’s financial position supported a reasonable expectation that the issuer would be able to pay interest and principal in respect of the maximum principal amount permitted under the terms of the revolving credit agreement, omnibus, umbrella, master, cash pool or similar agreement. If there is a material event, new written documentation must be prepared to support EGIs issued after the material event.

10. In the case of cash pooling arrangements or internal banking service that involves account sweeps, revolving cash advance facilities, overdraft set-off facilities, operational facilities, or similar features, the EGI satisfies the requirements of the first two documentation requirements only if the material documentation governing the ongoing operations of the cash pooling arrangement or internal banking service, including any agreements with entities that are not members of the expanded group, are also prepared and maintained in accordance with the documentation rules.

11. Timeliness Requirement. In response to comments, Treasury and the IRS have eased the deadlines for preparing the required documentation. Documentation is treated as timely under the final regulations if it is completed no later than the time for filing the issuer’s federal income tax return (taking into account any applicable extensions) for the taxable year that includes the “relevant date” described below for that documentation.

(a) For the first two categories of required documentation (unconditional obligation to repay and creditor’s rights), the relevant date is the date on which a covered member becomes an issuer of a new or existing EGI. A relevant date for this purpose does not include the date of any deemed issuance of an EGI resulting from an exchange under § 1.1001-3 unless the deemed issuance relates to an alteration of the terms of the EGI reflected in a written agreement or written amendment to the EGI. In the case of an applicable interest that becomes an EGI subsequent to its issuance, including an intercompany obligation as defined in

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§ 1.1502-13(g)(2)(ii) that ceases to be an intercompany obligation, the relevant date is the day on which the applicable interest becomes an EGI.

(b) For the third category of required documentation (reasonable expectation of repayment), each date on which a covered member of the expanded group becomes an issuer with respect to an EGI and each later date on which an issuance is deemed to occur under § 1.1001-3 is a relevant date for that EGI. See also the special rules below. In the case of an applicable interest that becomes an EGI subsequent to issuance, the relevant date is the date the interest becomes and EGI and any relevant date thereafter. Special relevant date rules apply in the case of an overall arrangement such as a revolver or omnibus agreement.

(c) For the fourth category (actions evidencing debtor-creditor relationship), each date on which a payment of interest or principal is due, taking into account all additional time permitted under the terms of the EGI, is a relevant date. In addition, each date on which an event of default or similar event occurs is a relevant date. For example, if the terms of the EGI require the issuer to maintain certain financial ratios, any date on which the issuer fails to maintain those ratios is a relevant date if the failure results in an event of default under the terms of the EGI.

12. The required documentation must be maintained for all taxable years that the EGI is outstanding and until the period of limitations expires for any federal tax return for which the treatment of the EGI is relevant.

13. If the required documentation is not prepared and maintained with respect to a particular EGI but the taxpayer demonstrates that the expanded group is otherwise highly compliant with the documentation rules, the EGI is not automatically treated as stock, but is presumed to be stock for federal tax purposes. The taxpayer can overcome the presumption by clearly establishing that there are common law factors present to treat the EGI as debt, including that the issuer intended to create debt when the EGI was issued.

14. To establish the required high degree of compliance, an expanded group must meet one of two tests:

(a) The first test is satisfied if the average total adjusted issue price of all EGIs that are undocumented and outstanding as of the close of each quarter during the calendar year is less than 10% of the average amount of the total adjusted issue price of all EGIs that are outstanding as of the close of that quarter.

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(b) The second test is satisfied if either—

i. no EGI that is undocumented during the calendar year has an issue price in excess of $100 million and the average total number of EGIs that are undocumented and outstanding as of the close of each calendar quarter during the year is less than 5% of the average total number of EGIs that are outstanding as of the close of that quarter; or

ii. no EGI that is undocumented during the calendar year has an issue price in excess of $25 million and the average total number of EGIs that are undocumented and outstanding as of the close of each calendar quarter during the year is less than 10% of the average total number of EGIs that are outstanding as of the close of that quarter.

15. If the presumption of stock treatment is rebutted, the determination of whether an EGI is properly treated as debt (or otherwise) for federal tax purposes will be made under general federal tax principles. See paragraph 19 below for new rules on the weighting of factors in making this determination.

16. Operating Rules. Treas. Reg. § 1.385-2(e) describes certain operating rules addressing changes in the character of instruments subject to the documentation rules.

(a) If an applicable interest that is not an EGI becomes an EGI, the documentation rules apply immediately after it becomes an EGI.

(b) If an EGI treated as stock ceases to be an EGI, and is subsequently treated as debt under general federal tax principles, the issuer is treated as issuing a new debt instrument to the holder immediately before the transaction that causes the EGI to cease to be treated as an EGI. The issue price of the new debt instrument is determined under either Section 1273(b)(4) or 1274, as applicable.

(c) If an applicable interest that is an EGI when issued is determined to be stock due to a failure of documentation, the EGI is treated as stock from the date it was issued. If an applicable interest that is not an EGI when issued subsequently becomes and EGI and is determined to be stock due to a failure of documentation, it is treated as stock as of the date it becomes an EGI. However, if an EGI initially treated as debt is recharacterized as stock due to a later failure to satisfy the fourth category of documentation (actions evidencing debtor-creditor relationship), the EGI ceases to be treated as debt as of the time the facts and circumstances cease to evidence a debtor-creditor relationship. For this purpose, the

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documentation rules apply before the rules of § 1.1001-3. Thus, an EGI initially treated as debt may be recharacterized as stock regardless of whether the debt is altered or modified under § 1.1001-3 and, in determining whether debt is recharacterized as stock, § 1.1001-3(f)(7)(ii)(A) does not apply.

(d) If an EGI initially treated as debt is recharacterized as stock, Treas. Reg. § 1.385-1(d) governs the consequences to the issuer and the holder arising from the deemed exchange of debt for stock. The holder is treated as having realized an amount equal to its adjusted basis in the portion of the debt to be treated as stock, and the issuer is treated as having retired that portion for an amount equal to its adjusted issue price. Neither party accounts for any accrued but unpaid qualified stated interest or any foreign exchange gain or loss with respect to such interest. However, any foreign exchange gain or loss with respect to principal and any other interest (OID, for example) are realized and recognized.

(e) In the case of an EGI issued by a disregarded entity and treated as stock due to a failure of documentation, the covered member that is the regarded owner of the disregarded entity is deemed to issue its stock to the holder. The regarded owner is treated as the holder of the EGI issued by the disregarded entity (and thus the EGI is generally disregarded for federal tax purposes), and the stock deemed issued by the regarded owner is deemed to have the same terms as the EGI.

17. Treas. Reg. § 1.385-2(a)(5) provides a consistency rule to implement Section 385(c)(1). If an issuer characterizes an EGI as debt, the issuer and the holder are each required to treat the EGI as debt for all federal tax purposes. An issuer is considered to have characterized an EGI as debt if the legal form of the EGI is debt, if the issuer claims any federal income tax benefit resulting from characterizing the EGI as debt, such as interest deductions, or if the issuer reports the EGI as debt or amounts paid or accrued on the EGI as interest on an applicable financial statement. However, this rule and § 385(c)(1) do not apply to the extent the EGI is treated as stock by reason of a failure of documentation or it has been determined that the EGI is treated as stock under applicable federal tax principles. Instead, in that case, the issuer and the holder are each required to treat the EGI as stock for all federal tax purposes.

18. The consistency rule does not appear to be intended to prevent issuers from characterizing instruments as equity, even if issued in the legal form of debt, if general federal tax principles so require. Clarification in this regard from Treasury and the IRS would be helpful.

19. Treas. Reg. § 1.385-2(b)(3) states:

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In applying federal tax principles to the determination of whether an EGI is indebtedness or stock, the indebtedness factors in paragraph (c)(2) of this section [i.e., the four required categories of documentation] are significant factors to be taken into account. Other relevant factors are taken into account in the determination as lesser factors, with the relative weighting of each lesser factor based on facts and circumstances.

This is a potentially very important rule. The traditional importance given to the parties’ intentions and the issuer’s ability to repay, whether or not documented, will be greatly reduced once these rules take effect. If an EGI is undocumented, but is excused from per se stock treatment under an exception, will it nonetheless be treated as stock under “general federal tax principles” weighted in this manner?

20. The anti-avoidance rule of the proposed regulations has been retained in the final regulations. If an applicable interest that is not an EGI is issued with a principal purpose of avoiding the application of the documentation rules, the applicable interest is treated as an EGI subject to the rules.

21. The final regulations reserve on the affirmative use rule pending further study. Commentators had urged that the rule be removed as it could cause significant uncertainty that could lead to conflicts with other tax authorities (for example, under BEPS-inspired anti-hybrid rules).

22. The documentation rules apply to taxable years ending on or after January 19, 2017. However, due to the delayed implementation date, the rules will have no practical effect before January 1, 2018.

G. Blacklisted Transactions

1. The blacklisted transaction rules under the final regulations follow the pattern set forth in the proposed regulations. The general rule and funding rule both remain in place essentially as proposed. However, the final regulations add a number of new exceptions and expand some of the existing exceptions to the application of the per se funding rule.

2. Under the general rule, unless an exception applies, a covered debt instrument (see definitions of terms in paragraph I below) is treated as stock to the extent it is issued by a covered member to a member of the covered member’s expanded group in one or more of the following transactions:

in a distribution;

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in exchange for expanded group stock, other than in an exempt exchange; or

in exchange for property in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder in the transferor corporation that is a member of the issuer’s expanded group immediately before the reorganization receives the covered debt instrument with respect to its stock in the transferor corporation.

3. The funding rule is intended to serve as a backstop, to prevent expanded group members from achieving the same result indirectly as could be achieved directly with a general rule transaction. Under the funding rule, unless an exception applies, a covered debt instrument is treated as stock to the extent it is issued by a covered member (the “funded member”) to a member of the funded member’s expanded group in exchange for property and, pursuant to a “per se” rule or a “principal purpose” rule, is treated as funding any one or more of the following blacklisted distribution or acquisition transactions:

A distribution of property by the funded member to a member of the funded member’s expanded group, other than in an exempt distribution of stock pursuant to an asset reorganization that is permitted to be received without the recognition of gain or income under § 354(a)(1) or 355(a)(1) or, when § 356 applies, that is not treated as “other property” or money described in § 356;

An acquisition of expanded group stock, other than in an exempt exchange, by the funded member from a member of the funded member’s expanded group in exchange for property other than expanded group stock; or

An acquisition of property by the funded member in an asset reorganization, but only to the extent that, pursuant to the plan of reorganization, a shareholder in the transferor corporation that is a member of the funded member’s expanded group immediately before the reorganization receives other property or money within the meaning of § 356 with respect to its stock in the transferor corporation.

4. Under the per se funding rule, a covered debt instrument is treated as funding a blacklisted distribution or acquisition if the covered debt instrument is issued by a funded member during the period beginning 36 months before the date of the distribution or acquisition and ending 36 months thereafter (the “per se period”). If two or more covered debt instruments could be treated as stock under this rule, the covered debt

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instruments are tested based on the order in which they are issued. Similarly, if a covered debt instrument could be treated as funding more than one blacklisted distribution or acquisition, the covered debt instrument is treated as funding the distributions or acquisitions based on the order in which they occur.

5. For purposes of the per se funding rule, if a covered debt instrument is deemed exchanged for a new covered debt instrument under § 1.1001-3, the new instrument is generally treated as issued on the original issue date of the original covered debt instrument. However, if the modification (or one of the modifications) that results in the deemed exchange includes the substitution of an obligor, the addition or deletion of a co-obligor, or the material deferral of scheduled payments, then the new covered debt instrument is treated as issued on the date of the deemed exchange.

6. Under the principal purpose funding rule, a covered debt instrument that is not issued by a funded member during the per se period with respect to a blacklisted distribution or acquisition is treated as funding the distribution or acquisition to the extent it is issued by a funded member with a principal purpose of funding the distribution or acquisition.

7. In applying the funding rule, subject to certain limitations, references to a funded member include references to a predecessor or successor of the funded member.

8. Exclusions from Funding Rule Transactions.

(a) A covered debt instrument issued by a covered member is not taken into account in applying the funding rule if it is a qualified short-term debt instrument. See Section I below.

(b) A distribution or acquisition that occurs before April 5, 2016 is not taken into account in applying the funding rule.

9. Anti-Abuse Rule. If a member of an expanded group enters into a transaction with a principal purpose of avoiding the purposes of the blacklisted transaction rules, an interest issued or held by that member or another member of the member’s expanded group may, depending on the facts and circumstances, be treated as stock. Examples of transactions where this rule may apply include a § 483 contract or a nonperiodic swap payment, or a covered debt instrument issued to a person that is not a member of the issuer’s expanded group if the covered debt instrument is later acquired from that person or that person later becomes a member of the expanded group. Additionally, a covered debt instrument is treated as stock if the funded member or any member of its expanded group engages in a transaction with a principal purpose of avoiding the purposes of the blacklist rules.

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10. Exceptions from the General Rule and the Funding Rule. Treas. Reg. § 1.385-3(c) provides several exceptions to the general rule and the funding rule. These exceptions are applied in a specified order: first, the exclusion for transactions otherwise described in those rules; second, the reductions for expanded group earnings and qualified contributions; and third, the $50 million threshold exception.

(a) Exclusion for Transactions Otherwise Described. An acquisition of expanded group stock is not treated as an acquisition to which the general rule or the funding rule applies:if, immediately after the acquisition, the covered member that acquires the stock (acquirer) controls the member whose stock it acquires (seller), and the acquirer does not relinquish control of the seller pursuant to a plan that existed on the date of the acquisition, other than in a transaction in which the seller ceases to be a member of the expanded group. Control for this purpose means direct or indirect ownership of more than 50% of the stock by vote and value. Other exclusions are provided for compensatory stock acquisitions, transactions resulting from transfer pricing adjustments (including pursuant to Rev. Proc. 99-32), acquisitions by dealers in securities, and acquisitions resulting from application of the blacklist rules (the cascading problem).

(b) Reductions of Acquisitions or Distributions.

i. The aggregate amount of any distributions or acquisitions to which the general rule or funding rule otherwise would apply in a taxable year during the covered member’s expanded group period is reduced by the covered member’s expanded group earnings account for the expanded group period as of the close of the taxable year. The “expanded group earnings account” means the excess of the covered member’s expanded group earnings for the expanded group period over the covered member’s reductions under this rule for the expanded group period. “Expanded group earnings” means the E&P accumulated by the covered member during the expanded group period as of the close of the taxable year, without regard to any distributions or acquisitions to which the general rule or the funding rule would apply, but not including any E&P accumulated in any taxable year ending before April 5, 2016. Detailed rules are provided for adjusting expanded group earnings following certain transactions.

ii. The amount of a distribution or acquisition by a covered member to which the general rule or funding rule otherwise would apply is reduced by the aggregate fair market value

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of the stock issued by the covered member in one or more qualified contributions during the qualified period, to the extent the contributions have not reduced other distributions or acquisitions. Detailed rules are provided for determining the amount of qualified contributions.

(c) Threshold Exception. A covered debt instrument is not treated as stock under the blacklist rules if, immediately after the covered debt instrument would be treated as stock but for this exception, the aggregate adjusted issue price of covered debt instruments held by members of the issuer’s expanded group that would be treated as stock but for this exception does not exceed $50 million. To the extent the aggregate adjusted issue price of such covered debt instruments exceeds $50 million, only the amount of the covered debt instrument in excess of $50 million is treated as stock.

11. Treatment of Controlled Partnerships. In detailed temporary regulations, the blacklist rules adopt an aggregate approach to controlled partnerships. Additionally, through a complex series of rules, the holder-in-form of a debt instrument issued by a controlled partnership is deemed to transfer a portion of the debt instrument to the expanded group partner in exchange for stock of equal value.

H. Consolidated Groups. For purposes of the blacklist rules, all members of a consolidated group are treated as one corporation The one-corporation rule does not apply, however, for purposes of determining the members of an expanded group. A partnership that is wholly owned by members of a consolidated group is nonetheless treated as a partnership. Special rules are provided for applying certain exclusions, reductions and other blacklisted transaction rules to the members of a consolidated group, and for debt instruments that become, or cease to be, owned by members of the consolidated group.

I. Definitions of Certain Terms

1. An “applicable financial statement” means a financial statement, prepared as of any date within the 3-year period preceding the date the applicable instrument first becomes an EGI, that includes the assets, a portion of the assets, or the annual total revenue of any member of the expanded group, if the financial statement is (i) required to be filed with the SEC, (ii) a certified audited financial statement accompanied by the report of an independent CPA (or, in the case of a foreign entity, the foreign equivalent) that is used for credit purposes, reporting to shareholders, or any other substantial non-tax purpose, or (iii) a financial statement (other than a tax return) required to be provided to the federal, state, or foreign government or any federal, state, or foreign agency.

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2. An “applicable interest” generally means any interest that is issued or deemed issued in the legal form of a debt instrument, or an intercompany payable and receivable documented as debt in a ledger, accounting system, open account intercompany debt ledger, trade payable, journal entry or similar arrangement if no legal instrument or written legal arrangement governs the legal treatment of such payable and receivable.

An “applicable interest” does not include: (i) an intercompany obligation as defined in § 1.1502-13(g)(2)(ii); (ii) production payments treated as a loan under § 636(a) or (b); (iii) a “regular interest” in a REMIC described in § 860G(a)(1); (iv) a debt instrument that is deemed to arise under § 1.482-1(g)(3), including adjustments made pursuant to Rev. Proc. 99-32; or (v) any other instrument or interest that is specifically treated as debt for federal tax purposes under a provision of the Code or regulations.

Under the delayed implementation rule, an “applicable interest” also does not include any interest issued or deemed issued before January 1, 2018.

3. A “cash management arrangement” means an arrangement the principal purpose of which is to manage cash for participating expanded group members. For this purpose, managing cash means borrowing excess funds from participating expanded group members and lending funds to participating expanded group members, and may also include foreign exchange management, clearing payments, investing excess cash with an unrelated person, depositing excess cash with another qualified cash pool header, and settling intercompany accounts, for example through netting centers and pay-on-behalf-of programs.

4. A “controlled partnership” means, with respect to an expanded group, a partnership with respect to which at least 80% of the interests in partnership capital or profits are owned, directly or indirectly, by one or more members of the expanded group.

5. A “covered debt instrument” means a debt instrument issued after April 4, 2016. However, the term “covered debt instrument” does not include (i) production payments treated as a loan under § 636(a) or (b); (ii) a “regular interest” in a REMIC described in § 860G(a)(1); (iii) a debt instrument that is deemed to arise under § 1.482-1(g)(3), including adjustments made pursuant to Rev. Proc. 99-32; (iv) a stripped bond or coupon described in § 1286, unless issued with a principal purpose of avoiding the blacklist rules, or (v) a lease treated as a loan under § 467. The term “covered debt instrument” also does not ertain debt instruments issued by qualified dealers, regulated financial companies, or regulated insurance companies.

6. A “covered member” means a member of an expanded group that is a domestic corporation. The definition reserves on other members of an

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expanded group. Accordingly, foreign issuers are excluded from all aspects of the regulations, unless and until Treasury and the IRS revisit the reserved paragraph.

7. A “debt instrument” means an interest that would be treated as a debt instrument as defined in § 1275(a) and § 1.1275-1(d), before taking into account the documentation rules and the blacklist rules.

8. A “distribution” means any distribution made by a corporation with respect to its stock.

9. An “exempt exchange” means an acquisition of expanded group stock in which—

(a) the transferor and transferee of the stock are parties to an asset reorganization, and either (i) § 361(a) or (b) applies to the transferor and the stock is not transferred by issuance, or (ii) § 1032 or § 1.1032-2 applies to the transferor and the stock is distributed by the transferee pursuant to the plan of reorganization;

(b) the transferor is a shareholder that receives property in a complete liquidation to which § 331 or 332 applies; or

(c) the transferor is an acquiring entity that is deemed to issue the stock in exchange for cash from an issuing corporation in a transaction described in § 1.1032-3(b).

10. An “expanded group” means one or more chains of corporations (other than S corporations) connected through stock ownership with a common parent corporation (other than a RIC, REIT, or S corporation, the “expanded group parent”), but only if—

the expanded group parent owns directly or indirectly stock in at least one of the other corporations having at least 80% of the total voting power or at least 80% of the total value of that other corporation’s stock, and

stock in each corporation in the group other than the expanded group parent having at least 80% of the total voting power or at least 80% of the total value of that corporation’s stock is owned directly or indirectly by one or more of the other corporations.

In applying the 80% ownership tests, “stock” has the same meaning as in § 1504, without regard to the special option rules in § 1.1504-4. All shares of stock in the same class are treated as having the same value. Thus, control premiums and minority and blockage discounts are ignored.

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“Indirect” stock ownership is determined under § 318(a)(2), substituting “5 percent” for “50 percent” in § 318(a)(2)(C). Thus, stock of a corporation can be owned indirectly through partnerships, trusts, and estates, as well as through other corporations that are at least 5% owned. The final regulations reserve on family attribution and downward attribution under § 318 pending further study. Option attribution under § 318(a)(4) applies in only a limited manner.

11. An “expanded group instrument” or “EGI” means an applicable interest the issuer of which is a member of an expanded group (or a disregarded entity whose regarded owner is a member of an expanded group) and the holder of which is another member of the same expanded group, a disregarded entity whose regarded owner is another member of the same expanded group, or a controlled partnership with respect to the same expanded group. Debt instruments issued by partnerships are not EGIs and generally are not subject to the documentation rules (but may be subject to the anti-avoidance rule in certain circumstances).

12. “Included assets” means, with respect to an entity, all assets other than inventory sold in the ordinary course of business, assets contributed to another entity in exchange for equity in such other entity, and investment assets such as portfolio stock investments to the extent that other investment assets or cash of equivalent value is substituted.

13. Solely for purposes of the documentation rules, an “issuer” means a person (including a disregarded entity) that is obligated to satisfy any material obligations created under the terms of an EGI. A person can be an issuer even if that person is not the primary obligor. The person could become obligated to satisfy a material obligation after the date the EGI is issued, for example, a person that becomes a co-obligor. A guarantor is not an issuer, however, unless the guarantor is expected to be the primary obligor.

14. A “material event” means, with respect to an entity, that the entity—(i) comes under the jurisdiction of a court in a case under Title 11 or a receivership, foreclosure or similar proceeding; (ii) becomes insolvent; (iii) materially changes its line of business; (iv) sells alienates, distributes, leases, or otherwise disposes of 50% or more of its included assets; or (v) merges or consolidates into another person and the surviving entity does not assume liability for any of the entity’s outstanding EGIs as of the time of the merger or consolidation.

15. “Predecessors” and “successors” arise from § 381 transactions or § 355 distributions. Additionally, a corporation is a successor if it receives property from a member of its expanded group (transferor) in exchange for expanded group stock and the transferor controls the corporation after the transaction, such that the transferor’s acquisition of the corporation’s

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stock qualifies for the exclusion from the blacklist rules for acquisitions of subsidiary stock.

16. A “qualified cash pool header” means an expanded group member, controlled partnership, or QBU described in § 1.989(a)-1(b)(2)(ii) that has as its principal purpose managing a cash-management arrangement for participating expanded group members, provided that the excess (if any) of any funds on deposit with such expanded group member, partnership, or QBU (the “header”) over the outstanding balance of loans made by the header is maintained on the books and records of the header in the form of cash or cash equivalents, or invested through deposits with, or the acquisition of obligations or portfolio securities of, persons that do not have a relationship to the header described in § 267(b) or 707.

17. A “qualified short-term debt instrument” means a covered debt instrument that meets one or more of the following requirements:

(a) the “specified current assets test,” see Temp. Treas. Reg. § 1.385-3T(b)(3)(vii)(A)(1);

(b) the “270-day test,” see Temp. Treas. Reg. § 1.385-3T(b)(3)(vii)(A)(2);

(c) the covered debt instrument is issued as consideration for the acquisition of property other than money in the ordinary course of the issuer’s trade or business, provided the obligation is reasonably expected to be repaid within 120 days of issuance;

(d) the covered debt instrument does not provide for stated interest (or no interest is charged), it does not have OID, interest is not imputed under § 483 or 7872 and the regulations thereunder, and interest is not required to be charged under § 482 and the regulations thereunder; or

J. the covered debt instrument is a demand deposit received by a qualified cash pool header pursuant to a cash-management arrangement, unless a purpose for making the demand deposit is to facilitate the avoidance of the purposes of the blacklist rules with respect to a QBU that is not a qualified cash pool header.

VI. FOREIGN TAX CREDITS.

A. Section 901(m): Temporary Regulations.

1. Section 901(m) was enacted in 2010. It provides that in the case of a covered asset acquisition (“CAA”), the disqualified portion of any foreign tax determined with respect to the income or gain attributable to relevant foreign assets (“RFAs”) will not be taken into account in determining the

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relevant foreign tax credit. Instead, the disqualified portion of any foreign income tax (the “disqualified tax amount”) is permitted as a deduction.

2. Under § 901(m)(2), a CAA is: (1) a qualified stock purchase as defined in § 338; (2) any transaction that is treated as an acquisition of assets for U.S. income tax purposes and as the acquisition of stock of a corporation (or is disregarded) for purposes of foreign income tax; (3) any acquisition of an interest in a partnership that has an election in effect under § 754 (“§ 743(b) CAAs”); and (4) to the extent provided by the IRS, any similar transaction.

3. Section 901(m)(3)(A) provides that the term “disqualified portion” means, with respect to any CAA, for any taxable year, the ratio (expressed as a percentage) of (1) the aggregate basis differences (but not below zero) allocable to that taxable year with respect to all RFAs; divided by (2) the income on which the foreign income tax referenced in § 901(m)(1) is determined. If the taxpayer fails to substantiate the income on which the foreign income tax is determined to the satisfaction of the IRS, the income will be determined by dividing the amount of the foreign income tax by the highest marginal tax rate applicable to the taxpayer’s income in the relevant jurisdiction.

4. Section 901(m)(3)(B)(i) provides the general rule that the basis difference with respect to any RFA will be allocable to tax years using the applicable cost recovery method for U.S. income tax purposes. If there is a disposition of an RFA, the basis difference allocated to the taxable year of the disposition will be the excess of the basis difference of the asset over the aggregate basis difference of the asset that has been allocated to all prior years.

5. Section 901(m)(4) provides that an RFA means, with respect to a CAA, an asset (including goodwill, going concern value, or other intangible) with respect to the acquisition if income, deduction, gain, or loss attributable to the asset as taken into account in determining the foreign income tax referenced in § 901(m)(1).

6. Notices 2014-44 and 2014-45.

(a) The temporary regulations largely adopt (consist of) the rules discussed in Notice 2014-44, 2014-32 I.R.B. 270, and Notice 2014-45, 2014-34 I.R.B. 388. These notices addressed the application to § 901(m) to dispositions of RFAs following CAAs and to CAAs described in § 901(m)(2)(C) (regarding partnership § 754 elections).

(b) The notices were issued in response to certain taxpayers engaging in transactions shortly after a CAA with the intention of invoking

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the application of the statutory disposition rule to avoid the purposes of § 901(m). To address these concerns, Notice 2014-44 described the definition of disposition that would be set forth in regulations, as well as the rules for determining the portion of the basis difference that would be taken into account upon the disposition of an RFA (the disposition amount). The notice also described the computation of basis difference and disposition amount with respect to an RFA that is subject to a § 743(b) CAA, and discussed successor rules.

(c) The notices provided that the regulations would apply (1) concerning dispositions, to dispositions occurring after July 21, 2014, (2) concerning § 743(b) CAAs, to those occurring on or after July 21, 2014, unless a taxpayer consistently applied those provisions to all § 743(b) CAAs occurring on or after January 1, 2011; and (3) concerning successor rules, to remaining basis differences with respect to an RFA as of July 21, 2014, and any basis difference with respect to an RFA that arises in a CAA occurring on or after July 21, 2014.

7. Overview of the Temporary Regulations.

(a) Temp. Treas. Reg. § 1.901(m)-1T provides definitions that apply for purposes of the temporary regulations. They also apply for purposes of the new proposed § 901(m) regulations discussed further below. Temp. Treas. Reg. § 1.901(m)-2T identifies the transactions that are CAAs and the assets are RFAs with respect to a CAA. Temp. Treas. Reg. § 1.901(m)-4T provides the general rule for determining basis difference with respect to an RFA under § 901(m)(3)(C), as well as a special rule for determining basis difference with respect to an RFA that arises as a result of an acquisition of an interest in a partnership that has made a § 754 election i.e., a § 743(b) CAA.

(b) Temp. Treas. Reg. § 1.901(m)-5T provides rules for taking into account basis difference under the applicable cost recovery method or as a result of a disposition of an RFA. Temp. Treas. Reg. § 1.901(m)-6T provides successor rules for applying § 901(m) to subsequent transfers of RFAs that have basis difference that has not yet been fully taken into account.

(c) The applicability dates of the temporary regulations relate back to the issuance of Notices 2014-44 and 2014-45. Accordingly, the temporary regulations apply to CAAs occurring on or after July 21, 2014, and to CAAs occurring before that date resulting from an entity classification election that is filed on or after July 29, 2014 and that is effective on or before July 21, 2014.

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(d) The temporary regulations also apply to CAAs occurring on or after January 1, 2011, and before the general applicability date (the “transition period”), but only if the basis difference within the meaning of § 901(m)(3)(C)(i) (statutory basis difference) in one or more RFAs with respect to such a CAA has not been fully taken into account under § 901(m)(3)(B) either as of July 21, 2014, or, in the case of an entity classification election that is filed on or after July 29, 2014 and that is to be effective on or before July 21, 2014, prior to the transactions that are deemed to occur under the check-the-box rules as a result of the change in classification.

(e) Taxpayers also may choose to consistently apply Temp. Treas. Reg. § 1.901(m)-4T(d)(1) (regarding the termination of basis difference in an RFA with respect to a § 743(b) CAA) to all § 743(b) CAAs occurring on or after January 1, 2011.

8. CAAs and RFAs.

(a) Temp. Treas. Reg. § 1.901(m)-2T(b) identifies the transactions that are CAAs under § 901(m)(2)(A)-(C). Temp. Treas. Reg. § 1.901(m)-2T(c) provides that, with respect to a foreign income tax and CAA, an RFA is any asset (including goodwill, going concern value, or other intangible) subject to the CAA that is relevant in determining foreign income for purposes of the foreign income tax.

(b) An asset is subject to a CAA, if, for example (1) in the case of a qualified stock purchase to which § 338 applies, new target is treated as purchasing the asset from old target; (2) in the case of a taxable acquisition of a disregarded entity that is treated as an acquisition of stock for foreign income tax purposes, the asset is owned by the disregarded entity at the time of the purchase and therefore the buyer is treated as purchasing the asset from the seller; and (3) in the case of a § 743(b) CAA, the asset is attributable to the partnership interest transferred in the § 743(b) CAA.

(c) Temp. Treas. Reg. § 1.901(m)-2T(d) provides that the statutory definitions under §§ 901(m)(2) and (4) apply to determine whether a transaction that occurred during the transition period is a CAA and which assets are RFAs.

(d) A basis difference is computed separately with respect to each foreign income tax for which an asset is an RFA. Consistent with § 901(m)(3)(C), Temp. Treas. Reg. § 1.901(m)-4T(b) provides a general rule that basis difference with respect to an RFA is the U.S. basis in the RFA immediately after the CAA, less the U.S. basis

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and the RFA immediately before the CAA. If, however, an asset is an RFA with respect to a § 743(b) CAA, Temp. Treas. Reg. § 1.901(m)-4T(d) provides that basis difference with respect to the RFA is a resulting basis adjustment under § 743(b) that is allocated to the RFA under § 755.

(e) Temp. Treas. Reg. § 1.901(m)-2T(e) “resets” the basis difference in an RFA with respect to a CAA that occurred during the transition period by defining basis difference in the RFA as the portion of statutory basis difference that had not been taken into account under § 901(m)(3)(B) either as of July 21, 2014, or, in the case of an entity classification election that is filed on or after July 29, 2014, and that is effective on or before July 21, 2014, prior to the transactions that are deemed to occur under the check-the-box rules as a result of the change in classification.

(f) Temp. Treas. Reg. § 1.901(m)-5T provides rules for determining the amount of basis difference with respect to an RFA that is taken into account in a given U.S. taxable year (allocated basis difference). The amount of basis difference taken into account in a U.S. taxable year is used to compute a disqualified tax amount for the U.S. taxable year. Basis difference is taken into account in two ways: under an applicable cost recovery method or as the result of a disposition of the RFA. If an asset is an RFA with respect to more than one foreign income tax, basis difference with respect to each foreign income tax is separately taken into account.

9. Determining Disposition Amounts.

(a) Section 901(m)(3)(B)(ii) provides that, except as otherwise provided by the IRS, if there is a disposition of an RFA, the basis difference allocated to the U.S. taxable year of the disposition is the excess of the bases difference of the RFA over the total amount of the bases difference that has been allocated to all prior U.S. taxable years (unallocated basis difference).

(b) This approach works when all gain or loss from the disposition is recognized for both U.S. and foreign income tax purposes. In other cases, however, a disposition might not be the appropriate time for all of the unallocated basis difference to be taken into account. For example, it may not be appropriate for all of the unallocated basis difference to be taken into account upon a disposition that is fully taxable for U.S. income tax purposes but not for foreign income tax purposes. Accordingly, the temporary regulations provide rules to determine when less than all of the unallocated basis difference is taken into account as a result of a disposition.

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(c) Temp. Treas. Reg. § 1.901(m)-1T(a)(10) defines a disposition for purposes of § 901(m) as an event that results in gain or loss being recognized with respect to an RFA for purposes of U.S. income tax or foreign income tax, or both. Thus, the definition excludes certain transactions that might otherwise be considered dispositions under the ordinary meaning of that term. For example, an entity classification election by an RFA owner that results in a tax-free deemed liquidation for U.S. income tax purposes but that is disregarded for foreign income tax purposes does not result in the disposition of the RFAs under § 901(m). This is because no gain or loss is recognized for U.S. or foreign income tax purposes with respect to the disposition.

(d) Temp. Treas. Reg. § 1.901(m)-5T(c)(2) provides rules for determining a disposition amount. If the disposition of an RFA is fully taxable for U.S. and foreign income tax purposes, the disposition amount will be any remaining unallocated basis difference with respect that RFA. There generally will no longer be a disparity in the U.S. basis and the foreign basis of the RFA.

(e) If a disposition is not fully taxable for both U.S. and foreign income tax purposes, generally there will continue to be a disparity in the U.S. basis and the foreign basis following the disposition, and it will be appropriate for the RFA to continue to have unallocated basis difference. To the extent that the disparity in the U.S. basis and the foreign basis is reduced as a result of the disposition, however, a portion of the unallocated basis difference should be taken into account.

(f) If an RFA has a positive basis difference, a reduction in basis disparity generally will occur upon a disposition of the RFA if: (1) a foreign disposition gain is recognized, which generally results in an increase in the foreign basis of the RFA, or (2) a U.S. disposition loss is recognized, which generally results in a decrease in the U.S. basis of the RFA. Accordingly, if an RFA has a positive basis difference, the disposition amount equals the lesser of (1) any foreign disposition gain plus any U.S. disposition loss (for this purpose, expressed as a positive amount), or (2) unallocated basis difference.

(g) If an RFA has a negative basis difference, a reduction in basis disparity generally will occur upon a disposition of the RFA if (1) a foreign disposition loss is recognized which generally results in a decrease in the foreign basis of the RFA or (2) a U.S. disposition gain is recognized, which generally results in an increase in the U.S. basis of the RFA. Accordingly, if an RFA has a negative basis difference, the disposition amount equals the

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greater of (1) any U.S. disposition gain (for this purpose, expressed as a negative amount) plus any foreign disposition loss or (2) unallocated basis difference.

(h) The determination of whether there is a disposition for U.S. income tax purposes, and the amount of U.S. disposition gain or U.S. disposition loss, is made without regard to whether gain or loss is deferred or disallowed or otherwise not taken into account currently (for example, under § 267 or Treas. Reg. § 1.1502-13). This principle also applies if foreign law has an equivalent concept whereby gain or loss that is realized and recognized is deferred or disallowed.

(i) If an asset is an RFA by reason of a § 743(b) CAA and subsequently there is a disposition of the RFA, then for purposes of determining the disposition amount, foreign disposition gain or foreign disposition loss means the amount of gain or loss recognized for purposes of a foreign income tax on the disposition of the RFA that is allocable to the partnership interest that was transferred in the § 743(b) CAA. U.S. disposition gain or U.S. disposition loss means the amount of gain or loss recognized for U.S. income tax purposes on the disposition of the RFA that is allocable to the partnership interest that was transferred in a § 743(b) CAA, taking into account the basis adjustment under § 743(b) that was allocated to the RFA under § 755.

10. Successor Rules.

(a) Temp. Treas. Reg. § 1.901(m)-6T(b) provides that § 901(m) continues to apply to any unallocated basis difference with respect to an RFA after there is a transfer of the RFA for U.S. income tax purposes (successor transaction), regardless of whether the transfer is a disposition, a CAA, or a non-taxable transaction. A successor transaction does not occur if, as a result of the transfer of an RFA, the entire unallocated basis difference is taken into account because, for example, the transfer results in all realized gain or loss in the RFA being recognized for U.S. and foreign income tax purposes.

(b) Notice 2014-44 stated that Treasury and the IRS were continuing to study whether and to what extent § 901(m) should apply to an asset received in exchange for an RFA in a transaction in which the U.S. basis of the asset is determined by reference to the U.S. basis of the transferred RFA. They have determined that an asset should not become an RFA solely because the U.S. basis of that asset is determined by reference to the U.S. basis of an RFA for which the asset is exchanged in a successor transaction.

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(c) Accordingly, for example, if in a successor transaction, an RFA owner transfers an RFA to a corporation in a transfer to which § 351 applies, the stock of the transferee corporation received is not an RFA even though the U.S. basis of the stock is determined under § 358 by reference to the U.S. basis of the RFA transferred.

(d) An asset may be an RFA with respect to multiple CAAs if a successor transaction is also a CAA (subsequent CAA). In this case, the subsequent CAA may give rise to additional basis difference. Temp. Treas. Reg. § 1.901(m)-6T(b)(4)(i) provides generally that the unallocated basis difference with respect to a CAA that occurred prior to the subsequent CAA (referred to as a “prior CAA”) will continue to be taken into account under § 901(m) after the subsequent CAA.

(e) Temp. Treas. § 1.901(m)-6T(b)(4)(iii) provides an exception to the general rule if an RFA is subject to two § 743(b) CAAs. In this case, to the extent the same partnership interest is transferred in the transactions, the RFA will be treated as having no unallocated basis difference with respect to the prior § 743(b) CAA if basis difference for the subsequent § 743(b) CAA is determined independently from the prior transaction.

11. Definition of Foreign Income Tax. The temporary regulations define “foreign income tax” as any income, war profits or excess profits tax for which a credit is allowable under § 901 or 903, other than any withholding tax determined on a gross basis as described in § 901(k)(1)(B). Treasury and the IRS have determined that a withholding tax should not be subject to a disallowance under § 901(m) because a withholding tax is a gross basis tax that is generally unaffected by changes in asset basis.

B. Section 901(m): Proposed Regulations.

1. The background to § 901(m) was discussed above in addressing the temporary § 901(m) regulations. A number of the definitional terms used in the proposed regulations also derive from those temporary regulations and are included in the proposed regulations by cross reference.

2. Overview of the Proposed Regulations.

(a) The proposed regulations provide rules for computing the disqualified portion of foreign income taxes under § 901(m). Prop. Treas. Reg. § 1.901(m)-1 provides definitions that apply for purposes of the proposed regulations. Prop. Treas. Reg. § 1.901(m)-2 identifies the transactions that are CAAs, including additional categories of transactions that are identified as CAAs,

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and provides rules for identifying assets that are RFAs with respect to a CAA.

(b) Prop. Treas. Reg. § 1.901(m)-3 provides rules for computing the disqualified portion of foreign income taxes, describes the treatment under § 901(m)(1) of the disqualified portion, and provides rules for determining whether and to what basis difference that is assigned to a given taxable year is carried over to subsequent taxable years.

(c) Prop. Treas. Reg. § 1.901(m)-4 provides rules for determining basis difference with respect to an RFA, including an election to use foreign basis for purposes of this determination. Prop. Treas. Reg. § 1.901(m)-5 provides rules for taking into account basis difference under an applicable cost recovery method or as a result of a disposition of an RFA, rules for allocating that basis difference, when necessary, to one or more persons subject to § 901(m), and rules for assigning that basis difference to a U.S. taxable year.

(d) Prop. Treas. Reg. § 1.901(m)-6 provides successor rules for applying § 901(m) to subsequent transfers of RFAs that have basis difference that has not been fully taken into account, as well as for transferring an aggregate basis difference carryover of a person subject to § 901(m) either to another aggregate basis difference carryover account of that person or to another person subject to § 901(m).

(e) Prop. Treas. Reg. § 1.901(m)-7 provides de minimis rules under which certain basis differences are not taken into account under § 901(m). Prop. Treas. Reg. § 1.901(m)-8 provides guidance on the application of § 901(m) to pre-1987 foreign income taxes and anti-abuse rules relating to built-in loss assets.

3. Relevance of Certain Terms.

(a) As provided in Prop. Treas. Reg. § 1.901(m)-1, a § 901(m) payor is a person that is eligible to claim the foreign tax credit allowed under § 901(a), regardless of whether the person chooses to claim the foreign tax credit, as well as a § 902 corporation. Therefore, a § 901(m) payor is the person required to compute a disqualified tax amount when § 901(m) applies.

(b) The foreign payor is the individual or entity (including a disregarded entity) subject to a foreign income tax. The RFA owner (US) is a person that owns one or more RFAs for U.S. income tax purposes and therefore is required to report, or

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otherwise track, items of income, deduction, gain, or loss attributable to the RFAs for purposes of computing the U.S. taxable income of the RFA owner (US).

(c) The § 901(m) payor may also be the foreign payor, the RFA owner (US), or the RFA owner (foreign), or any combination thereof. Alternatively, the § 901(m) payor may not be any of them depending upon the application of the entity classification rules for U.S. income tax purposes. Further, the foreign payor and the RFA owner (foreign) may or may not be the same person for purposes of a foreign income tax depending on whether the RFA owner (foreign) is a fiscally transparent entity for purposes of the foreign income tax. For example, if a foreign corporation, that is a § 902 corporation owns RFAs and is the entity that is subject to a foreign income tax under the relevant foreign law, the foreign corporation is the § 901(m) payor, foreign payor, RFA owner (US) and RFA owner (foreign).

(d) As another example, if two U.S. corporations each own a 50% interest in a partnership and the partnership owns a disregarded entity that is subject to a foreign income tax and that, for purposes of the foreign income tax, owns one or more RFAs, the corporate partners are each a § 901(m) payor, the disregarded entity is the foreign payor and the RFA owner (foreign), and the partnership is the RFA owner (US).

(e) Finally, because the computation of a § 901(m) payor’s disqualified tax amount is based on items determined at the level of the foreign payor, the RFA owner (US) and the RFA owner (foreign), the regulations provide rules for allocating those items when the § 901(m) payor is not the foreign payor, the RFA owner (US), or the RFA owner (foreign), or any combination thereof.

4. CAAs.

(a) Prop. Treas. Reg. § 1.901(m)-2(b) identifies six categories of transactions that constitute CAAs, three of which are specified in the statute (incorporated by cross reference to the temporary regulations) and three of which are additional categories of transactions that are identified as CAAs:

(1) A qualified stock purchase (as defined in § 338(d)(3)) to which § 338(a) applies (§ 338 CAA);

(2) Any transaction that is treated as an acquisition of assets for U.S. income tax purposes and as an acquisition of stock of a

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corporation (or the transaction is disregarded) for foreign income tax purposes;

(3) Any acquisition of an interest in a partnership that has an election in effect under § 754 (§ 743(b) CAA)

(4) Any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as an acquisition of assets for purposes of U.S. income tax and as the acquisition of an interest in a fiscally transparent entity for purposes of a foreign income tax;

(5) Any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as a partnership distribution of one or more assets the U.S. basis of which is determined by § 732(b) or 732(d) or which causes the U.S. basis of the partnership’s remaining assets to be adjusted under § 734(b), provided the transaction results in an increase in the U.S. basis of one or more of the assets distributed by the partnership or retained by the partnership without a corresponding increase in the foreign basis of such assets; and

(6) Any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as an acquisition of assets for purposes of both U.S. income tax and a foreign income tax, provided the transaction results in an increase in the U.S. basis without a corresponding increase in the foreign basis of one or more assets.

(a) For transactions that occurred on or after January 1, 2011, and before the general applicability date of the temporary regulations (referred to as the “transition period” in the preamble to the temporary regulations) Prop. Treas. Reg. § 1.901(m)-2(d) defines CAAs by reference to the statutory definition under § 901(m)(2).

(b) Transactions are CAAs regardless of whether any gain, income, loss, or deduction realized in connection with the transaction is taken into account for U.S. income tax purposes. However, basis difference resulting from a CAA might not be taken into account under § 901(m) pursuant to de minimis rule in Prop. Treas. Reg. § 1.901(m)-7.

(c) Prop. Treas. Reg. § 1.901(m)-2(b)(1)-(4) describes four specific types of transactions that are generally expected to result in an increase in basis of assets for U.S. income tax purposes without a corresponding increase in basis for foreign income tax purposes.

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This is because these transactions generally are treated as an acquisition of assets for U.S. income tax purposes and either are treated as an acquisition of stock or of a partnership interest or are disregarded for foreign income tax purposes.

(d) The other two categories of transactions, which are described in Prop. Treas. Reg. § 1.901(m)-2(b)(5) and (6), involve an acquisition of assets for both U.S. and foreign tax purposes. They are CAAs only if the transaction results in an increase in the basis of an asset for U.S. income tax purposes but not for foreign income tax purposes. These transactions could include, for example, an acquisition of assets that are structured to avoid the application of the Code’s corporate nonrecognition provisions, such as § 332, 351, or 361, while still qualifying for nonrecognition treatment for foreign income tax purposes.

(e) The following examples illustrate the CAA rules:

Example 1. CAA involving an acquisition of a partnership interest for foreign income tax purposes--(A) FPS is an entity organized in Country F that is treated as a partnership for both U.S. and Country F income tax purposes. FPS is owned 50-50 by FC1 and FC2, each of which is a corporation organized in Country F and treated as a corporation for both U.S. and Country F income tax purposes. FPS has a single asset, Asset A. USP, a domestic corporation, owns all the interests in DE, a disregarded entity.

(B) Pursuant to the same transaction, USP acquires FC1’s interest in FPS, and DE acquires FC2’s interest in FPS. For U.S. income tax purposes, with respect to USP, the acquisition of the interests in FPS is treated as the acquisition of Asset A by USP. See Rev. Rul. 99-6, 1999-1 C.B. 432. For Country F tax purposes, the acquisitions of the interests of FPS by USP and DE are treated as acquisition of partnership interests.

(C) The transaction is a CAA under Transaction Category No. 4 because it is treated as the acquisition of Asset A for U.S. income tax purposes and the acquisition of interests in a partnership for Country F tax purposes.

Example 2. CAA involving an asset acquisition for purposes of both U.S. income tax and a foreign income tax--(A) USP, a domestic corporation, wholly owns CFC1, a foreign corporation, and CFC1 wholly owns CFC2, also a foreign corporation. CFC1 and CFC2 are organized in Country F. CFC1 owns Asset A.

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(B) In an exchange described in § 351, CFC1 transfers Asset A to CFC2 in exchange for CFC2 common stock and cash. CFC1 recognizes gain on the exchange under § 351(b). Under § 362(a), CFC2’s U.S. basis in Asset A is increased by the gain recognized by CFC1. For Country F tax purposes, gain or loss is not recognized on the transfer of Asset A to CFC2, and therefore there is no increase in the foreign basis in Asset A.

(C) The transaction is a CAA under CAA Transaction Category No. 6 because it is treated as an acquisition of Asset A by CFC2 for both U.S. and Country F income tax purposes, and it results in an increase in the U.S. basis of Asset A without a corresponding increase in the foreign basis of Asset A.

5. RFAs.

(a) Prop. Treas. Reg. § 1.901(m)-2(c)(1) incorporates by cross reference to the temporary regulations the general definition of an RFA, which provides that an RFA means, with respect to a foreign income tax and a CAA, any asset (including goodwill, going concern value, or other intangible) subject to the CAA that is relevant to determining foreign income for purposes of the foreign income tax.

(b) Prop. Treas. Reg. § 1.901(m)-2(c)(2) provides that an asset is relevant in determining foreign income if income, deduction, gain or loss attributable to that asset is or would be taken into account in determining foreign income immediately after the CAA. Prop. Treas. § 1.901(m)-2(c)(3) provides, however, that, after a CAA, an asset will become relevant with respect to another foreign income tax if, pursuant to a plan or series of related transactions that have a principal purpose of avoiding the application of § 901(m), an asset that is not relevant in determining foreign income for purposes of that foreign income tax immediately after the CAA later becomes relevant in determining foreign income. A principal purpose of avoiding § 901(m) will be deemed to exist if income, deduction, gain, or loss attributable to the asset is taken into account in determining the foreign income within the one-year period following the CAA.

(c) Example regarding “relevance”:

Example 3. RFA status determined immediately after CAA; application of principal purpose rule--(A) USP1 and USP2 are unrelated domestic corporations. USP1 wholly owns USSub, also a domestic corporation. On January 1 of Year 1, USP2 acquires all of the stock of USSub from USP1 in a qualified stock purchase (as

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defined in § 338(d)(3)) to which § 338(a) applies. Immediately after the acquisition, none of the income, deduction, gain, or loss attributable to any of the assets of USSub is taken into account in determining foreign income for purposes of a foreign income tax nor would such items be taken into account in determining foreign income for purposes of a foreign income tax immediately after the acquisition if such assets were to give rise to income, deduction, gain, or loss immediately after the acquisition.

(B) On December 1 of Year 1, USSub contributes all its assets to FSub, its wholly owned subsidiary, which is a corporation for both U.S. and Country X income tax purposes, in a transfer described in § 351 (subsequent transfer). USSub recognizes no gain or loss for U.S. or Country X income tax purposes as a result of the subsequent transfer. As a result of the subsequent transfer, income, deduction, gain, or loss attributable to the assets of USSub that were transferred to FSub is taken into account in determining foreign income of FSub for Country X tax purposes.

(C) The acquisition by USP2 of the stock of USSub is a § 338 CAA. None of the assets of USSub are RFAs immediately after the CAA, because none of the income, deduction, gain, or loss attributable to such assets is taken into account for purposes of determining foreign income with respect to any foreign income tax immediately after the CAA (nor would such items be taken into account for purposes of determining foreign income immediately after the CAA if such assets were to give rise to income, deduction, gain, or loss at such time).

(D) Although the subsequent transfer is not a CAA, the subsequent transfer causes the assets of USSub to become relevant in the hands of FSub in determining foreign income for Country X tax purposes. Because the subsequent transfer occurred within the one-year period following the CAA, it is presumed to have a principal purpose of avoiding § 901(m). Accordingly, the assets of USSub with respect to the CAA occurring on January 1 of Year 1 become RFAs with respect to Country X tax as a result of the subsequent transfer. Thus, a basis difference with respect to Country X tax must be computed for the RFAs and taken into account under § 901(m).

6. Disqualified Tax Amount and Aggregate Basis Difference Carryover.

(a) Prop. Treas. Reg. § 1.901(m)-3 sets forth the rules for computing the disqualified portion of foreign income taxes (referred to as “the disqualified tax amount”). Prop. Treas. Reg. § 1.901(m)-3 also sets forth the treatment under § 901(m)(1) of the disqualified tax

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amount and provides rules for determining whether and to what extent basis difference that is assigned to a given U.S. taxable year is carried over to subsequent U.S. taxable years (referred to as the “aggregate basis difference carryover”).

(b) A disqualified tax amount is computed separately for each foreign tax return that takes into account income, gain, deduction, or loss from one or more RFAs in computing the foreign taxable income and for each § 901(m) payor that pays or accrues, or is considered to pay or accrue, a portion of the foreign income taxes reflected on the foreign tax return. If the foreign income taxes relate to more than one separate category described in Treas. Reg. § 1.904-4(m) (including § 904(d) categories), a separate disqualified tax amount computation is done for each separate category.

(c) The proposed regulations refer to the total taxable income (or loss) that is computed under foreign law for a foreign taxable year and reflected on a foreign tax return as “foreign income” and the total amount of tax reflected on a foreign tax return as a “foreign income tax amount.”

(d) Thus, foreign income does not include income that is exempt from the foreign tax. The proposed regulations use the term “foreign country creditable taxes” (or “FCCTs”) to refer to any foreign income taxes imposed by another country or possession of the U.S. that were allowed under the relevant foreign law as a credit to reduce the foreign income tax amount and for which a credit is allowed under § 901 or 903. In addition, the proposed regulations define “foreign income tax” to mean any income, war profits, or excess profits tax for which a credit is allowable under § 901 or 903, other than any other withholding tax determined on a gross basis.

(e) The foreign income, foreign income tax amount, and any FCCTs are determined at the foreign-payor level. If the foreign payor is not a § 901(m) payor, current law provides rules for determining the person that is considered to pay or accrue a foreign income tax for purposes of the foreign tax credit. See, for example, Treas. Reg. §§ 1.702-1(a)(6) and 1.901-2(f). Those rules are not changed by these proposed regulations and therefore apply for purposes of determining the extent to which a foreign income tax amount is paid or accrued by, or considered paid or accrued by, a § 901(m) payor for purposes of § 901(m).

(f) Prop. Treas. Reg. § 1.901(m)-3(b) sets forth the treatment of the disqualified tax amount and the computation of the disqualified tax amount. Under Prop. Treas. Reg. § 1.901(m)-3(b)(1), the

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disqualified tax amount is not taken into account for purposes of determining foreign tax credits under § 901, 902 or 960. The § 901(m) payor must compute a disqualified tax amount for any U.S. taxable year for which it is assigned a portion of the basis difference with respect to one or more RFAs.

(g) The disqualified tax amount is the lesser of the tentative disqualified tax amount and the foreign income tax amount paid or accrued by, or considered paid or accrued by, a § 901(m) payor. The tentative disqualified tax amount is determined using a modified version of the formula provided in § 901(m)(3).

(h) To determine the tentative disqualified tax amount, the foreign income tax amount paid or accrued by, or considered paid or accrued by, the § 901(m) payor for its U.S. taxable year (multiplicand) is multiplied by a ratio (disqualified ratio), the numerator of which is the sum of the portion of the basis difference for all RFAs that is taken into account and assigned to the U.S. taxable year of the § 901(m) payor, and the denominator of which is the portion of the foreign income reflected on the foreign tax return that relates to the foreign income tax amount included in the multiplicand. The numerator and the denominator are referred to as the “aggregate basis difference” and “allocable foreign income,” respectively.

(i) Allocable foreign income (the denominator of the disqualified ratio) and the foreign income tax amount (the multiplicand) are determined using the total amount of foreign income and foreign income tax amount reflected on the foreign income tax return that are allocable to the § 901(m) payor, instead of by reference only to the amounts determined with respect to RFAs. Treasury and the IRS believe this approach appropriately carries out the purposes of § 901(m) while avoiding the administrative and compliance burdens that would result from a requirement of trace amounts of income to RFAs and identify the portion of foreign income taxes imposed on that income.

(j) If a foreign income tax amount is computed taking into account an FCCT, the multiplicand of the tentative disqualified tax amount computation is the sum of the foreign income tax amount and any FCCTS paid or accrued by, or considered paid or accrued by, the § 901(m) payor. Treasury and the IRS believe that it is appropriate to include any FCCTS in the multiplicand to better reflect the effective tax rate imposed on the aggregate basis difference. However, the tentative disqualified tax amount is reduced (but not below zero) to the extent any portion of the FCCTs is itself treated

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as a disqualified tax amount of the § 901(m) payor with respect to a different foreign income tax.

(k) The aggregate basis difference in the numerator includes cost recovery amounts and disposition amounts taken in account with respect to RFAs and assigned to the U.S. taxable year of the § 901(m) payor under Prop. Treas. § 1.901(m)-5. When the numerator and denominator are both positive amounts, the amount of aggregate basis difference included in the numerator is limited to the amount of foreign income in the denominator of the disqualified ratio. (In other words, the allocable foreign income).

(l) This limitation ensures that multiplying the foreign income tax amount included in the multiplicand by the disqualified ratio would not produce a disqualified tax amount greater than 100% of the foreign income tax amount.

(m) The denominator of the disqualified ratio is the allocable foreign income. When the entire foreign income tax amount reflected on a foreign tax return is paid or accrued by, or considered paid or accrued by, a single § 901(m) payor for U.S. income tax purposes, the allocable foreign income is simply the total foreign income reflected on the foreign tax return. In general, this will be the case with the § 901(m) payor is the foreign payor or owns a disregarded entity that is the foreign payor, unless there is a change in ownership or change in entity classification of the foreign payor requiring an allocation of the foreign income tax amount of the foreign payor (a mid-year transaction).

(n) If the foreign income tax amount reflected on the foreign tax return is allocated to more than one person for U.S. income tax purposes, the allocable foreign income and the denominator of the disqualified ratio for a particular§ 901(m) payor is equal to the portion of the foreign income reflected on the foreign tax return that relates to the foreign income tax amount allocated to, and considered paid or accrued by, that § 901(m) payor.

(o) Prop. Treas. Reg. § 1.901(m)-3(b)(2)(iii)(C) provides guidance on how to determine the allocable foreign income in three types of cases:

(1) The foreign income tax amount is allocated to a § 901(m) payor because the foreign payor is involved in a mid-year transaction, such as the transfer of a disregarded entity during the disregarded entity’s foreign taxable year or acquisitions involving elections under § 338 or § 336(e);

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(2) The foreign income tax amount is allocated to a § 901(m) payor that is a partner because the foreign payor is a partnership for U.S. income tax purposes that is legally liable for the foreign income tax (or the foreign payor is a disregarded entity and its assets are owned for U.S. income tax purposes by an entity that is treated as a partnership for U.S. tax purposes and that is legally liable for the foreign income tax amount); and

(3) The foreign income tax amount is allocated to a § 901(m) payor under Treas. Reg. § 1.901-2(f)(3)(i) because the § 901(m) payor is a member of a group whose income is taxed on a combined basis for foreign income tax purposes.

(p) Notwithstanding these rules, if the § 901(m) payor fails to substantiate its allocable foreign income to the satisfaction of the IRS, then Prop. Treas. Reg. § 1.901(m)-3(b)(2)(iii)(D) provides that allocable foreign income will equal the amount determined by dividing the sum of the foreign income tax amount and the FCCTs that are paid or accrued by, or considered paid or accrued by, the § 901(m) payor by the highest marginal tax rate applicable to income of the foreign payor under the relevant foreign income tax.

(q) If the numerator is less than zero, the denominator is less than or equal to zero, or the multiplicand is zero, the tentative disqualified tax amount (and therefore the disqualified tax amount) is zero. If the disqualified tax amount for a year is either zero or is limited by the foreign income tax amount paid or accrued by, or considered paid or accrued by, the§ 901(m) payor, there will be an aggregate basis difference carryover, as discussed below.

7. Aggregate Basis Difference Carryover.

(a) Prop. Treas. Reg. § 1.901(m)-3(c) provides rules for determining the amount of aggregate basis difference carryover for a given U.S. taxable year of a§ 901(m) payor that will be included in the§ 901(m) payor’s aggregate basis difference for the next U.S. taxable year (and therefore included in the numerator of the disqualified ratio for purposes of next year’s disqualified tax amount computation). The carryover reflects the extent to which the aggregate basis difference for the U.S. taxable year has not yet given rise to a disqualified tax amount.

(b) If the disqualified tax amount is zero, none of the aggregate basis difference gives rise to a disqualified tax amount and therefore the full amount of the § 901(m) payor’s aggregate basis difference for

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that year will be reflected in an aggregate basis difference carryover (positive or negative).

(c) Only one example illustrates this rule, and it is quite basic. Additional examples would be helpful.

(d) If the disqualified tax amount is not zero, an aggregate basis difference carryover may still arise in two situations. First, if the aggregate basis difference exceeds the § 901(m) payor’s allocable foreign income (the denominator of the disqualified ratio) and therefore the amount of the aggregate basis difference included in the numerator is limited, the excess is reflected in an aggregate basis difference carryover.

(e) Second, and seemingly most complex, if the tentative disqualified tax amount (which takes into account FCCTs) exceeds the foreign income tax amount paid or accrued by the § 901(m) payor (which does not include FCCTs), that excess amount is converted into an equivalent amount of aggregate basis difference that is reflected in an aggregate basis difference carryover.

(f) There are no examples that illustrate this rule. Examples would be helpful.

8. Determination of Basis Difference.

(a) Prop. Treas. Reg. § 1.901(m)-4 incorporates by cross reference the general rules in the temporary regulations for determining basis difference. Under these rules, basis difference is determined separately with respect to each foreign income tax for which an asset is an RFA.

(b) Prop. Treas. Reg. § 1.901(m)-4(c)(1) provides for a foreign basis election, pursuant to which basis difference is equal to the U.S. basis in the RFA immediately after the CAA less the foreign basis in the RFA immediately after the CAA (including any adjustments to the foreign basis resulting from the CAA). A foreign basis election generally is made by the RFA owner (US).

(c) For example, in a § 338 CAA, the foreign basis election is made by the corporation that is the subject of the qualifying stock purchase (new target). If the RFA owner (US) is a partnership, however, each partner in the partnership (and not the partnership) may independently make a foreign basis election. A foreign basis election is made separately for each CAA and respect to each foreign income tax and each foreign payor. A series of CAAs occurring as part of the plan (“aggregated CAA transaction”) is treated as a single CAA.

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(d) The election is made by using foreign basis to determine the basis differences for purposes of computing a disqualified tax amount and an aggregate basis difference carryover. The election generally must be filed on a timely filed original federal income tax return for the first U.S. taxable year that the foreign basis election is relevant, with two exceptions that we will not discuss.

(e) While we applaud Treasury and the IRS for offering an election such as the one we just discussed, the issue the taxpayer has to address is whether the election is beneficial or detrimental. That is, the election will eliminate potentially substantial administrative work in determining what the pre-close U.S. basis was since this is a hypothetical number. However, making the election could be costly. The taxpayer will not know whether it is advisable to make the election unless the taxpayer does all of the computations. This is not the government’s fault in the regulations, of course. It is just that making the election for administrative ease could be very costly and the taxpayer won’t know how costly unless it does the computations to determine the pre-close U.S. basis that the election suggests can be avoided.

9. Basis Difference Taken Into Account. Prop. Treas. Reg. § 1.901(m)-5 provides rules for determining the amount of basis difference with respect to an RFA that is taken into account in a given U.S. taxable year (“allocated basis difference”). This allocated basis difference is used to compute or disqualify tax amount for a U.S. taxable year. Basis difference is taken into account in two ways: under an applicable cost recovery method or as a result of a disposition of the RFA.

10. Cost Recovery Rules.

(a) Prop. Treas. Reg. § 1.901(m)-5(b)(2)(i) incorporates by cross reference the general rule in the temporary regulations that a cost recovery amount for an RFA is determined by applying an applicable cost recovery method to the basis difference rather than to the U.S. basis of the RFA.

(b) Prop. Treas. Reg. § 1.901(m)-5(b)(2)(ii) provides that if the entire U.S. basis of the RFA is not subject to the same cost recovery method, the applicable cost recovery method for determining the cost recovery amount is the cost recovery method that applies to the portion of the U.S. basis that corresponds to the basis difference.

(c) Prop. Treas. Reg. § 1.901(m)-5(b)(3) provides that, for purposes of § 901(m), an applicable cost recovery method includes any method recovering the cost of property over time for U.S. income tax

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purposes. These methods include depreciation, amortization, or depletion, as well as a method that allows cost (or a portion of the cost) of property to be expensed in the year of acquisition or in the placed-in-service year, such as under § 179.

(d) Under Prop. Treas. Reg. § 1.901(m)-5(b)(1), when an RFA owner (U.S.) is a § 901(m) payor, all of the cost recovery is attributed to that payor and assigned to the taxable year of that payor in which the corresponding U.S. basis deduction is taken into account. If, however, the RFA owner (U.S.) is not a § 901(m) payor the fiscally transparent entity for U.S. income tax purposes in which a § 901(m) payor directly or indirectly owns an interest, the proposed regulations allocate all or a portion of the cost recovery amount to the § 901(m) payor.

(e) Special rules allocate a cost recovery amount that arises from an RFA with respect to a § 743(b) CAA.

11. General Disposition Rules.

(a) Prop. Treas. Reg. § 1.901(m)-1(a)(10) defines (by cross reference to the temporary regulations) a disposition for purposes of § 901(m) as an event that results in gain or loss being recognized with respect to an RFA for purposes of U.S. income tax, a foreign income tax, or both.

(b) Temp. Treas. Reg. § 1.901(m)-5T(c)(2) provides that, if a disposition of an RFA is fully taxable for U.S. and foreign income tax purposes, the disposition amount will be any remaining unallocated basis (positive or negative). The temporary regulations further provide that, if a disposition of an RFA is not fully taxable for both U.S. and foreign income tax purposes and the RFA has a positive basis difference, the disposition amount is based solely on the amount, if any, of the foreign disposition gain and U.S. disposition loss.

(c) If, on the other hand, the disposition of an RFA is not fully taxable for both U.S. and foreign income tax purposes and the RFA has a negative basis difference, the temporary regulations provide that the disposition amount is based on the amount if any, of the foreign disposition loss and U.S. disposition gain.

(d) Under Prop. Treas. Reg. § 1.901(m)-5(c)(1), when the RFA owner (US) is a § 901(m) payor, all of the disposition amount is attributed to § 901(m) payor and assigned to the U.S. taxable year of the § 901(m) payor in which the disposition occurs.

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(e) If instead the RFA owner (US) is not a § 901(m) payor but a fiscally transparent entity for U.S. income tax purposes in which a § 901(m) payor directly or indirectly owns an interest, the proposed regulations allocate all or a portion of the disposition amount to the § 901(m) payor and assigns it to a U.S. taxable year of that payor.

(f) Special rules allocate a disposition amount to a § 901(m) payor and assign it to a U.S. taxable year of that payor when the disposition amount arises from an RFA with respect to certain § 743(b) CAAs. Special rules also apply to specifically allocate a disposition amount to a § 901(m) payor in certain other situations as well.

(g) Prop. Treas. Reg. § 1.901(m)-5(d)(3) addresses the allocation of a disposition amount attributable to foreign disposition gain or foreign disposition loss of an RFA. These rules are to be interpreted and applied in a manner consistent with the principle that a disposition amount attributable to foreign disposition gain or foreign disposition loss should be allocated to a § 901(m) payor in the same proportion that the gain or loss is taken into account in computing a foreign income tax amount that is paid or accrued by, or considered paid or accrued by, the § 901(m) payor.

(h) There are two separate rules for identifying the extent to which a foreign disposition gain or foreign disposition loss is taken into account in computing a foreign income tax amount that is paid or accrued by, or considered paid or accrued by, a § 901(m) payor that directly or indirectly owns an interest in an RFA owner (US) that is a fiscally transparent entity for U.S. income tax purposes.

(i) The first rule applies when a § 901(m) payor, or a disregarded entity directly owned by a § 901(m) payor, is a foreign payor whose foreign income includes a distributive share of the foreign income (that includes the foreign disposition gain or foreign disposition loss) of the RFA owner (foreign). In this situation, the entire foreign income tax amount reflected on the foreign income tax return of the foreign payor is paid or accrued by, or considered paid or accrued by, the § 901(m) payor. This will be the case when the RFA owner (US) is treated as fiscally transparent entity not just for U.S. income tax purposes, but also for foreign income tax purposes, and the § 901(m) payor directly or indirectly owns an interest in the RFA owner (US).

(j) The first allocation rule allocates a portion of a disposition amount attributable to foreign disposition gain or foreign disposition loss, as applicable, to the § 901(m) payor proportionately to the amount of the foreign disposition gain or foreign disposition loss that is

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included in the foreign payor’s distributive share of the foreign income of the RFA owner (foreign) for foreign income tax purposes.

Assume a domestic entity that is a corporation for both U.S. and foreign tax purposes (corporate partner) directly owns, for both U.S. and foreign income tax purposes, an interest in a foreign entity that is treated as a partnership for both U.S. and foreign income tax purposes and that is the RFA owner (US) and the RFA owner (foreign). When the partnership recognizes foreign disposition gain with respect to an RFA, the foreign income tax amount with respect to the gain is paid by the partners on their distributive shares of the foreign income of the partnership that includes the foreign disposition gain.

The corporate partner, and not the partnership, is therefore the foreign payor and a § 901(m) payor. If the partnership recognizes $100 of foreign disposition gain and 50% of that gain is included in the U.S. corporate partner’s distributive share of the foreign income of the partnership, and the disposition amount attributable to the foreign disposition gain is $40, the corporate partner would be allocated $20 of that amount.

(k) The second special rule applies when a § 901(m) payor directly or indirectly owns an interest in a fiscally transparent entity for U.S. income tax purposes (other than a disregarded entity directly owned by the § 901(m) payor) that is a foreign payor whose foreign income includes all or a portion of the foreign income (that includes the foreign disposition gain or foreign disposition loss of the RFA owner (foreign)). Therefore, the § 901(m) payor is considered to pay or accrue only an allocated portion of the foreign income tax amount reflected on the foreign income tax return of the foreign payor.

(l) This will be the case when a § 901(m) payor directly or indirectly owns an interest in the foreign payor, and the foreign payor is (1) the RFA owner (US), (2) another fiscally transparent entity for U.S. income tax purposes that directly or indirectly owns an interest in the RFA owner (US) for both U.S. and foreign income tax purposes, or (3) a disregarded entity directly owned by the RFA owner (US).

(m) The mechanics of the second allocation rule are different from those under the first allocation rule. This is because the second rule applies when neither the § 901(m) payor, nor a disregarded entity directly owned by that payor, is a foreign payor and takes into account the foreign disposition gain or foreign disposition loss

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for purposes of calculating a foreign income tax amount, but instead, for U.S. income tax purposes, a foreign income tax amount of the foreign payor is allocated to, and considered paid or accrued by, the § 901(m) payor.

To illustrate the second rule, assume a domestic entity that is a corporation for both U.S. and foreign income tax purposes (corporate partner) directly owns an interest in a foreign entity, the RFA owner (US) and RFA owner (foreign), that is a partnership for U.S. income tax purposes but a corporation for purposes of a foreign income tax (a hybrid partnership). In this case, when the hybrid partnership recognizes foreign distribution gain with respect to an RFA, it is the hybrid partnership, rather than the partners, that takes the gain into account for purposes of calculating a foreign income tax amount. The hybrid partnership is therefore the foreign payor.

If the hybrid partnership pays a foreign income tax amount of $30 and $200 of foreign income that includes $100 of foreign disposition gain and $15 of foreign income tax amount is allocated to and considered paid by the corporate partner, the corporate partner’s allocable foreign income would be $100, which would include the disposition gain amount of $50.

(n) Prop. Treas. Reg. § 1.901(m)-5(f) provides rules for allocating a disposition amount when there is a disposition of an RFA during a foreign taxable year in which the foreign payor is involved in a mid-year transaction, and the disposition results in foreign disposition gain or foreign disposition loss that is allocated under the principles of Treas. Reg. § 1.1502-76(b) to the persons involved in the mid-year transaction for purposes of allocating the foreign income tax amount of the foreign payor. Pursuant to Treas. Reg. § 1.901(m)-2(f)(4)(ii), the foreign income tax must be allocated between the buyer and seller of the disregarded entity based on the respective portions of foreign income that are attributable under the principles of Treas. Reg. § 1.1502-76(b) to the buyer’s and seller’s respective periods of ownership. Under Prop. Treas. Reg. § 1.901(m)-5(f)(2), the disposition amount attributable to foreign disposition gain is similarly allocated between the buyer and seller.

(o) Prop. Treas. Reg. § 1.901(m)-5(g) addresses the allocation of cost recovery amounts and disposition amounts when the RFA owner (US) is either a reverse hybrid or a fiscally transparent entity for both U.S. and foreign income tax purposes that is directly or indirectly owned by a reverse hybrid for U.S. and foreign income tax purposes.

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12. Successor Rules. Prop. Treas. Reg. § 1.901(m)-6 provides successor rules for applying § 901(m) following a transfer of RFAs that have basis difference that has not yet been fully taken into account (“unallocated basis difference”) as well as for determining when an aggregate basis difference carryover of a § 901(m) payor either becomes an aggregate basis difference carryover of the § 901(m) payor with respect to another payor or is transferred to another § 901(m) payor.

13. Unallocated Basis Difference.

(a) Prop. Treas. Reg. § 1.901(m)-6(b)(1) and (2) incorporate by cross reference the successor rules set forth in the temporary regulations, which provide generally that § 901(m) continues to apply to an RFA after it has been transferred for U.S. income tax purposes if the RFA continues to have unallocated basis difference following the transfer.

(b) Prop. Treas. Reg. § 1.901(m)-6(b)(3) sets forth two clarifications for applying the successor rules. First, if an asset is an RFA with respect to more than one foreign income tax, the successor rules apply separately with respect to each foreign income tax. Second, any subsequent cost recovery amount for an RFA transferred in a successor transaction will be determined based on the applicable cost recovery that applies to the U.S. basis (or portion thereof) that corresponds to the unallocated basis difference. Thus, if a successor transaction restarts the depreciation schedule for an RFA, the transaction may result in unallocated basis difference being taken into account at a different recovery rate than otherwise would have applied.

(c) Prop. Treas. Reg. § 1.901(m)-6(b)(4)(ii) provides an exception to the general successor rule if a foreign basis election is made under Prop. Treas. Reg. § 1.901(m)-4(c) with respect to a subsequent CAA that otherwise would trigger the rules for successor transactions. In this case, the only basis difference that will be taken into account after the subsequent CAA with respect to that foreign income tax is the basis difference determined for the subsequent CAA.

14. Aggregate Basis Difference Carryover.

(a) Prop. Treas. Reg. § 1.901(m)-6 provides successor rules for aggregate basis difference carryovers. An aggregate basis difference carryover is treated as a tax attribute of the § 901(m) payor that retains its character as an aggregate basis difference carryover with respect to a foreign income tax and foreign payor

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and with respect to a separate category, as described in Treas. Reg. § 1.904-4(m).

(b) When a § 901(m) payor transfers its assets in a transaction to which § 381 applies, Prop. Treas. Reg. § 1.901(m)-6(c)(1) provides that any aggregate basis difference carryovers of the § 901(m) payor are transferred to the corporation that succeeds to the earnings and profits, if any. When substantially all of the assets of one foreign payor are transferred to another foreign payor, both of which are directly owned by the same § 901(m) payor, Prop. Treas. Reg. § 1.901(m)-6(c)(2) provides that an aggregate basis difference carryover of the § 901(m) payor with respect to the transferor foreign payor becomes an aggregate basis difference carryover of the § 901(m) payor with respect to the transferee foreign payor.

(c) Prop. Treas. Reg. § 1.901(m)-6(c)(3) provides an anti-abuse rule that would transfer an aggregate basis difference carryover when, with a principal purpose of avoiding the application of § 901(m), there is a transfer of assets or a change in either the allocation of foreign income for foreign income tax purposes or the allocation of foreign income tax amounts for U.S. income tax purposes that is intended to separate foreign income tax amounts from the related aggregate basis difference carryover. This anti-abuse rule would apply, for example, if, with the principal purpose of avoiding the application of § 901(m), a partnership agreement is amended in order to reduce the allocation of foreign income to a partner that is a § 901(m) payor with an aggregate basis difference carryover.

15. De Minimis Rules.

(a) Prop. Treas. Reg. § 1.901(m)-7 provides de minimis rules under which certain basis differences are not taken into account for purposes of § 901(m). This determination is made when an asset subject to a CAA first becomes an RFA. If that same asset is also an RFA by reason of being subject to a subsequent CAA, the de minimis test are applied only to the additional basis difference, if any, that results from the subsequent CAA. Accordingly, any unallocated basis difference that arose from the prior CAA that did not qualify for the de minimis exception at the time of the prior CAA will not be retested at the time of the subsequent CAA.

(b) A basis difference with respect to an RFA is not taken into account for purposes of § 901(m) if either:

(1) the sum of the basis differences for all RFAs with respect to the CAA is less than the greater of $10 million or 10% of the total U.S. basis of all RFAs immediately after the CAA; or

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(2) the RFA is part of a class of RFAs for which the sum of the basis differences for all RFAs in the class is less than the greater of $2 million or 10% of the total U.S. basis of all RFAs in the class. For this purpose, the classes of RFAs are the seven asset classes defined in Treas. Reg. § 1.338-6(b).

(c) In transactions between related parties the threshold dollar amounts and percentages to meet the de minimis exceptions are lower than those for unrelated party CAAs, halving the amounts and percentages above and replacing them with $5 million, $1 million and 5%.

(d) In addition, an anti-abuse provision in Prop. Treas. Reg. § 1.901(m)-7(e) denies application of the de minimis exceptions to CAAs between related parties that are entered into or structured with a principal purpose of avoiding the application of § 901(m).

16. Miscellaneous.

(a) Prop. Treas. Reg. § 1.901(m)-8(b) provides that, when a foreign corporation becomes a § 902 corporation for the first time, as a part of the required reconstruction of the U.S. tax history of pre-1987 foreign income taxes of the foreign corporation, § 901(m) and the regulations must be applied to determine any disqualified tax amounts or aggregate basis difference carryovers that apply to the foreign corporation.

(b) Prop. Treas. Reg. § 1.901(m)-8(c) provides an anti-abuse rule that applies to disregard an RFA with a built-in loss to the extent it relates to any asset acquisition structured with a principal purpose to use that RFA to avoid the application of § 901(m). This rule may apply, for example, if, with a principal purpose of avoiding the application of § 901(m) an asset is acquired in a transaction that preserves a built-in loss in the asset for U.S. income tax purposes but not for foreign income tax purposes.

17. Modifications to the § 704(b) Regulations.

(a) Treas. Reg. § 1.704-1(b)(4)(viii) provides a safe harbor under which allocations of creditable foreign tax expenditures (“CFTEs”) by a partnership to its partners are deemed to be in accordance with the partners’ interests in the partnership. In general, the purpose of the safe harbor is to match allocations of CFTEs with the income to which the CFTEs relate.

(b) A CFTE may be subject to § 901(m) because it is a foreign income tax amount that is paid or accrued by a partnership. Specifically, if a partnership owns an RFA with respect to a foreign income tax

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that RFA has a basis difference subject to § 901(m), a portion of the foreign income tax amount paid or accrued by the partnership that relates to that foreign income tax may be disallowed as a foreign tax credit under § 901(m) in the hands of the § 901(m) payors to whom the foreign income tax amount is allocated.

(c) The disqualified tax amount is determined by taking into account cost recover amounts and disposition amounts with respect to the RFA that are allocated to those § 901(m) payors pursuant to the rules in Prop. Treas. Reg. § 1.901(m)-5.

Assume that a domestic entity that is a partnership for U.S. tax purposes but a corporation for foreign purposes of a foreign income tax (a hybrid partnership) is owned by A and B, each a U.S. corporation.

Assume also that in a given year the hybrid partnership has 110 (foreign currency) of income, and a 10 depreciation deduction solely for U.S. income tax purposes, regarding an RFA. All partnership items are allocated 50-50, except the 10 deduction is allocated to A.

Thus, A’s distributive share is 45 (110 x 50%, less 10) and B’s distributive share of income is 55. Because the U.S. depreciation deduction is (or will be in) in A’s distributive share of income for U.S. income tax purposes, the entire cost recovery amount that corresponds to the U.S. depreciation deduction of 10 is allocated to A.

As a result, A will take into account the 10 cost recovery amount in calculating a disqualified tax amount with respect to the portion of the relevant foreign income tax amount paid or accrued by the hybrid partnership and allocated to A on the CFTE allocation rules.

In order to ensure that the portion of the foreign income tax amount paid or accrued by the hybrid partnership that is attributable to the 10 basis differences properly subject to § 901(m), the U.S. depreciation deduction should not be taken into account under the CFTE allocation rules so that the portion of the foreign income tax attributable to the 10 basis difference is allocated to A. Accordingly, the net income of the CFTE category that includes the U.S. basis deduction should be increased by 10 (from 100 to 110) to back out the portion of the U.S. depreciation

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deduction that corresponds to the cost recovery amount, in A’s share of the net income should be increased by 10.

(d) In the example, as a result of the adjustment, the foreign income tax amount paid or accrued by the hybrid partnership will be allocated equally between A and B. Absent the adjustment, a portion of the foreign income tax amount attributable to the 10 basis difference would be allocated to B, a person that is not subject to § 901(m) (because no cost recovery amount is allocated to B).

(e) The proposed regulations add special rules to the § 704 regulations to address partnership items that give rise to cost recovery amounts and disposition amounts attributable to CAAs (other than § 743(b) CAAs). Specifically, these rules provide that, if an RFA has a positive basis adjustment, net income in the CFTE category that takes into account partnership items of income, deduction, gain, or loss attributable to the RFA (applicable CFTE category) is increased by the sum of the cost recovery amounts and disposition amounts attributable to U.S. disposition loss that correspond to those partnership items.

(f) Furthermore, to the extent the partner is allocated those cost recovery amounts or disposition amounts attributable to U.S. disposition loss, that partner’s share of the net income in the CFTE category is increased by the same amount. Alternatively, if an RFA has a negative basis difference, the net income in that applicable CFTE category is decreased by the sum of the cost recovery amounts and disposition amounts attributable to U.S. disposition gain that corresponds to partnership items in that CFTE category.

18. Effective/Applicability Dates. The proposed regulations will apply to CAAs occurring on or after the date the regulations are published in the Federal Register as final regulations. Taxpayers may, however, rely on the proposed regulations prior to the date they are applicable provided that they both consistently apply the proposed regulations to all CAAs occurring on or after the date the proposed regulations are published and consistently apply the regulations to all CAAs occurring on or after January 1, 2011.

C. New Foreign Tax Credit Splitter Guidance.

1. Treasury and the IRS issued a surprising notice seeming directly related to the Apple state-aid issue. While Notice 2016-52 seems focused on EU state-aid adjustments, it is more broad then simply dealing with that issue. The Notice states that following a foreign-initiated adjustment, such as

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under the EU state-aid rules, a U.S. parent company may attempt to change its ownership structure or cause the relevant § 902 corporation to make an extraordinary distribution so that the subsequent tax payment creates a high-tax pool of post-1986 undistributed earnings. This high-tax pool then can be used to generate substantial amounts of foreign taxes deemed paid, without repatriating and including in U.S. taxable income the earnings and profits to which the taxes relate.

2. Treasury and the IRS state that regulations will treat these transactions as foreign tax credit splitter transactions under § 909. Accordingly, two new splitter arrangements are described in the Notice.

3. The Notice sets forth a number of definitions including what constitutes a “specified foreign-initiated adjustment.” A specified foreign-initiated adjustment is a foreign-initiated adjustment (or series of related adjustments to more than one taxable year) that results in additional foreign income tax liability that is greater than $10 million, regardless of whether the liability is actually paid in one or more taxable years (due, for example, to an installment plan).

4. Under the first new splitter arrangement, a “covered transaction” generally means any transaction or series of related transactions that meet the following conditions:

(a) the transaction or series of related transactions results in covered taxes being paid by a payor that is a § 902 corporation and that is not the § 902 corporation that would have been the payor of the covered taxes (the predecessor entity) if the covered taxes had been paid or accrued in the relation-back year; and

(b) the predecessor entity (or a successor of the predecessor entity) was a covered person with respect to the payor immediately before the transaction or series of related transactions, or, if the payor did not exist immediately before the transaction or series of related transactions, the processor entity was a covered person with respect to the payor immediately after the transactions or series of related transactions.

5. The following exceptions apply: (1) the transaction or series of related transactions results in the transfer of the earnings and profits of the predecessor entity to the payor pursuant to § 381; or (2) the taxpayer demonstrates by clear and convincing evidence that the transaction or series of related transactions were not structured with a principal purpose of separating covered taxes from the post-1986 undistributed earnings of the predecessor entity that include the earnings to which the covered taxes relate.

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6. The Notice sets forth the following example. USP, a domestic corporation, wholly owned CFC1. CFC1 wholly owns CFC2. Both CFCs are residents of country X. CFC1 wholly owns a disregarded entity (“DE”), which is organized in country X and treated as a corporation for country X tax purposes. CFC1 does not earn any income or pay any foreign taxes, other than through DE. For years 1 through 5, DE earns $200 of earnings and profits with respect to which it accrues and pays no foreign tax. These earnings and profits constitute CFC1’s pool of post-1986 undistributed earnings, which equals $1,000 as of the end of year 5. In year 6 (a year in which DE earns no income), CFC1 transfers all of its interest in DE1 to CFC2 in exchange for CFC2 stock in a transaction that qualifies under § 351. In year 8, after exhausting all effective and practical remedies to minimize its liability for country X tax, DE1 pays $200 in foreign income taxes to country X to settle a series of related adjustments proposed by country X with respect to years 1-5. The result is a § 909 splitter arrangement, and the related income equals $1,000.

7. The Notice also describes a second new splitter arrangement. It states that taxpayers could achieve a result similar to the arrangement described above by using distributions, to, in effect, move post-1986 undistributed earnings from one § 902 corporation to another before the first § 902 corporation makes a tax payment pursuant to a specified foreign-initiated adjustment.

8. A “covered distribution” is any distribution with respect to the payor’s stock to the extent the distribution:

(a) occurred in a taxable year of the payor to which the covered taxes relate or any subsequent taxable year up to and including the taxable year immediately before the taxable year in which the covered taxes are paid;

(b) resulted in a distribution or allocation (for example, pursuant to Treas. Reg. § 1.312-10) of the payor’s post-1986 undistributed earnings to a § 902 covered person; and

(c) was made with a principal purpose of reducing the payor’s post-1986 undistributed earnings that included the earnings to which the covered taxes relate in advance of the payment of covered taxes.

9. A distribution will be presumed to have been made with the tainted principal purpose if the sum of all distributions that would be covered distributions without regard to the principal purpose requirement is greater than 50% of the sum of:

(a) the payor’s post-1986 undistributed earnings as of the beginning of the payor’s taxable year in which the covered tax is paid; and

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(b) the sum of all distributions that would be covered distributions without regard to the principal purpose requirement. A taxpayer may rebut this presumption with clear and convincing evidence.

10. The Notice sets forth the following example. USP, a domestic corporation, wholly owns CFC1. CFC1 wholly owns CFC2. Both CFCs are resident in country X. For each of years 1 through 9, CFC2 earns $100 of earnings and profits with respect to which it does not accrue or pay any foreign tax. In year 11, CFC2 distributes $750 of its post-1986 undistributed earnings to CFC1. In year 12, after having exhausted all available and practical remedies to minimize its liability for country X tax, CFC2 pays $20 of foreign income tax to country X with respect to each of years 1 through 9 to settle related audit adjustments proposed by country X. The result is a splitter arrangement.

11. The Notice states that no inference is intended as to the treatment of transactions described in the Notice under current law, and that the IRS may challenge these transactions under applicable Code provisions or judicial doctrines. In addition, no inference is intended as to whether (1) payments made pursuant to any particular foreign-initiated adjustment, including those arising under EU state-aid rules, qualify as payments of creditable foreign income taxes, or (2) taxes paid by a U.S. person pursuant to a foreign-initiated adjustment to the tax liability of a subsidiary § 902 corporation are eligible as a direct foreign tax credit under § 901.

12. Treasury and the IRS request comments on the rules described in the Notice. In particular, Treasury and the IRS solicit comments on whether transactions addressed in the Notice would be more appropriately addressed pursuant to the rules under § 905(c) providing that additional payments of tax be accounted for through adjustments to the pools of post-1986 foreign income taxes and post-1986 undistributed earnings of § 902 corporations that are not the same entity as the payor of the tax.

13. Treasury and the IRS also are considering whether an objective test, rather than a subjective test based on taxpayer intent, should be used to determine when the transactions described above are treated as splitter arrangements. Accordingly, they solicit comments on this issue

D. Foreign Tax Credit Splitter Transactions.

1. The New York State Bar Association submitted comments on IRS Notice 2016-52 which identified new foreign tax credit splitter arrangements under § 909. The NYSBA made four recommendations.

2. First and foremost, Treasury and the IRS should consider issuing regulations under § 905(c) to address long-delayed foreign-initiated

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adjustments in a manner that avoids a separation of foreign income from foreign income taxes.

3. If Treasury and the IRS believe that certain transactions cannot be appropriately addressed through adjustments under § 905(c), the NYSBA further recommends that the examples in sections 3.01 and 3.02 of the Notice be revised or replaced. They do not appear to present an abusive separation of foreign income taxes from related foreign income. Future examples should clarify the relevant points. The NYSBA writers state that only cross-chain transfers (of the lower-tier technical taxpayer after a distribution of its earnings or a disregarded entity or hybrid partnership interest) or repatriations to a § 902 shareholder would allow for the separate repatriation of the foreign tax pool without also repatriating the related foreign earnings.

4. Treasury and the IRS should also consider using a lower, annual threshold in lieu of the $10 million threshold for adjustments or series of related adjustments, in order to avoid the need to determine whether several adjustments over a period of years by the same or differing taxing authorities are parts of the series of related adjustments.

5. The principal purpose requirement should not be regarded as satisfied if he taxpayer shows its absence by a preponderance of evidence, not by the higher standard of clear and convincing evidence.

E. Foreign Tax Credit Issues: Exhaustion of Remedies.

1. In Vento v. Commissioner, 147 T.C. No. 7 (2016), the taxpayers (three sisters) did not file U.S. federal income tax returns for 2001 but instead filed income tax returns with the Virgin Islands Bureau of Internal Revenue. The taxpayers subsequently conceded they were not bona fide residents of the Virgin Islands for 2001. They sought to credit against their U.S. tax liabilities for that year, under § 901, payments made with their Virgin Islands tax returns and estimated payments they made to the U.S. Treasury for 2001 that were later “covered into” the Virgin Islands Treasury under § 7654.

2. The Court held that the taxpayers could not credit against their U.S. income tax under § 901 the amounts paid as tax to the Virgin Islands for that year. The taxpayers failed to establish that their determination that they were subject to Virgin Islands tax rather than U.S. tax for 2001 was based on a reasonable interpretation of applicable law and that they had exhausted all effective and practical means of securing a refund of the amounts paid to the Virgin Islands. Consequently, the taxpayers did not meet their burden of proving that the amounts in issue were “taxes paid” within the meaning of Treas. Reg. § 1.901-2(e).

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3. The taxpayers claimed that, because there was no clear authority on determining residency in the Virgin Islands for 2001, the position that they were bona fide residents of the Virgin Islands and thus were required to pay Virgin Islands income tax for that year was a reasonable interpretation of applicable law. The Court stated that there was no evidence the taxpayers relied on the advice of competent advisors in taking the position that they were bona fide residents of the Virgin Islands as of December 31, 2001.

4. Moreover, the concerns expressed by the IRS and Congress in 2004 about perceived abuses of the standards for determining bona fide residence then in effect gave the taxpayers reason to know, before the expiration of the period of limitations for claiming a refund of the Virgin Islands tax, that their claims of bona fide Virgin Islands residence might be erroneous.

5. In sum, the taxpayers had not demonstrated on the basis of advice obtained in good faith from competent advisors or otherwise that they paid Virgin Islands tax for 2001 in reliance on a reasonable interpretation of the relevant law. The record also did not detail the efforts they made in pursuing their refund claim, and provided no evidence of any attempt by two of the taxpayers to pursue their claim for a refund of the tax they had paid to the Virgin Islands despite being on notice of the possible error in the legal interpretation on the basis of which they paid the tax.

6. Therefore, the Court felt the taxpayers had also failed to demonstrate that they exhausted “all effective and practical remedies” to reduce their liabilities for Virgin Islands tax.

7. Even if the amounts were otherwise creditable under § 901, the Court rejected the taxpayers’ argument that the § 904 limitation does not apply to taxes paid to the Virgin Islands. The Court agreed with the IRS that the taxpayers had failed to demonstrate that they had a § 904 limitation for 2001 sufficient to allow them to credit the amounts in issue.

8. The Court stated that its conclusion was reinforced by a more fundamental point that the taxpayers’ arguments missed: Congress did not intend taxes paid by U.S. citizens or residents to the Virgin Islands to be eligible for the foreign tax credit.

9. The imposition of Virgin Islands tax on the income of U.S. individuals need not result in the type of double taxation that the foreign tax credit is designed to prevent. The coordination rules of § 932 allow taxpayers to avoid that possibility and thus supplant the foreign tax credit regime.

10. The taxpayers’ rather unusual situation might have given them an opportunity to slip through a crack in the statutory framework. The literal terms of § 932(a)(3) do not deny the taxpayers the credits in issue because

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none of them earned as much as a dollar of Virgin Islands income. The Court stated that it could not imagine, however, that, while Congress did not intend to allow a foreign tax credit for Virgin Islands taxes paid by bona fide residents of the Virgin Islands or by non-Virgin Islands residents with Virgin Islands income, it nonetheless intended to allow a credit under § 901 for amounts paid as tax to the Virgin Islands by a taxpayer who is not a bona fide resident of the Virgin Islands, has no Virgin Islands income for the year in question, and thus did not actually owe tax to the Virgin Islands for that year.

11. In any event, the Court stated that it did not need to decide the case solely on the basis of Congress’ intent to allow credits under § 901 for taxes paid by U.S. individuals to the Virgin Islands. Here, the taxpayers had failed to establish that (1) the amounts in issue were “taxes paid,” within the meaning of Treas. Reg. § 1.901(2)(e) or (2) the claimed credits do not exceed their applicable § 904 limitations.

F. Santander Case. Not surprisingly, the First Circuit reversed the district court in Santander Holdings USA v. United States, __F.3d__ (1st Cir. 2016), finding that Santander’s STARS transaction lacked economic substance. Previously, other circuit courts that addressed STARS or similar transactions had held similarly.

VII. SECTION 367.

A. Sections 367(a) and (d): Final Regulations.

1. Treasury and the IRS finalized without any substantive changes the § 367 regulations that significantly (1) narrow the active foreign trade or business exception and (2) change the rules governing the outbound transfer of intangibles in particular regarding foreign goodwill and going concern value. The final regulations also retain the proposed regulation’s effective date so that the new rules apply to transfers on or after September 14, 2015.

(a) If the issuance of the proposed regulations was a surprising development (it was), that Treasury and the IRS finalized them in this manner is even more surprising. They ignored the very clear legislative history, the relevant statutory language, virtually all written commentary and testimony at the hearings.

(b) In the preamble to the final regulations, Treasury and the IRS discuss and reject virtually every taxpayer comment or suggestion regarding the proposed regulations with one exception that deals with useful life and which is discussed below.

(c) They argue that the world has changed since 1984 when § 367(d) was enacted. The preamble, a seemingly anticipatory defense to what almost certainly will be taxpayers’ legal challenges to the

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regulation, assumes that intangibles were not particularly relevant internationally in 1984, or that they were not as relevant as they are today. This is wrong.

(d) The whole focus of Congress in enacting § 367(d) in 1984 was on intangibles. Outbound transfers of intangibles were as relevant then as they are now.4 Under 1968 ruling guidelines, IRS personnel, as gatekeepers, reviewed and blessed all outbound intangibles transfers up to and until the enactment of § 367(d). They were very knowledgeable about the intangibles landscape at that time. Goodwill, at least in a domestic context, also had been the subject of tax litigation for decades at that point. It was not something that was first discovered after 1984.

(e) Treasury and the IRS needed to go to Congress to make changes of this magnitude. Unfortunately, there will now be a period of substantial uncertainty until the next administration withdraws these regulations5 or the courts address them.

2. The New Rules.

(a) The proposed regulations generally provided five substantive changes from the 1986 temporary regulations:

i. Eliminating the favorable treatment for foreign goodwill and going concern value by narrowing the scope of the active trade or business exception under § 367(a)(3) and eliminating the exception under Temp. Treas. Reg. § 1.367(d)-1T(b) that provided that foreign goodwill and going concern value are not subject to § 367(d);

ii. Allowing taxpayers to apply § 367(d) to certain property that otherwise would be subject to § 367(a);

iii. Removing the twenty-year limitation on useful life for purposes of § 367(d) under Temp. Treas. Reg. § 1.367(d) -1T(c)(3);

iv. Removing the exception under Temp. Treas. Reg. § 1.367(a)-5T(d)(2) that permitted certain property

4 In fact, on the very day before § 367(d)’s 1984 effective date, we effected § 367 intangibles transfers for four

different clients. Each later was approved in an IRS “no tax avoidance” ruling letter under Rev. Proc. 68-23, 1968-1 C. B. 821. But they had to be done before § 367(d)’s effective date.

5 Precedent for this might be the § 901 creditability regulations issued near the end of the Carter Administration. The Reagan Administration’s Treasury withdrew those strict, anti-taxpayer regulations and replaced them with the § 901 creditability regulations that are still the operative regulations today over 30 years later.

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denominated in foreign currency to qualify for the active trade or business exception; and

v. Changing the valuation rules under Temp. Treas. Reg. § 1.367(a)-1T in an effort to better coordinate the regulations under §§ 367 and 482 (including temporary regulations under § 482 issued with the proposed regulations (see Temp. Treas. Reg. § 1.482-1T(f)(2)(i)).

(b) Regarding No. 1 above, the new regulations specify the categories of property that are eligible for the active trade or business exception. Intangible property, including foreign goodwill and going concern value, is not included and thus cannot qualify for the exception. This is the opposite of the prior rules. Under the 1986 temporary regulations, all property was eligible for the active trade or business exception, subject only to five narrowly tailored exceptions. While § 367(d) intangibles did not qualify (because they are subject to § 367(d)), foreign goodwill and going concern value did qualify under the prior rules if they were used in an active foreign trade or business.

(c) Regarding No. 2 above, Treasury and the IRS state that the proposed regulations did not resolve the extent to which property, including foreign goodwill and going concern value, that is not explicitly enumerated in §§ 936(h)(3)(B)(i) through (v) is nonetheless described in § 936(h)(3)(B) and therefore subject to § 367(d) (in our view, there is no way foreign goodwill and going concern value is described in § 936(h)(3)(B)).

(d) However, the new regulations nonetheless require taxpayers to elect to apply § 367(d)’s periodic royalty rules to a transfer of foreign goodwill or going concern value to a foreign corporation to avoid being taxed on the fair market value of those assets in the year of the transfer. This effectively treats them as § 367(d)/§ 936(h)(3)(B) assets contrary to the statute.

(e) This will leave taxpayers with a potentially huge issue-spotting concern. If, for example, a UK branch with nine employees is incorporated, does the fact that there are nine employees give rise to going concern value or goodwill? What if there are three employees? One employee? If so, should the election be made to include in income periodic royalties? What would be the amount of a lump-sum inclusion?

(f) As noted above, the new rules are retroactive to September 14, 2015.

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3. Useful Life.

(a) Regarding No. 3 above, the proposed regulations would have eliminated the long-standing 20-year cap on the useful life of § 367(d) intangible property. It had been in the regulations for decades. The final regulations effectively do the same thing, but with a twist.

(b) Commenters requested that the final regulations retain the 20-year cap because it promotes administrability for both taxpayers and the IRS. Some writers argued that a cap of 20 years is too long and that it should be shorter.

(c) Curiously, while Treasury and the IRS agreed that a 20-year cap on inclusions may promote administrability for both taxpayers and the IRS in cases where the useful life of the transferred property is indefinite or is reasonably anticipated to exceed 20 years, what they offer as a substitute for the 20-year cap does not help at all.

(d) The final regulations provide that taxpayers may, in the year of transfer, choose (elect) to take into account § 367(d) inclusions only during the 20-year period beginning with the first year in which the U.S. transferor takes into account income pursuant to § 367(d). However, they state that this limitation should not affect the present value of all amounts included by the taxpayer under § 367(d).

(e) Accordingly, the regulations require a taxpayer that elects to limit § 367(d) inclusions to a 20-year period to include, during that period, amounts that reasonably reflect amounts that, in the absence of the 20-year limitation, would be included over the useful life of the transferred property following the end of that 20-year period. Thus, a higher-than-arm’s-length amount would need to be included in income in each of the first 20 years. Who would ever make such an election?

(f) The regulations further provide that, for purposes of determining whether income inclusions during the 20-year period are commensurate with the income attributable to the transferred property, and whether adjustments should be made for taxable years during that period while the statute of limitations for those taxable years is still open, the IRS may take into account information with respect to taxable years after that period, such as the income attributable to the transferred property during those later years.

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(g) The regulations also revise the definition of useful life to provide that it includes the entire period during which exploitation of the transferred intangible property is reasonably anticipated to affect the determination of taxable income in order to appropriately account for the fact that exploitation of intangible property can result in both revenue increases and cost decreases. An example would be using product generation 1 IP for research in producing product generation 2, and so forth.

(h) The regulation states:

“(3) Useful life—(i) In general. For purposes of determining the period of inclusions for deemed payments under § 1.367(d)-1T(c)(1), the useful life of intangible property is the entire period during which exploitation of the intangible property is reasonably anticipated to affect the determination of taxable income, as of the time of transfer. Exploitation of intangible property includes any direct or indirect use or transfer of the intangible property, including use without further development, use in the further development of the intangible property itself (and any exploitation of the further developed intangible property), and use in the development of other intangible property (and any exploitation of the other developed intangible property).”

(i) Treasury and the IRS believe that the value of many types of intangible property is derived not only from the use of the intangible property in its present form, but also from its use in further development of the next generation of that intangible and other property.

(j) They state, for example, that if a software developer were to sell all of its copyright rights in its software to an unrelated party, and the copyright rights are expected to derive value both from the exclusive right to use the current generation computer code to make and sell current generation software products and from the exclusive right to use the current generation code in the development of other versions of the software, which will then be used to make and sell future-generation software products, the software developer would expect to be compensated for the latter right.

(k) Treasury and the IRS believe that if the software has value in developing a future generation of products, the software developer would not ignore the value of the use of the software in future research and development and hand over those rights free of charge, and an uncontrolled purchaser would be willing to compensate the developer to obtain such rights.

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(l) This obviously ignores the likely substantially reduced value most intangibles will have over time – perhaps a short time – when viewed from the perspective of an on-going arm’s length charge. Imagine 20 or 25 years after the event of transfer trying to determine the remaining value, if any, that is attributable to the date-of-transfer value and that is not a result of the 20 or 25 years of subsequent continuous and substantial maintenance, expenditures and efforts to maintain and enhance that value since the transfer.

(m) Treating product generation 1 IP as included in generation 2 and so forth also will raise an amazing array of issues. In one case involving software in which we were involved, for example, the IRS examiner suggested that we count lines of software in generation 1, generation 2, and so forth to determine which lines of software originated in generation 1.

(n) We explained that this type of an analysis would ignore whether the generation 1 software had become known to the public (competitors) after generation 1 was released, or otherwise had any proprietary value left after that time. In our case, the generation 1 software was known to the public (competitors) after product generation 1 was released and thus had no further value as a proprietary software property right even if it was used in helping to develop generation 2. Anybody in the industry could have, and may have, used the generation 1 software without paying for it to develop future products.

(o) Similar situations can arise for trademarks, goodwill and other intangibles. After 20 years (or even some shorter period) to what is the value at that later point in time attributable? Is it due to the original item transferred or, as stated above, to the 20 years of subsequent continuous and substantial maintenance, expenditures and efforts after the transfer? Conversely, what would the value be, for example, even four years post-transfer if there were no such continued maintenance, expenditures and effort to keep the intangible valuable and to maintain and to grow the relevant market?

(p) This area, without the cap, will be one in which accountants, lawyers, economists, and litigators will make a lot of money in the future. In short, we think the cap should be no more than 10 years, probably less. In this era, even 20 years is way too long. Eliminating the useful-life cap in no way enhances administrability of the new rules. Worse, Treasury and the IRS’s actions in eliminating the cap are likely to bring about judicial resolutions

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inconsistent with those which would enhance the government’s revenue stream.

4. Changes Nos. 4 and 5. We will not discuss changes Nos. 4 and 5 above. Change No. 4 seems fairly easy to follow, and change No. 5 was already implemented in the 2015 temporary § 482 regulations.

5. Additional Subtle Points Worth Noting.

(a) Ryan Finley reported on a presentation regarding the new regulations by Brenda Zent, Special Advisor, Treasury Office of International Tax Counsel. 2016 TNT 245-1. Zent is quoted as having said that the final § 367 regulations reserve the government’s right to argue that a transfer of foreign goodwill and going concern value to a foreign subsidiary must be compensated with a deemed royalty.

(b) Thus, even declining to make the royalty election apparently will not protect taxpayers from the application of § 367(d) to foreign goodwill and going concern value. After all, this is what Treasury and the IRS really wanted all along even though the statute doesn’t get them there.

(c) Further, in an additional subtle point of note, the preamble to the final regulations also states that:

“Because the identification of items that are neither explicitly listed in § 936(h)(3)(B)(i) through (v) nor explicitly listed as potentially qualifying for the [active trade or business] exception generally will require a case-by-case functional and factual analysis, the final regulations do not address the characterization of such items as similar items (within the meaning of § 936(h)(3)(B)(vi)) or as something else.”

(d) Thus, the outer boundaries of what the new rules cover is explicitly left open, and vague. This, of course, is the exact opposite of what Congress did in 1984: it enacted very clear and specific rules under § 367.

B. Section 367 Coordination Rule.

1. Treasury and the IRS finalized temporary regulations that were issued in 2013 regarding indirect stock transfers and certain coordination rule exceptions. An IRS person described the temporary regulations package (which contained more than solely the coordination rules) as an “International M&A Ph.D. course.” Since the temporary regulations were

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finalized with virtually no changes, we will not discuss them here in detail. They are not new news.

2. In brief, the temporary regulations removed one of the exceptions to the coordination rule. The coordination rule generally provides that if, in connection with indirect stock transfer, a U.S. person (“U.S. Transferor”) transfers assets to a foreign corporation (“Foreign Acquiring Corporation”), in an exchange described in § 351 or § 361, § 367 applies first to the direct asset transfer and then to the indirect stock transfer.

3. Pursuant to the exceptions to the coordination rule, §§ 367(a) and (d) will not apply to the outbound transfer of assets by the U.S. Transferor to the Foreign Acquiring Corporation to the extent those assets are re-transferred by the Foreign Acquiring Corporation to a domestic corporation in certain nonrecognition transactions, provided certain conditions are satisfied. The continuing exceptions require that the transferee domestic corporation’s adjusted basis in the re-transferred assets not be greater than the U.S. Transferor’s adjusted basis in those assets, and that the indirect domestic stock transfer exception rules are satisfied. This typically involves a transaction with an unrelated person.

4. There also was a so-called § 367(a)(5) exception, which was removed by the temporary regulations. The regulations are those at Treas. Reg. §§ 1.367(a)-3(d) and (e).

C. Notice 2016-73: Killer B Repatriation Transactions.

1. Notice 2016-73 announced that the Treasury and the IRS intend to issues regulations under § 367 to modify the so-called “Killer B” anti-repatriation rules relating to the treatment of certain triangular reorganizations involving one or more foreign corporations. The Notice also announced that the Treasury and the IRS intend to issue § 367 regulations to modify the amount of an income inclusion required certain inbound nonrecognition transactions (the “all E&P” amount).

2. The rules in the new Notice remind us of an admonition once stated by a senior IRS official with respect to a different set of proposed § 367 regulations. The regulations described in the Notice seem clearly to constitute an additional to the IRS’s “International M&A PhD Course.”

3. Treas. Reg. § 1.367(b)-10.

(a) Treas. Reg. § 1.367(b)-10 (the “Regulations”) applies to triangular reorganizations in which a subsidiary (“S”) acquires stock securities of its parent corporation (“P”) in exchange for property (the “P acquisition”), and S exchanges the P stock or securities so acquired for stock, securities, or property of a target corporation (“T”). The Regulations do not apply unless P or S (or both) is a

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foreign corporation. The application of the Regulations also is subject to certain exceptions, including the § 367(a) priority rule discussed below.

(b) The primary target of the Regulations and Notice 2016-73 is the repatriation of earnings and profits without tax. When applicable, the Regulations require that adjustments be made that have effect of the distribution of property from S to P under § 301. The amount of the deemed distribution generally is the amount of the property that was transferred by S to acquire the P stock and securities in the P acquisition.

(c) Under Treas. Reg. § 1.367(b)-10(a)(2)(iii), the Regulations do not apply to a triangular reorganization if, in an exchange under § 354 or 356, one or more U.S. persons exchange stock or securities of T and the amount of gain in the T stock or securities recognized by these U.S. persons under § 367(a) is equal to greater than the sum of the amount of the deemed distribution that would be treated by P as a dividend under § 301(c)(1) and the amount of the deemed distribution that would be treated by P as gain from the sale or exchange of property under § 301(c)(3) if the Regulations otherwise would apply to the transaction (the “§ 367(a) priority rule”).

(d) Treas. Reg. § 1.367(a)-3(a)(2)(iv) provides a similar priority rule that turns off the application of § 367(a) to an exchange under § 354 or 356 that occurs in connection with a triangular reorganization described in the Regulations if the amount of gain that otherwise would be recognized under § 367(a) is less than the amount of the § 367(b) income recognized under the Regulations (the “§ 367(b) priority rule”).

(e) The Regulations provide that appropriate adjustments shall be made if, in connection with a triangular reorganization, a transaction is engaged in with a view to avoid the purpose of the Regulations (the “anti-abuse rule”). The anti-abuse rule sets forth an example which provides that the earnings and profits of S would be deemed to include the earnings and profits of a corporation related to P or S for purposes of determining the consequences of the adjustments provided in the Regulations if S is created, organized or funded to avoid the application of the Regulations.

(f) Notice 2014-32 announced that new regulations would be issued modifying and clarifying the Regulations. The 2014 Notice addressed, in part, certain inversion transactions that were structured to be subject to the Regulations in order to avoid

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shareholder-level gain recognition under § 367(a) by reason of the § 367(b) priority rule, notwithstanding that only a minimal amount of income was subject to U.S. tax by reason of a deemed distribution under the Regulations.

(g) The Notice announced that the Regulations would be modified to provide that § 367(b) income includes a § 301(c)(1) dividend or § 301(c)(3) gain that would arise if the Regulations applied to the triangular reorganization but only to the extent the dividend income or gain would be subject to U.S. tax or that would give rise to an income inclusion under Subpart F that would be subject to U.S. tax.

(h) The 2014 Notice also announced that the anti-abuse rule would be clarified to provide that S’s acquisition of P stock or securities in exchange for a note may invoke the anti-abuse rule, and that the earnings and profits of a corporation (or a successor corporation) may be taken into account for purposes of determining the consequences of the adjustments provided in the Regulations, as modified by rules announced in the Notice, regardless of whether the corporation is related to P or S before the triangular reorganization.

(i) Finally, the 2014 Notice announced that the anti-abuse rule would be clarified to provide that a funding of S may occur after the triangular reorganization and that a funding of S could include capital contributions, loans, and distributions.

4. Notice 2016-73: Transactions at Issue.

(a) Treasury and the IRS are concerned that taxpayers have been engaging in transactions designed to repatriate earnings and profits of foreign corporations without incurring U.S. tax by exploiting the § 367(a) priority rule, as modified in the 2014 Notice.

(b) In one such transaction, USP, a domestic corporation, wholly owns FP, a foreign corporation, which, in turn, wholly owns FS, another foreign corporation. FP has no earnings and profits, but FS has substantial earnings from profits. A dividend from FS to FP would qualify for the exception to foreign personal holding company under § 954(c)(6).

(c) USP also wholly owns USS, a domestic corporation, which, in turn, wholly owns FT, a foreign corporation. Pursuant to a transaction undertaken for the purported business purpose of integrating FT into FP-FS ownership chain, FS acquires FP stock from FP in exchange for cash, a note or other property (FP

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acquisition) and uses the FP stock to acquire all of the stock of FT from USS in a transaction intended to qualify as a reorganization described in § 368(a)(1)(B) (FT reorganization).

(d) On a later date, and purportedly unrelated to the FT reorganization, FP engages in an inbound transaction described in Treas. Reg. § 1.367(b)-3, for example, a transfer of all of FP’s assets, including the cash, note or other property received from FS, to USP or domestic subsidiary of USP.

(e) In the transaction, the transfer by USS of the FT stock to FS in exchange for stock of FP pursuant to the FT reorganization is an indirect stock transfer described in Treas. Reg. § 1.367(a)-3(d)(1)(iii)(A). The taxpayer files a gain recognition agreement with respect to all but a de minimis amount of FT stock, and recognizes a small amount of gain on the de minimis amount of stock.

(f) The taxpayer then applies the priority rules by comparing the § 367(b) income to the de minimis amount of § 367(a) gain to determine whether the Regulations apply to the FP acquisition. In computing the amount of § 367(b) income for purposes of § 367(a) priority rule, the taxpayer takes the position that a deemed disposition from FS to FP would not result in § 367(b) income, as described in the 2014 Notice, because any dividend income to FP would not be subject to US tax and would not give rise to an income inclusion under Subpart F by reason of § 954(c)(6).

(g) Accordingly, the taxpayer takes the position that the § 367(b) income (which, under its position, is zero) does not exceed the § 367(a) gain and, therefore, the Regulations do not apply to the FP acquisition by reason of the § 367(a) priority rule.

(h) The taxpayer also takes the position that the subsequent inbound transaction with respect to FP results no income inclusion to USP under Treas. Reg. § 1.367(b)-3 because FP’s earnings from profits were not increased under the Regulations and thus FP’s all earnings and profits amount is zero.

(i) Finally, the taxpayer takes the position that the anti-abuse rule does not apply in this case for various reasons that may include: (1) the FP acquisition was not engaged in with the view to avoid the purpose of the Regulations because it was engaged in for the purpose of integrating FT into the FP-FS chain; (2) the FP acquisition is not a transaction that occurs in connection with the FT reorganization because the acquisition is specifically contemplated by the Regulations; (3) the inbound transaction with

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respect to FP did not occur in connection with the FT reorganization because it does not occur pursuant to the same plan as the FT reorganization; or (4) the anti-abuse rule only applies to adjust the earnings and profits of FS to take into account the earnings and profits of another corporation and, in this regard, FS is not created, organized, or funded to avoid the purpose of the Regulations with respect to the earnings and profits of another corporation.

(j) Treasury and the IRS also are concerned about a similar transaction in which taxpayers take advantage of the rule in § 951(a)(1)(A) that requires a U.S. shareholder to include in its gross income a pro-rata share of Subpart F income of a foreign corporation only if the foreign corporation has been a controlled foreign corporation for an uninterrupted period of 30 days or more during the taxable year. In this form of the transaction, FP is formed, and FP acquisition occurs, during the final 29 days of FP’s taxable year. In computing the amount of § 367(b) income for the purposes of the § 367(a) priority rule in this transaction, the taxpayer takes the position that a deemed distribution from FS to FP would not result in any § 367(b) income, as described in the 2014 Notice, because any income recognized by FP (including capital gain under § 301(c)(3)) would not be subject to U.S. tax and would not give rise to an income inclusion under § 951(a)(1)(A) by reason of the 30-day rule.

(k) Treasury and the IRS state they are also aware of yet another transactional variation intended to accomplish a repatriation of earnings of a foreign corporation without U.S. tax. This one involves the use of nonqualified preferred stock. In one such transaction, USP, a domestic corporation, fully owns both FP, a foreign corporation, and USS, a domestic corporation. USS wholly owns FT, a foreign corporation that has substantial earnings and profits. FP has no earnings and profits. FP acquires newly-issued stock of USP from USP in exchange for nonqualified preferred stock of FP, and then FP uses the USP stock as consideration to acquire all of the stock of FT from USS in a transaction intended to quantify as a reorganization described in Section 368(a)(1)(B). On a subsequent date, when FP still has no earnings and profits, FP redeems the FP nonqualified preferred stock held by USP in exchange for cash or a note.

(l) The taxpayer takes the position that FP’s acquisition of USP stock is not subject to the Regulations because the FP nonqualified preferred stock is not “property” within the meaning of Treas. Reg. § 1.367(b)-10(a)(3)(ii). The taxpayer also takes the position that USP’s transfer of its own stock to FP in exchange for nonqualified

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preferred stock does not qualify as an exchange described in § 351 pursuant to § 351(g)(2) and, therefore, USP takes a basis in the FP nonqualified preferred stock equal to its fair market value under Treas. Reg. § 1.1032-1(d).

(m) Finally, the taxpayer takes the position that the redemption of the FP nonqualified preferred stock does not result in dividend income or capital gain to USP under § 301(c) because FP does not have earnings and profits and the redemption is applied against and reduces USP’s basis in the FP stock under § 301(c)(2). The taxpayer also takes the position that the anti-abuse rule does not apply in such a case for reasons similar to those discussed above in the context of the transaction involving § 954(c)(6).

5. Regulations to be Issued: Priority Rules.

(a) Treasury and the IRS are concerned that the transactions described above raise significant policy concerns and believe that revisions to the Regulations are necessary to prevent the avoidance of U.S. federal income taxes.

(b) Accordingly, they intend to modify § 367(a) priority rule to apply only when T is a domestic corporation. Accordingly, when T is a foreign corporation, the Regulations, as modified by the rules described in the Notice, will apply to a triangular reorganization described in Treas. Reg. § 1.367(b)-10(a)(1), unless an exception in Treas. Reg. § 1.367(b)-10(a)(2)(i) or (ii) applies.

(c) Treasury and the IRS also intend to modify § 367(b) priority rule to provide that, in an exchange under § 354 or 356 that occurs in connection with a transaction described in the Regulations, to the extent one or more U.S. persons exchange stock or securities of a foreign corporation for P stock or securities acquired by S in exchange for property in the T acquisition, § 367(a) will not apply to those U.S. persons with respect to the exchange of the stock or securities of the foreign corporation.

(d) Instead, the exchange will be subject to the § 367(b) regulations, as modified by the new regulations as described in Notice 2016-73. The § 367(b) priority rule, as modified by the regulations described in the 2014 Notice, will continue to apply when T is a domestic corporation. In addition, § 367(a) will apply to the exchange of stock or securities of a foreign corporation to the extent that the T stock or securities are exchanged for P stock or securities that are not acquired by S in exchange for property in connection with a transaction described in Treas. Reg. § 1.367(b)-10.

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(e) Treasury and the IRS intend to modify Treas. Reg. § 1.367(b)-4 and 1.367(b)-4T to provide that, in an exchange under § 354 or 356 that occurs in connection with a transaction described in the Regulations, to the extent an exchanging shareholder exchanges stock or securities of a foreign acquired corporation for P stock or securities acquired by S in exchange for property in the P acquisition, the shareholder must:

i. include in income as a deemed dividend the § 1248 amount attributable to the stock of the foreign acquired corporation that it exchanges; and

ii. after taking into account the increase in basis provided in Treas. Reg. § 1.367(b)-2(e)(3)(ii) resulting from the deemed dividend (if any), recognize all realized gain with respect to the stock or securities of the foreign acquired corporation exchanged that would not otherwise be recognized.

(f) For purposes of the preceding rule, an exchanging shareholder is a U.S. person or a foreign corporation that exchanges stock of a foreign acquired corporation in a prescribed exchange, regardless of whether the U.S. person is a § 1248 shareholder or the foreign person is a foreign corporation in which a U.S. person is a § 1248 shareholder.

6. All Earnings & Profits Amounts.

(a) The definition of the “all earnings and profits amount” also will be modified.

i. This change is quite broad, and could affect, for example, inbound § 367(b)/§ 332 liquidations, that is, more than simply “Killer B” transactions. It is not clear why Treasury and the IRS believe that policy considerations require such a significant change to the current “all E&P amount” definition, which has withstood the test of time over many decades.

ii. However, the new “E&P accelerator” likely will not apply in most generic § 332 inbound liquidations (see “(c)”, “(d)” and “(e)” below). Nonetheless, it will need to be included as a checklist item in considering such a transaction, as it could be material.

(b) Treasury and the IRS state that they intend to modify Treas. Reg. § 1.367(b)-2(d)(3)(ii) to provide that, if there is excess asset basis with respect to a foreign acquired corporation, then, in the case of

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an exchanging shareholder to which Treas. Reg. § 1.367(b)-3(b)(3) applies, the all earnings and profits amount with respect to the stock in the foreign acquired corporation that it exchanges will be increased by the specified earnings with respect to that stock (if any).

(c) The term “excess asset basis” means, with respect to a foreign acquired corporation, the amount by which the inside asset basis of the foreign acquired corporation exceeds the sum of the following amounts:

i. FT’s E&P. The earnings and profits of the foreign acquired corporation attributable to the outstanding stock of the foreign acquired corporation. For this purpose, the earnings and profits attributable to stock of the foreign acquired corporation is determined under the principles of Treas. Reg. § 1.367(d)-2(d) but without regard to whether the exchanging shareholder is described in Treas. Reg. § 1.367(b)-3(b)(1) or as a U.S. person or a foreign person. Furthermore, the earnings and profits of the foreign acquired corporation will include amounts described in § 1248(d)(3) or 1248(d)(4).

ii. Aggregate outside basis. The aggregate basis in the outstanding stock of the foreign acquired corporation determined immediately before the inbound transaction and without regard to any basis increase in Treas. Reg. § 1.367(b)-2(e)(3)(ii) resulting from the inbound transaction.

iii. Liabilities assumed. The aggregate amount of liabilities of the foreign acquired corporation that are assumed by the domestic acquiring corporation in the inbound transaction determined under the principles of § 357(d).

(d) The term “inside asset basis” means, with respect to a foreign acquired corporation, the adjusted basis of the assets of the foreign acquired corporation in the hands of the domestic acquiring corporation determined immediately after the inbound transaction.

(e) The term “specified earnings” means, with respect to the stock of the foreign acquired corporation that is exchanged by an exchanging shareholder, the lesser of the following amounts (but not below zero):

i. Lower-tier E&P. The sum of the earnings and profits (including a deficit) with respect to each foreign subsidiary

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of the foreign acquired corporation that are attributable under § 1248(c)(2) to the stock of the foreign acquired corporation exchanged. For this purpose, the modifications described in Treas. Reg. § 1.367(b)-2(d)(2) and (d)(3)(i) apply. Thus, for example, the amount of earnings and profits of a foreign subsidiary that are attributable to stock of the foreign acquired corporation is determined without regard to whether the foreign subsidiary was a controlled foreign corporation at any time during the five years preceding the inbound transaction. The amount described here is referred to as “lower-tier earnings.”

ii. Excess asset basis times specified percentage. The product of excess asset basis of the foreign acquired corporation multiplied by the exchanging shareholders’ specified percentage (below).

iii. Specified stock gain. The amount of gain that would be realized by the exchanging shareholder if, immediately before the inbound transaction, the exchanging shareholder had sold the stock of the foreign acquired corporation for fair market value, reduced by the exchanging shareholders’ all earnings and profits amount. The amount described here is referred to as the “specified stock gain.”

(f) The term “specified percentage” means, with respect to an exchanging shareholder, a fraction (expressed as a percentage), the numerator of which is the amount of the exchanging shareholders’ specified stock gain, and the denominator of which is the (1) sum of the aggregate of the specified stock gain with respect to all exchanging shareholders to which Treas. Reg. § 1.367(b)-3(b)(3) applies plus (2) the aggregate of the gain realized (regardless of whether the gain is recognized) with respect to the stock exchanged by all other exchanging shareholders.

(g) If the specified earnings attributable to the stock of the foreign acquired corporation exchanged by an exchanging shareholder is less than the lower-tier earnings attributable to the stock exchanged, the specified earnings of the exchanging shareholder will be sourced from lower-tier earnings of foreign subsidiaries of the following acquired corporation under the principles of Treas. Reg. § 1.1248-1(d)(3).

(h) If there is excess asset basis with respect to a foreign acquired corporation, the taxpayer may reduce the excess asset basis to the extent that the excess asset basis is not attributable, directly or indirectly, to property provided by a foreign subsidiary of the

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foreign acquired corporation. For example, if there was a transfer of property to the foreign acquired corporation described in § 362(e)(2), and the election described in § 362(e)(2)(C) was made to limit the basis of the stock received in a foreign acquired corporation to its fair market value, then, for purposes of determining excess asset basis, the basis in the stock of the foreign acquiring corporation may be determined without regard to the application of § 362(e)(2).

(i) The regulations to be issued will include an anti-abuse rule to address transactions engaged in with a view to avoid the purposes of these rules. Under the anti-abuse rule, adjustments must be made, including by disregarding the effects of transactions, to carry out the purposes of these rules. Thus, as one example, if a transaction is engaged in with a view to reduce excess asset basis, including by increasing the basis of the stock of the foreign acquired corporation without a corresponding increase in the basis of the assets of the foreign acquired corporation, that increase in the basis of the stock of the foreign corporation will be disregarded for purposes of computing at excess asset basis.

7. Nonqualified Preferred Stock. The definition of property provided in Treas. Reg. § 1.367(b)-10(a)(3)(ii) will be modified to include S stock that is nonqualified preferred as defined in § 351(g)(2).

8. Example.

(a) Example No. 1. In the first example, USP, a domestic corporation, wholly owns FP and USS. FP is a foreign corporation that wholly owns FS, a foreign corporation. USS is a domestic corporation that wholly owns FT, a foreign corporation. USS owns 100 shares of FT stock, which constitutes a single block of stock with a fair market $100, an adjusted basis of $20, and a § 1248 amount of $50. FS has earnings and profits of $60. A dividend from FS to FP would qualify for the exception to foreign personal holding company income under § 954(c)(6). FP issues 100 shares of voting stock with a fair market value of $100 to FS in exchange for $40 of common stock of FS and $60 of cash. FS acquires all of the stock of FT held by USS solely in exchange for the $100 of FP voting stock in a triangular reorganization described in § 368(a)(1)(B).

(b) The triangular reorganization is described in Treas. Reg. § 1.367(b)-10(a). Pursuant to Treas. Reg. § 1.367(b)-10(b)(1), as modified by the rules announced in the 2014 Notice, adjustments must be made that have the effect of a distribution of property in the amount of $60 from FS to FP under § 301.

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(c) The $60 deemed distribution is treated as separate from, and occurring immediately before, FS’s acquisition of $60 of the FP stock used in a triangular reorganization. The $60 deemed distribution from FS to FP results in $60 of dividend income to FP under § 301(c)(1) that is not Subpart F income under § 954(c)(6). Treas. Reg. § 1.367(b)-4, as modified by the 2016 Notice, rather than § 367(a)(1) applies to the $60 of FT stock exchanged for the $60 of FP stock acquired by FS from FP in exchange for $60 of cash.

(d) Thus, USS must include in income a $30 deemed dividend ($50 § 1248 amount times 60%) with respect to the FT stock exchanged for FP stock that was acquired by FS from FP for $60 cash. In addition, USS must recognize the remaining $18 gain ($48 gain ($80 gain times 60%) minus $30 deemed dividend) realized with respect to the FT stock. If USS properly files a gain recognition agreement, USS does not recognize gain under § 367(a) with respect to the $40 of FT stock exchanged for FP stock that was acquired by FS from FP in exchange for the $40 of FS common stock.

(e) Example No. 2. In the second example, USP, a domestic corporation owns 90% of the stock of FP, a foreign corporation. The remaining 10% is owned by an unrelated foreign person (X). FP wholly owns FS1, also a foreign corporation, which in turn, owns FS-2, a foreign corporation. The FP stock owned by USP has a fair market value of $90 and a basis of $17.

(f) The FP stock owned by X has a fair market value of $10 and a basis of $6. The all earnings and profits amount with respect to USP’s stock, determined without regard to the Notice, is $27.

(g) The assets of FP have a basis of $78, FP has no liabilities, and the earnings and profits of FP attributable to the outstanding FP stock is $30 (determined without regard to whether USP and X are exchanging shareholders or U.S. or foreign persons).

(h) The earnings and profits of FS1 and FS2 attributable to the FP stock owned by USP under § 1248(c)(2) are $80 and ($20 deficit) respectively.

(i) In an inbound F reorganization, US Newco, a newly formed company wholly owned by USP, acquires all of the assets of FP in exchange for US Newco stock.

(j) The all earnings and profits amount attributable to USP’s stock in FP before the Notice is $27, an amount which USP would

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normally have included in income. After the Notice, the all earnings and profits amount is $50, which now is the amount that USP must include in income.

(k) The calculations start with the $27. This amount must be increased by FP’s specified earnings because there is excess asset basis with respect to FP. The excess asset basis is $25: the amount that the inside basis of FP ($78) exceeds the sum of (i) FP’s earnings and profits ($30); (ii) the aggregate basis in all of the FP stock ($23); and (iii) the FP liabilities assumed by US Newco ($0).

(l) The specified earnings with respect to the stock of FP exchanged by USP equals $23. It’s the lesser of the following amounts: (i) $60, the sum of the earnings and profits (including deficits) with respect to FS1 and FS2; (ii) $23, the product of the excess asset basis with respect to FP ($25) multiplied by USP’s specified percentage (92%), determined based on fraction the numerator of which is USP’s aggregate of the specified stock gain ($46) and the denominator of which is the sum of the aggregate of the specified stock gain plus gain realized with respect to the FP stock ($50); and (iii) $46, USP’s specified stock gain, which is an amount that would have been realized by USP if immediately before the inbound transaction USP had sold the stock of FP for fair market value ($73) reduced by USP’s all earnings and profits amount before applying the Notice ($27).

(m) The all earnings and profits amount that USP must include in income as a deemed dividend is $50 ($27 plus $23). Under the Notice, $23 of the deemed dividend is determined by reference of the earnings and profits of FS1 and is considered to have been paid by FS1 to USP through FP. Immediately before the exchange, USP’s basis in the stock of FP is increased by $50, the deemed dividend, for purposes of determining USP’s basis in its stock of US Newco.

9. Effective Date. The regulations described in Notice 2016-73 will apply to transactions completed on or after December 2, 2016 and to any inbound transactions treated as completed before December 2, 2016 as a result of an entity classification election that is filed on or after December 2, 2016. No inference is intended regarding the treatment of transactions described on the new Notice under current law. For example, the transactions are currently subject to challenge under the anti-abuse rule.

10. Comments Requested. Treasury and the IRS requested comments on the rules described in Notice 2016-73. Comments are specifically requested on whether, in light of the modifications announced in the 2016 Notice, it may be more appropriate (in particular, when T is a foreign corporation) to

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treat the deemed distribution as occurring immediately after, rather than before, the triangular reorganization.

VIII. SECTION 987.

A. Section 987 Final Regulations.

1. Treasury and the IRS finalized 2006 proposed § 987 regulations generally adopting the proposed regulations’ substantive approach, but with changes intended to reduce the proposed rules’ complexity and to make them more administrable.

2. Section 987 provides that when a taxpayer owns one or more qualified business units (“QBUs”) with a functional currency other than the U.S. dollar and the functional currency is different from that of the taxpayer, the taxable income or loss of the taxpayer with respect to each QBU is determined by computing the taxable income or loss of each QBU separately in its functional currency and translating the income or loss at the appropriate exchange rate.

3. Section 987 also requires the taxpayer to make “proper adjustment” (as prescribed by the IRS) for transfers of property between QBUs having different functional currencies, including by treating post-1986 remittances from a QBU as made on a pro rata basis out of post-1986 accumulated earnings and by treating § 987 gain or loss as ordinary income or loss and sourcing it by reference to the source of income giving rise to the post-1986 accumulated earnings.

4. Treasury and the IRS referred to the 2006 proposed regulations’ method as the foreign exchange exposure pool (“FEEP”) method. The FEEP method provides that the income of a QBU that is subject to § 987 is determined by reference to the items of income, gain, deduction, and loss booked to the § 987 QBU in its functional currency, adjusted to reflect U.S. tax principles. Items of income and deduction generally are translated into the functional currency of the § 987 QBU’s owner at the average exchange rate for the year. However, the basis of certain historic assets and the deductions for depreciation, depletion, and amortization of certain assets are translated at the historic rates for those assets. The 2006 proposed regulations also required the adjusted basis and amount realized with respect to “marked assets” to be translated using a spot rate, which for assets acquired in prior taxable years would be the spot rate for the closing balance sheet of the prior taxable year.

5. The FEEP method also uses a balance sheet approach to determine exchange gain or loss, which is not recognized until a § 987 QBU makes a remittance. Under the FEEP method, exchange gain or loss with respect to marked items is determined annually but is pooled and deferred until a

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remittance is made. A marked item was generally defined as an asset (marked asset) or liability (marked liability)) that would generate § 988 gain or loss if the asset or liability were held or entered into directly by the owner of the § 987 QBU. A remittance was defined as a net transfer of amounts from a § 987 QBU to its owner. When the § 987 QBU makes a remittance, a portion of the pooled exchange gain or loss is recognized.

6. The FEEP method became controversial and many comments were received. Compliance seemed close to impossible for many taxpayers. Some comments expressed a preference to more closely align the § 987 regulations with the financial accounting rules under Accounting Standards Codification, Foreign Currency Matters, § 830 (“ASC 830”).

7. Treasury and the IRS believe that the approach of the 2006 regulations is the appropriate one and the regulations were finalized generally as proposed but modified to take into account administrability and policy considerations unique to § 987. In particular, Treasury and the IRS acknowledged taxpayers’ observations about the complexity and administrability of the 2006 proposed regulations.

8. Retention of Basic Concepts Set Forth in the Proposed Regulations. The Examples set forth in Treas. Reg. §§ 1.987-1 and 2 are generally the same as those in the proposed regulations. We summarize them as a review:

Treas. Reg. § 1.987-1(b)(7) Examples

Ex. 1

US Corp

US Corp owns business A and DE1which has £ debt and owns FC.

A is a 987 QBU; DE1 is not. The £ debt will be subject to 988.

FC

DE1A€

£

£ debt

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Ex. 2

US CorpUS

US Corp owns business A and DE1, which owns DE2. DE2 owns businesses B and C.

A is a 987 QBU. DE1 and DE2 are not. B is a 987 QBU. C is not.

US Corp is the direct owner of A, B and C. [The “flat” approach.]

DE1A€

DE2

B¥

C$

Ex. 3

US CorpUS

US Corp owns DE1, which owns businesses A and B. A and B and 987 QBUs; DE1 is not. US Corp is treated as the owner of A & B and may electively treat them as one QBU.

DE1

A€

B€

Ex. 4

US Corpus

US Corp and FC are partners in P, a § 987 aggregate partnership. P owns business A and DE1 which owns business B.

A and B are 987 QBUsof Y to the extent portions thereof are allocated to Y. A is a 987 QBU of CFC to the extent allocated to FC.

P and DE1 are not 987 QBUs.

Y and CFC are the direct owners of A and B, respectively.

DE1A€

B¥

CFC

P

¥Yus

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Ex. 5

US Corpus

US Corp owns DE1, which owns DE2. DE2owns DE3. The DEseach conduct a business.

A, B and C are 987 QBUs owned by US Corp. The DEs are not 987 QBUs.

A QBU does not own another QBU. US Corp is the indirect owner of A, B and C.

DE1A€

DE2B¥

C RR

DE3

Treas. Reg. § 1.987-2(c)(10) Examples

Example 1

Xus

X owns DE1, which owns business A. X loans €100 to DE1 for business A.

The loan is a disregarded transaction and not taken into account.

There has been a €100 transfer from X to business A. See alsoTreas. Reg. § 1.988-1(a)(10)(ii) re § 988.

DE1

A€

Example 2

Xus

X owns business A and B. A transfers equipment used in its business to B.

There is a triangular distribution to X and contribution by X to B.

A€

B¥

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Example 3

Xus

X owns DE1 and DE2, which in turn own businesses A and B. A sells equipment to B.

There are 2 triangular distributions: The equipment to X and a related contribution to B from X, and the cash from B to X with a related contribution to A.

DE1

A€

DE2

B¥

Example 5

Xus

A and Y each have a 50% interest in P, an aggregate partnership. P owns DE1 and DE2 which own businesses A and B.

DE1 licenses IP to DE2 and X. The royalty received from DE2 is disregarded. The royalty does not result in income or deduction. The royalty amount is a triangular distribution to X and Y and a contribution by them to DE1.

The royalty received from X is regarded. It gives rise to an item of income and deduction, and the royalty payment does not give rise to a transfer to a 987 QBU.

DE1

A€

B¥

Y

P

DE2

License

License

50

50

Example 6

Xus

X and Y each have a 50% interest in P, an aggregate partnership, which owns business A.

Z acquires a 20% interest in P via a contribution to P. This reduces X and Y to 40% each.

Ten percent of the assets of A are treated as transferred to each of X and Y. Z has a 987 QBU.

A€

Y

P

50

50

Z

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Example 8

XusX owns DE1, which owns business A. X sells a 50% interest in DE1 to Y. DE1 becomes an aggregate partnership.

A is treated as transferring 50% of its assets and liabilities to X.

Y has a 987 QBU.

DE1

A€

Ysale of 50%

Example 9

Xus

X owns DE1 which owns business A. Y contributes property to DE1 for a 50% interest in DE1. DE1becomes a partnership.

A is treated as transferring 50% of its original assets and liabilities to X. X is deemed to transfer them to Y and Y is deemed to contribute those assets and liabilities to A (Y’s A 987 QBU).

Further, 50% of the assets contributed by Y to DE1 are treated as though they were transferred by Y to X and by X to X’s A 987 QBU.

DE1

A€

Y

Examples 11-17

These examples involve circular cash flows, transfers without economic substance, and QBUs with offsetting positions (debt and borrowed cash) some to trigger 987 losses.

9. Improvements Intended to Reduce Complexity and Improve Administrability.

(a) In order to reduce complexity and improve administrability, the final regulations modified the 2006 proposed regulations in several ways, including by permitting more items to be treated as § 987 marked items, simplifying the treatment of marked items so that net income attributable to these items is translated at the average exchange rate, and simplifying the adjustments that are required to translate basis recovery for historic items at the historic rate.

(b) These changes are intended to balance the administrability benefits of simplifying the final regulations and bringing them into closer

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conformity with financial accounting rules against the need to minimize the distortions that would result from permitting taxpayers to include uncertain and remote foreign currency gains and losses in taxable income. The final regulations allow taxpayers to:

i. use the yearly average exchange rate as the historic rate,

ii. treat prepaid expenses and liabilities for advance payments of unearned income as § 987 marked items,

iii. apply a simplified method with respect to inventory, and

iv. translate both basis recovery an amount realized with respect to marked assets at the yearly average exchange rate.

(c) However, the complexity of the basic rules we just reviewed (the regulation’s initial examples) remains. Further, Treas. Reg. § 1.987-4, which contains the key provisions for determining a § 987 QBU’s “Net Unrecognized § 987 Gain or Loss,” also is essentially unchanged from the proposed regulation.

10. Yearly Average Exchange Rate as Historic Rate.

(a) Under the proposed regulations, the historic rate used to translate the basis of historic assets was the spot rate on the date on which the assets was transferred to, or otherwise acquired by, a § 987 QBU. This rule was modified in the final regulations to permit taxpayers to use the yearly average exchange rate rather than a spot rate in translating historic items. Treas. Reg. § 1.987-1(c)(3)(i) generally provides that the historic rate is the yearly average exchange rate for the taxable year when a historic asset is acquired, or a historic liability is incurred, by a § 987 QBU.

(b) Taxpayers that prefer to use the spot rate as the historic rate, as under the proposed regulations, may elect to do so. A taxpayer that makes the election is deemed to also make the historic inventory election.

(c) To further improve administrability, Treas. Reg. § 1.987-1(c)(3)(iii) permits a § 987 QBU that acquires depreciable or amortizable property in one year and places the asset in service in another year to determine the historic rate for the property based on the date the property is placed in service rather than the year that property was acquired, provided that this convention is consistently applied for all such property attributable to that § 987 QBU.

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11. Prepaid Expenses and Liabilities Treated as Marked Items. Comments suggested that prepaid expenses and liabilities for advance payments of unearned income should be treated as § 987 marked items because they typically have a short duration and often concern small amounts. Treasury and the IRS agreed believing that this would generally promote administrability without introducing significant distortions in the determination of § 987 gain or loss. Accordingly, the definition of marked item under Treas. Reg. § 1.987-1(d) includes prepaid expenses and liabilities for an advance payment of unearned income where the items have an original term of one year or less.

12. Costs of Goods Sold/Inventory.

(a) Inventory was treated as a historic item under the proposed regulations. As a result, to determine § 987 taxable income or loss with respect to a § 987 QBU, cost of goods (“COGS”) had to be translated at a historic spot rate that corresponded to the date the liquidated inventory was acquired or manufactured. A historic spot rate also had to be used to determine the Owner Functional Currency Net Value (“OFCNV”) of the QBU.6 For these purposes, the cost basis of inventory purchased for resale generally would have been translated into the owner’s functional currency at the spot rate on the date of purchase. With respect to inventory that was manufactured by the § 987 QBU, it would have been necessary to translate individually the various components of COGs at the appropriate historic spot rate for each cost component, resulting in an effective historic rate for manufactured inventory that was a blend of historic rates applicable to these components.

(b) The final regulations simplify the translation of COGS and ending inventory in two significant ways. First, the use under Treas. Reg. § 1.987-1(c)(3) of the yearly average exchange rate rather than a spot rate as the historic rate will significantly simplify the translation of COGS and ending inventory. This change makes it possible to translate all inventory purchased in a given year, and all costs incurred in the production of inventory in a given year (other than depreciation, which is always translated at the historic rate for the year the depreciated property was acquired or placed in service, regardless of whether it is an inventoriable cost), using a single exchange rate.

(c) Second, Treas. Reg. § 1.987-3(c)(2)(iv)(A) prescribes a simplified inventory method under which

6 In Treas. Reg. § 1.987-4, determining the year-over-year change in OFCNV is Step 1 in the (now) 8-step

formula to determine the “Net Unrecognized § 987 Gain or Loss” of a § 987 QBU. The rules for determining OFCNV are in Treas. Reg. § 1.987-4(e).

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i. COGS is translated into the functional currency of the § 987 QBU owner at the yearly average exchange rate for the current taxable year with a requirement to make only two discrete adjustments to the translated COGS amount, and

ii. A simplified historic rate is used for purposes of determining the OFCNV under Treas. Reg. § 1.987-4 for inventory to which the simplified method applies.

(d) A taxpayer that prefers the inventory method under the proposed regulations can elect under Treas. Reg. § 1.987-3(c)(2)(iv)(B) to translate inventoriable costs that are included in COGS or ending inventory at the historic rate for each such cost and, if they wish, can further elect under Treas. Reg. § 1.987-1(c)(1)(iii) to use spot rate as the historic rate.

(e) Under the simplified inventory method, the § 987 QBU determines COGS in it functional currency and translates that amount at the yearly average exchange rate for the taxable year rather than translating each inventoriable cost at the appropriate historic rate. Taxpayers applying this method must make two adjustments to COGS described in Treas. Reg. § 1.987-3(c)(3). These adjustments mitigate the consequences of translating COGS at the early average exchange rate, as if inventory were a marked asset, rather than translating the inventoriable costs reflected in the inventory sold during the taxable year at the appropriate historic rates, as under the proposed regulations.

(f) In particular, the adjustments generally prevent inventory from giving rise to § 987 gain or loss reflected in the FEEP. The adjustments also cause § 987 taxable income or loss to correspond over time to the § 987 taxable income or loss that would have resulted if inventoriable cost were translated at historic rates.

(g) Special adjustments are necessary for purposes of inventory that can be somewhat complicated. We will not cover those here.

13. Excluded Entities. The proposed regulations provided that banks, insurance companies and similar financial companies would not be subject to the regulations. The regulations identified leasing companies, finance coordination centers, regulated investment companies and real estate investment trusts as “similar financial entities.” The reference to similar financial entities was unclear, and eliminated. Further, entities that primarily engage in transactions with related persons that are not themselves financial entities are subject to the final regulations. See Treas. Reg. § 1.987-1(b)(1)(ii).

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14. Ordinary Course Transactions.

(a) Several commenters recommended that transactions entered into between two § 987 QBUs of the same taxpayer, or by a § 987 QBU in its home office, in the ordinary course of business should not be considered “transfers” that are taken into account in determining the amount of a remittance. These comments noted the complexity associated with tracking a large number of ordinary-course transactions and suggested that these transactions were not an appropriate occasion to recognize § 987 gain or loss.

(b) Treasury and the IRS rejected this comment. They determined that it would not be feasible to define the perimeters of an ordinary-course exception to the definition of a transfer with sufficient clarity to avoid abuse and permit effective enforcement given the potentially high volume and variety of transactions between the § 987 QBU and its home office. Treasury and the IRS also believe that the annual netting convention of Treas. Reg. § 1.987-5 appropriately limits the extent to which ordinary course transactions between a § 987 QBU and its home office give rise to a remittance.

15. Grouping Rules.

(a) The proposed regulations allowed a taxpayer to elect to treat all of its directly owned § 987 QBUs with the same functional currency as a single QBU for purposes of § 987. This rule, however, did not allow different members of a consolidated group to group their § 987 QBUs with the same currency into a single QBU.

(b) Several comments recommended extending the grouping rules to corporations that file consolidated returns so that the consolidated group could make transfers among § 987 QBUs without causing a remittance. Treasury and the IRS rejected this comment. They were unable to reconcile in a satisfactory manner the timing of § 987 gain or loss and § 987 taxable income with the principles of the consolidated return regulations.

(c) A commenter requested an election to group § 987 QBUs that are directly owned with § 987 QBUs that are indirectly owned through § 987 aggregate partnerships. Treasury and the IRS rejected this comment, as well, believing that it would be inconsistent with the treatment of transactions between a partnership and its partner as regarded transactions for federal income tax purposes.

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16. Treas. Reg. § 1.987-4’s Eight-Step Calculation to Determine Net Unrecognized § 987 Gain or Loss of a § 987 QBU.

(a) The proposed regulations provided multi-step calculations for determining the “Net Unrecognized § 987 Gain or Loss” of a § 987 QBU for a taxable year. These calculations, in Treas. Reg. § 1.987-4, obviously are at the heart of the FEEP method.7 Commenters noted that this calculation did not take into account the effects of tax exempt income and nondeductible expenses on a § 987 QBUs cash flows.

(b) In response to these comments, Treas. Reg. § 1.987-4(d) reflects additional steps in the calculation of unrecognized § 987 gain or loss that account for nondeductible expenses (Step 7) and tax-exempt income (Step 8). Step 7 also now explicitly accounts for foreign taxes claimed as a credit, which must be translated at the same rate at which the taxes are translated under § 986(a) (discussed further below).

(c) However, the final version of Treas. Reg. § 1.987-4 otherwise is essentially the same as it was proposed. Two new examples were added, one to illustrate LIFO inventories, but the substantive rules are the same.

17. Partnerships.

(a) The proposed regulations apply to all partnerships based on an approach (the aggregate approach) that treated a partnership as an aggregate of its partners rather than as an entity separate from its owners. Accordingly, under the proposed regulations a partnership itself was not treated as a § 987 QBU, but certain activities of a partnership that constituted a trade or business could qualify as a QBU that is an eligible QBU of a partner. Some commenters said that the aggregate approach was overly complex and that minority partners would not have the power to compel a partnership to provide them with information needed to make the calculations required under the aggregate approach.

(b) Treasury and the IRS believe that the aggregate approach is appropriate for partners with substantial partnership interests and that this approach should be continued with respect to a partnership that is wholly owned by related persons. Accordingly, the final regulations retain the aggregate approach but only for so-called “§ 987 aggregate partnership,” which are defined as partnerships

7 The typed version of the final § 987 regulations is 95 pages in length (excluding the preamble, index and

signature page). Treas. Reg. § 1.987-4 is 23 pages in length, accounting for nearly a quarter (24%) of the final § 987 regulations.

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for which all of the capital and profits interests are owned, directly or indirectly, by persons that are related within the meaning of § 267(b) or § 707(b).

(c) Partnerships other than § 987 aggregate partnerships under the final regulations will constitute a QBU.

18. Terminations.

(a) Under the proposed regulations, a § 987 QBU terminates when its activities cease, substantially all of its assets are transferred to its owner, a CFC owner ceases being a CFC, or the owner ceases to exist in a transaction other than certain liquidations in reorganizations described in § 381(a) (discussed further below).

(b) Under the final regulations the transfer of substantially all of the § 987 QBUs assets and liabilities under § 351 would result in the termination because the owner ceases to be subject to § 987 and has no successor in a § 381(a) transaction.

(c) Nonetheless, Treasury and the IRS thought it appropriate in certain cases to defer § 987 gain or loss that otherwise would be recognized as a result of certain transactions, including terminations, that result in a deemed transfer from a § 987 QBU where some or all of the assets of the QBU continue to be reflected on the books and records of a § 987 QBU in the same group.

(d) Additionally, Treasury and the IRS believe that combinations and separations of § 987 QBUs of the same owner generally should not result in recognition of § 987 gain or loss. Accordingly, new temporary regulations (discussed below) provide rules under which certain § 987 gain or loss that otherwise would be recognized upon a combination, separate, termination, or other event with respect to a § 987 QBU is deferred and recognized upon a subsequent event to the extent that the § 987 QBU assets continue to be reflected on the books and records of a § 987 QBU in the same controlled group.

(e) Comments indicated that it was unclear under the proposed regulations whether a check-the-box election to treat a foreign disregarded entity that legally owns a § 987 QBU as a corporation for U.S. tax purposes would cause the § 987 QBU to terminate. To provide greater clarity, Treas. Reg. § 1.987-8(f) Example 6 illustrates that when a foreign disregarded entity that legally owns a § 987 QBU elects to be treated as a corporation under the check-the-box regulations, the § 987 QBU terminates due to the deemed transfer of assets from the § 987 QBU to the owner immediately

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prior to the deemed transfer of assets from the owner to the transferee corporation under § 351.

(f) Additionally, Treas. Reg. § 1.987-2(b)(2)(ii) clarifies that if an asset or liability of a § 987 QBU is sold or exchanged (including in a nonrecognition transaction) for an asset or liability that is not attributable to the § 987 QBU immediately after the exchange (for example, non-portfolio stock deemed to be received in a § 351 exchange), the exchanged asset is treated as transferred from the § 987 QBU to its owner in a disregarded transaction immediately before the exchange. The transfer would be taken into account in determining the amount of the remittance from the § 987 QBU.

19. Transition Rules.

(a) Under the proposed regulations, a taxpayer that used a reasonable method to comply with § 987 prior to transitioning to the final regulations could choose between the deferral transition method and the fresh start transition method. The deferral transition method generally preserved § 987 gain or loss determined under the taxpayer’s prior method, whereas the fresh start method did not.

(b) Under the deferral method, a taxpayer would determine § 987 gain or loss under the taxpayer’s prior method as if all § 987 QBUs of the taxpayer terminated on the last day of the taxable year preceding the transition date. The § 987 gain or loss was not recognized but rather was considered as net unrecognized § 987 gain or loss of new § 987 QBUs for purposes of applying § 987 to the taxable year that begins on the transition date.

(c) The owner of a § 987 QBU that was deemed terminated under this rule was treated as having transferred all of the assets and liabilities attributable to the § 987 QBU to the new § 987 QBU on the transition date.

(d) Under the fresh start transition method, the same deemed transactions would be deemed to occur as under the deferral method, but no § 987 gain or loss would be determined upon the deemed termination. Exchange rates for translating the amount of assets and liabilities deemed transferred to the new § 987 QBU were determined with reference to the historic spot rates for these assets and liabilities without adjustment. Accordingly, § 987 gain or loss determined under the owner’s prior method was not taken into account. Except to the extent of any previously recognized § 987 gain or loss, the effect of the fresh start method is as if the assets and liabilities on the books and records of a § 987 QBU on

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the transition date had been the only assets and liabilities held by the QBU from its inception.

(e) Treasury and the IRS agreed with a comment that suggested that the fresh start method is sufficient and that the availability of an election between two different transaction methods is unnecessary and detrimental to the IRS. By requiring the translation of assets and liabilities of transitioning QBUs at historic rates, unlike a “true fresh start” method, the fresh start transition method appropriately takes into account the applicability of § 987 prior to the issuance of the final regulations.

(f) Allowing an election to use the deferral method would allow taxpayers with substantial overall § 987 losses determined under their prior method, which may not correspond to economic losses, to preserve those losses while taxpayers with substantial overall § 987 gains determined under their prior method could avoid taking some of those gains into account by using the fresh start method.

(g) Accordingly, the final regulations do not include an election to use the deferral method. Additionally, the final regulations do not include an election to use a “true fresh start” method, since that method would fail to account in any way for the applicability of § 987 prior to the transition date with respect to assets and liabilities sold by a § 987 QBU on the transition date.

(h) Treasury and the IRS recognize that certain taxpayers have adopted a § 987 method based on a reasonable application of the 2006 proposed regulations (the “2006 method”). Taxpayers that adopted the 2006 method generally already transitioned to that method. Because the final regulations adopt 2006 proposed regulations without fundamental changes, it is not necessary or appropriate for taxpayers to transition from the 2006 method to the final regulations under a fresh start method. However, Treas. Reg. § 1.987-10(c)(2) provides rules clarifying how net unrecognized § 987 gain or loss with respect to a QBU that was subject to the 2006 method is determined under the final regulations.

20. Elections.

(a) Several elections have been included in the final regulations to mitigate potential complexity or administrative burdens associated with complying with the regulations. Treas. Reg. § 1.987-1(g) provides rules for making elections. Elections must be made by the owner and must be made for the first taxable year for which the election is relevant in determining the § 987 taxable income or loss

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or § 987 gain or loss of the § 987 QBU. Elections may not be revoked or changed without the consent of the IRS. A revocation will be considered if the taxpayer can demonstrate significantly changed circumstances or other circumstances that demonstrate a substantial non-tax business reason for revoking the election.

(b) With one exception, the elections under the final regulations are made on a QBU-by-QBU basis. An owner must make the grouping election described in Treas. Reg. § 1.987-1(b)(2)(ii) with respect to all of its § 987 QBUs that have the same functional currency.

(c) Under the proposed regulations, if an owner failed to make an election in a timely manner, the owner was considered to have satisfied the timeliness requirement if it could demonstrate that the failure was due to reasonable cause. Procedures described in the 2006 proposed regulations are not included in the final regulations. Taxpayers who fail to make a timely election may seek relief in accordance with the general rules described in Treas. Reg. § 301.9100-1 for requesting an extension of time to make an election.

21. Effective Date. The final regulations generally apply to taxable years beginning on or after one year after the first day of the first taxable year following December 7, 2016 (2018 for calendar year taxpayers). A taxpayer may elect to apply them one year earlier (2017 for calendar year taxpayers) subject to a consistency requirement.

B. Temporary Regulations – Section 987.

1. Final regulations were issued under § 987, as discussed above. In addition, temporary § 987 regulations also were issued to provide: (1) an annual deemed-termination election for a § 987 QBU; (2) an elective method, available to taxpayers that make annual deemed-termination election, for translating all items of income or loss with respect to a § 987 QBU at the yearly-average rate; (3) rules regarding the treatment of § 988 transactions of a § 987 QBU; (4) rules regarding QBUs with the U.S. dollar as their functional currency; (5) rules regarding combinations and separations of § 987 QBUs; (6) rules regarding the translation of income used to pay creditable foreign income taxes; and (7) rules regarding the allocations of assets and liabilities of certain partnerships for purposes of § 987. Temporary regulations under § 988 were also issued requiring the deferral of certain § 988 losses that arises with respect to related-party loans.

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2. Deferral of Section 987 Gain or Loss on Certain Terminations and Other Transactions Involving Partnerships.

(a) Under the final regulations, the owner of a § 987 QBU that terminates includes in income all of the net unrecognized § 987 gain or loss with respect to the § 987 QBU in the year that it terminates. Treas. Reg. §§ 1.987-8(b) and (c) describe the circumstances in which a § 987 QBU terminates, which include the transfer (or deemed transfer) of substantially all of the assets of the § 987 QBU and when the § 987 QBU’s owner ceases to exist (except in connection with certain liquidations or reorganizations).

(b) Under these rules, a termination can result solely from a transfer of a § 987 QBU between related persons or, when a QBU is owned by an entity that is disregarded as an entity separate from its owner for tax purposes (DE), from the deemed transfer that occurs when an election is made to treat the DE as a corporation for U.S. tax purposes, notwithstanding that QBU’s assets continue to be used in the same trade or business.

(c) Because a termination can result in the deemed remittance of all the assets of a § 987 QBU in circumstances in which the assets continue to be used by a related person in the conduct of the same trade or business that was formally conducted by the § 987 QBU, terminations can facilitate the selective recognition of § 987 losses. Treasury and the IRS believe that terminations generally should not be permitted to achieve this selective recognition of losses when the assets and liabilities of the § 987 QBU are transferred to a related person and remain subject to § 987 in the hands of the transferee, as in the case, for example, of a § 351 transfer of a § 987 QBU within a consolidated group. Similar policy concerns arise when the transfer of a partnership interest to a related person results in deemed transfers that cause the recognition of § 987 loss with respect to a § 987 QBU owned through the partnership.

(d) Treasury and the IRS acknowledge that part of the rationale for deferring § 987 losses, that is, the continuity of ownership of the § 987 QBU within the group, applies equally to § 987 gains that otherwise would be triggered when taxpayers transfer a § 987 QBU within a single controlled group.

(e) Thus, Temp. Treas. Reg. § 1.987-12T generally defers § 987 gains and losses resulting from certain termination events and partnership transactions in which the assets and liabilities of the § 987 QBU remain within a single control group (defined as all persons with the relationships to each other described in § 267(b) or 707(b)) and remain subject to § 987. Gains, however, will not

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be deferred to the extent the assets of the § 987 QBU are transferred by a U.S. person to a related foreign person.

(f) Treasury and the IRS also believe that selective recognition of losses should not be permitted in the context of certain outbound transfers even when the assets do not remain subject to § 987 in the hands of the transferee (because, for example, the transferee has the same functional currency as the QBU). Accordingly, the temporary regulations also provide special rules to prevent the selective recognition of § 987 losses in certain other transactions involving outbound transfers.

(g) The temporary regulations also apply to any foreign currency gain or loss realized under § 987(3) (transfers of property between QBUs of the taxpayer having different functional currencies), including foreign currency gain or loss realized under § 987 with respect to a QBU to which the final regulations generally are not applicable. To achieve this, the temporary regulations specify that references in Temp. Treas. Reg. § 1.987-12T to § 987 gain or loss refer to any foreign currency gain or loss realized under § 987(3) and that references to a § 987 QBU refer to any eligible QBU that is subject to § 987. The Temporary regulations also specify that references and Temp. Treas. Reg. § 1.987-12T to the recognition of § 987 gain or loss under Treas. Reg. § 1.987-5 encompass any determination and recognition of gain or loss under § 987(3) that would occur but for Temp. Treas. Reg. § 1.987-12T.

(h) These policy concerns regarding selective realization of § 987 losses do not apply, however, with respect to a § 987 QBU that has made the annual deemed-termination election described below because all § 987 gain or loss is recognized annually under that election. Accordingly, Temp. Treas. Reg. § 1.987-12T is not applicable to § 987 gain or loss of a § 987 QBU with respect to which the annual deemed-termination election is in effect.

(i) Finally, in order to avoid any compliance burdens associated with applying Temp. Treas. Reg. § 1.987-12T in situations involving relatively small amounts of § 987 gain or loss, the regulation includes a de minimis rule. The rule does not apply if an unrecognized § 987 gain or loss of the § 987 QBU that, as a result of Temp. Treas. Reg. § 1.987-12T, would not be recognized under Treas. Reg. § 1.987-5 does not exceed $5 million.

3. Deferral Events.

(a) Temp. Treas. Reg. § 1.987-12T provides that, notwithstanding Treas. Reg. § 1.987-5, the owner a § 987 QBU with respect to

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which a deferral events occurs (a deferral QBU) must defer § 987 gain or loss that otherwise would be taken into account under Treas. Reg. § 1.987-5 in connection with the deferral event to the extent determined under Temp. Treas. Reg. § 1.987-12T(b)(3) and (c). A deferral event with respect to a § 987 QBU means any transaction of series of transactions that satisfy two conditions.

(b) Under the first condition, the transaction or series of transactions must be described in one of two categories. The first category, which is set forth in Temp. Treas. Reg. § 1.987-12T(b)(2)(ii)(A), is any termination of a § 987 QBU other than

i. a termination described in Treas. Reg. § 1.987-8(b)(3) (that is, a termination that results from the owner of the § 987 QBU ceasing to be a controlled foreign corporation);

ii. a termination described in Treas. Reg. § 1.987-8(c) (a termination that results from a liquidation or asset reorganization involving an inbound or outbound transfer, a transfer by a controlled foreign corporation to a related non-controlled foreign corporation or a transfer to a transferee that has the same function or currency as a § 987 QBU); or

iii. a termination described solely in Treas. Reg. § 1.987-8(b)(1) (a termination that results solely from the cessation of the trade or business of the § 987 QBU).

(c) Thus, the first category generally involves terminations that occur as a result of a transfer of a substantially all the assets of a § 987 QBU other than a transfer as part of transaction described in § 381 in which the owner ceases to exist.

(d) The second category, which is described in Temp. Treas. Reg. § 1.987-12T(b)(ii)(B), encompasses certain partnership transactions that result in a net deemed transfer from a § 987 QBU to its owner as a result of which § 987 gain or loss would otherwise be recognized under Treas. Reg. § 1.987-5. The second category includes two types of transactions involving partnerships:

i. A disposition of part of an interest in a DE or partnership. Under Treas. Reg. § 1.987-2(c)(5), a transfer of part of an interest in a DE or § 987 aggregate partnership results in deemed transfers to the owner of a § 987 QBU held through that DE or partnership that may result in a remittance, but generally do not cause a termination.

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ii. A contribution of assets by a related person to a partnership or DE through which a § 987 QBU is held, provided that the contributed assets are not included on the books and records of an eligible QBU and the contribution causes a net transfer from a § 987 QBU owned through a partnership or DE.

(e) The rules of Treas. Reg. § 1.987-2 must be applied to determine whether the contribution in “(2)” immediately above would cause a net transfer from any § 987 QBUs held through a partnership. For example, if two partners (Partner A and Partner B) each own a 50% interest in an existing § 987 aggregate partnership with a single § 987 QBU, and Partner A contributes cash that is included on the books of the § 987 QBU after the contribution and Partner B contributes an equal amount of non-portfolio stock, the contributions would not cause either Partner A or Partner B to have a net transfer from the § 987 QBU under Treas. Reg. § 1.987-2 and there would be no § 987 gain or loss to defer.

(f) The second category includes transactions involving partnerships that are not § 987 aggregate partnerships even though QBUs that are held through those partnerships generally are not subject to the final regulations. Accordingly, Temp. Treas. Reg. § 1.987-12T applies to a disposition of a partnership interest or a contribution to a partnership if it otherwise would result in recognition of gain or loss under a taxpayer’s reasonable method of applying § 987.

(g) The second condition described in Temp. Treas. Reg. § 1.987-12T(b)(2) is that, immediately after the transaction or series of transactions, assets of the § 987 QBU are reflected on the books and records of a successor QBU. For this purpose, a successor QBU with respect to a § 987 QBU (original QBU) generally means a § 987 QBU on whose books and records assets of the original QBU are reflected immediately after the deferral event, provided that, immediately after the deferral event, the § 987 QBU is owned by a member of the controlled group that includes the person that owned the original QBU immediately before the deferral event. This relatedness requirement would not be met, for example, if the person that owned the original QBU ceased to exist in connection with the deferral event.

(h) However, if the owner of the original QBU is a U.S. person, then a successor QBU does not include a § 987 QBU owned by a foreign person, except in the case of a deferral event that is solely described in the second category of transactions involving partnerships and DE interests. This limitation on the definition of a successor QBU in the context of outbound transfers serves two

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purposes. First, consistent with the general policy of recognizing foreign currency gains in an outbound transfer, the limitation ensures the § 987 gain is recognized to the extent § 987 QBU assets are transferred outbound in connection with a termination. Second, the limitation coordinates the deferral event rules with the outbound loss event rules (described below).

(i) The temporary regulations provide that, in the taxable year of a deferral event, the owner of the deferral QBU generally recognizes § 987 gain or loss as determined under Treas. Reg. § 1.987-5, except that, solely for purposes of applying Treas. Reg. § 1.987-5, all assets and liabilities of the deferral QBU that, immediately after the deferral event are properly reflected on the balance sheet of a successor QBU are treated as not having been transferred and therefore as remaining on the balance sheet of the deferral QBU, notwithstanding the deferral event. The effect of these rules is that, in the tax year of a deferral event, only assets and liabilities of the deferral QBU that are not reflected on the books and records of a successor QBU immediately after the deferral event are taken into account in determining the amount of a remittance from the deferral QBU. Section 987 gain or loss that, as a result of these rules, is not recognized under Treas. Reg. § 1.987-5 in the taxable year of the deferral event is referred to as deferred § 987 gain or loss.

(j) Temp. Treas. Reg. § 1.987-2T provides rules for determining when a deferral QBU owner recognizes deferred § 987 gain or loss. A deferral QBU owner means, with respect to a deferral QBU, the owner of the deferral QBU immediately before the deferral event with respect to the deferral QBU or the owner’s qualified successor. A qualified successor with respect to a corporation (transferor corporation) is another corporation (acquiring corporation) that acquires the assets of the transferor corporation in a transaction described in § 381(a) but only if (1) the acquiring corporation is a domestic corporation and the transferor corporation was a domestic corporation or (2) the acquiring corporation is a controlled foreign corporation and the transferor corporation was a controlled foreign corporation.

(k) Deferred § 987 gain or loss is recognized upon subsequent remittance from the successor QBU, or upon a deemed remittance that occurs when a successor QBU ceases to be owned by a member of the deferral QBU owner’s controlled group, subject to an exception that applies when a successor QBU terminates in an outbound transfer. In general, these rules depend on the continued existence of the deferral QBU owner (which includes a qualified successor) and a successor QBU and preserve the location of the

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deferred § 987 gain or loss as gain or loss of the deferral QBU owner.

(l) In certain cases there may be multiple successor QBUs with respect to a single deferral QBU. For instance, there may be multiple successor QBUs if the owner of a § 987 aggregate partnership transfers part of its interest or if a successor QBU separates into two or more separated QBUs. To ensure that a deferral QBU owner recognizes the appropriate amount of deferral § 987 gain or loss in connection with a remittance in such cases, the temporary regulations provide that multiple successor QBUs of the same deferral QBU are treated as a single successor QBU for purposes of determining the amount of deferred § 987 gain or loss that is recognized.

(m) For example, if the owner (Corp A) of a § 987 aggregate partnership interest transfers part of its interest to another member of Corp A’s consolidated group (Corp B), the transfer would give rise to a deferral event with respect to the § 987 QBU (QBU A) that Corp A indirectly owns through the partnership. QBU A would be considered a deferral QBU, and Corp A would be considered a deferral QBU owner. In addition, QBU A would be considered a successor QBU with respect itself, and the § 987 QBU (QBU B) that Corp B owns indirectly through the partnership interest it acquired also would be considered a successor QBU with respect to QBU A. In determining the amount of deferred § 987 gain or loss recognized upon subsequent remittances from successor QBUs, the two successor QBUs are treated as a single successor QBU, such that their remittance proportion is determined under Treas. Reg. § 1.985-5 on a combined basis, taking into account the assets and remittances of both successor QBUs.

4. Outbound Loss Events.

(a) Temp. Treas. Reg. § 1.987-12T(d) contains rules that defer § 987 loss to the extent the assets of a § 987 QBU are transferred outbound to a related foreign person in connection with an “outbound loss event.” Specifically, the temporary regulations provide that, notwithstanding Treas. Reg. § 1.987-5, the owner of a § 987 QBU with respect to which an outbound loss event occurs (outbound loss QBU) includes in taxable income in the year of the outbound loss event § 987 loss with respect to that § 987 QBU only to the extent provided in Temp. Treas. Reg. § 1.987-12T(d)(3).

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(b) Similar to the definition of deferral event, an outbound loss event includes two categories of transactions with respect to a § 987 QBU with net unrecognized § 987 loss.

i. Any termination of the § 987 QBU in connection with the transfer of assets of the § 987 QBU by a U.S. person to a foreign person that was a member of the same controlled group as the U.S. transferor immediately before the transaction.

ii. Any transfer by a U.S. person of part of an interest in a § 987 aggregate partnership or DE through which the U.S. person owns the § 987 QBU to a related foreign person that has the same functional currency as the § 987 QBU.

(c) The second category also includes a contribution of assets by such a related person to the partnership or DE if the contribution has the effect of reducing the U.S. person’s interest in the § 987 QBU (and therefore causes a deemed transfer of assets and liabilities to the U.S. person from the § 987 QBU) and the contributed assets are not included on the books and records of an eligible QBU of the partnership or DE. The second category would be implicated, for example, if a U.S. person transferred part of its interest in a DE through which it owned a § 987 QBU to a foreign corporation that had the same functional currency as the § 987 QBU in an outbound § 351 transaction.

(d) Under these rules, the owner of the outbound loss QBU recognizes § 987 loss in the taxable year of the outbound loss event as described in Treas. Reg. § 1.987-5 and the deferral event rules of Temp. Treas. Reg. § 1.987-12T(b) and (c), except that, solely for purposes of applying Treas. Reg. § 1.987-5, certain assets and liabilities of the outbound loss QBU are treated as not having been transferred and therefore as remaining on the balance sheet of the § 987 QBU, notwithstanding the outbound loss event.

(e) In the first category of outbound loss event (involving outbound asset transfers resulting in termination), assets and liabilities that, immediately after the outbound loss event, are properly reflected on the books and records of the related foreign person or a § 987 QBU of the related foreign person are treated as not having been transferred.

(f) In the second category of outbound loss event (involving certain partnerships and DE transactions), assets and liabilities, that, immediately after the outbound loss event, are reflected on the books and records of the eligible QBU from which the assets and

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liabilities of the outbound loss QBU are treated as not having been transferred.

(g) Although an outbound loss event in the second category would also constitute a deferral event, the rules governing deferral events only defer § 987 loss of a deferral QBU to the extent assets and liabilities are reflected on the books and records of a successor QBU immediately after the deferral event. Assets and liabilities of a deferral QBU that are reflected on the books and records of an eligible QBU of a partnership and allocated to a partner that has the same functional currency as the eligible QBU, as would occur in an outbound loss event, are not reflected on the books and records of a successor QBU and so would not cause § 987 loss to be deferred under the deferral events rule.

5. Anti-Abuse Rule. The temporary regulations provide an anti-abuse rule to address transactions structured to avoid the deferral rules in Temp. Treas. Reg. § 1.987-12T. This rule provides that no § 987 loss is recognized under Treas. Reg. § 1.987-5 in connection with a transaction or series of transactions that are under taken with a principal purpose of avoiding the purposes of Temp. Treas. Reg. § 1.987-12T. This rule would apply, for example, if, with a principal purpose of recognizing a deferred § 987 loss, a taxpayer engaged in the transaction that caused the deferral QBU owner to cease to exist without a qualified successor or caused a successor QBU to cease to exist, such that deferred § 987 loss otherwise would be recognized under Temp. Treas. Reg. § 1.987-12T(c).

6. Fresh Start. A number of rules address Temp. Treas. Reg. § 1.987-12T in the context of a fresh start transition. Certain adjustments are necessary that we will not cover here.

7. Annual Deemed Termination Election.

(a) Treasury and the IRS have determined that an annual deemed termination election could enhance administrability of the final regulations by reducing the recordkeeping requirements necessary to apply the final regulations. Moreover, when an annual deemed termination election is in effect, taxpayers could not strategically time remittances in order to selectively recognize § 987 losses but not § 987 gains.

(b) Thus, Temp. Treas. Reg. § 1.987-8T(d) provides an election for a taxpayer to deem its § 987 QBUs to terminate on the last day of each taxable year for which the election is in effect. Because the considerations supporting an annual deemed termination election generally are relevant regardless of whether a taxpayer is subject to the final regulations, the election under Temp. Treas. Reg. § 1.987-

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8T(d) is available to any taxpayer without regard to applicability of the final regulations to that taxpayer or any of its § 987 QBUs.

(c) A § 987 QBU to which this rule applies is treated as having made a remittance of all of its gross assets to its owner immediately before the § 987 QBU terminates on the last day of each taxable year, resulting in the recognition of any net unrecognized § 987 gain or loss of the § 987 QBU. The owner is then treated as having transferred all the assets and liabilities of the terminated § 987 QBU to a new § 987 QBU on the first day of the following year.

(d) The taxpayer that finds the annual deemed termination election preferable to Temp. Treas. Reg. § 1.987-12T based on ease of compliance or other reasons may make the annual deemed termination election. The Temp. Treas. Reg. § 1.987-12T deferral provisions do not apply to taxpayers that have made the annual deemed termination election.

(e) Temp. Treas. Reg. § 1.987-1T(g)(2)(i)(B)(1) provides that the annual deemed termination election generally applies to all § 987 QBUs owned by an electing taxpayer, as well as to all § 987 QBUs owned by any person that has a relationship to the taxpayer described in § 267(b) or § 707(b). This is to prevent taxpayers from making the election only with respect to § 987 QBUs that have net unrecognized § 987 losses at the time of the election.

(f) A taxpayer that is subject to the final regulations and that must transition to the final regulations under the fresh start transition method of Treas. Reg. § 1.987-10(b) (fresh start taxpayer) may make the annual deemed termination election only if the first taxable year for which the election would apply is either (1) the first taxable year beginning on or after the transition date with respect to the taxpayer or (2) a subsequent taxable year in which the taxpayer’s controlled group aggregate § 987 loss, if any, does not exceed $5 million.

8. Election to Translate All Items at the Yearly Average Exchange Rate.

(a) The temporary regulations permit a taxpayer that is otherwise subject to the final regulations to elect to apply a hybrid approach with respect to a § 987 QBU that is subject to the annual deemed termination election. In particular, Temp. Treas. Reg. § 1.987-3T(d) provides that, notwithstanding the rules of Treas. Reg. § 1.987-3(c) for translating items determined under Treas. Reg. § 1.987-3(b) in a § 987 QBU’s functional currency into the owner’s functional currency, a taxpayer may elect to translate all items of income, gain, deduction and loss of a § 987 QBU with

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respect to which the annual deemed termination election described in Temp. Treas. Reg. § 1.987-8T(d) is in effect into the owner’s functional currency, if necessary, at the yearly average exchange rate for the taxable year.

(b) An owner of multiple § 987 QBUs may make this election, described in Temp. Treas. Reg. § 1.987-3T(d), with respect to all of its § 987 QBUs or only certain designated § 987 QBUs.

9. Section 988 Transactions of a § 987 QBU.

(a) The 2006 proposed regulations reflected a two-pronged approach to the application of § 988 to transactions of a § 987 QBU, with different consequences depending on whether a transaction is denominated in (or determined by reference to) the owner’s functional currency or a currency that is a nonfunctional currency with respect to both the owner and the § 987 QBU (third currency).

(b) Prop. Treas. Reg. § 1.987-3(e)(1) provided that § 988 applies to § 988 transactions attributable to a § 987 QBU and that timing of any gain or loss is determined under the appropriate provisions of the Code, but those regulations did not clearly specify whether § 988 gain or loss would be determined with respect to the functional currency of the § 987 QBU or the owner’s functional currency.

(c) Additionally, Prop. Treas. Reg. § 1.987-3(d) provided that an item of income, gain, deduction, or loss of a § 987 QBU denominated in a currency other than the functional currency of the owner is translated at the spot rate on the date the item is appropriately taken into account.

(d) The new temporary regulations clarify and elaborate on the application of § 988 to transactions attributable to a § 987 QBU. Treasury and the IRS have determined that computing § 988 gain or loss by reference to the functional currency of the § 987 QBU, rather than the owner’s functional currency, and translating that amount at the yearly average exchange rate would be inconsistent with the treatment of items that give rise to § 988 transactions as historic items.

(e) They believe that it is appropriate to continue to treat assets and liabilities giving rise to § 988 transactions of a § 987 QBU as historic items under the § 987 regulations. Thus, for example, a note denominated in a nonfunctional currency that gives rise to a § 988 transaction when acquired is a historic asset. The temporary regulations also provide that § 988 gain or loss arising from § 988

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transactions of a § 987 QBU is determined by reference to the owner’s functional currency, rather than the functional currency of the § 987 QBU. See Temp. Treas. Reg. § 1.987-3T(b)(4)(i).

(f) Accordingly, in determining § 988 gain or loss with respect to a § 988 transaction of a § 987 QBU, the amounts required under § 988 to be translated on the applicable booking date or payment with respect to that transaction are translated from the currency in which the amounts are denominated into the owner’s functional currency at the rate required under § 988 and the § 988 regulations, which provide for transaction at the appropriate spot rate.

(g) When a § 987 QBU recognizes gain or loss on the disposition of a historic asset that gives rise to a § 988 transaction, some or all of the total gain or loss that is realized on the disposition may be § 988 gain or loss that under § 988, is ordinary income that is source by reference to the residence of the § 987 QBU. For example, on the disposition of a nonfunctional currency note, the total gain or loss realized may be comprised of § 988 gain or loss that reflects exchange rate changes and other gain or loss that reflects other factors, such as changes in prevailing interest rates or in the credit worthiness of the note issuer.

(h) The total gain or loss on the disposition of a historic asset that gives rise to a § 988 transaction is determined under the general rules of § 987 by reference to the functional currency of the § 987 QBU. Section 988 gain or loss on the note is determined under Treas. Reg. §§ 1.988-2(b)(5) and (8) and Temp. Treas. Reg. § 1.987-3T(b)(4)(i) by comparing the § 987 QBU’s acquisition price with the note and the nonfunctional currency translated into the owner’s functional currency at the spot rates on the date of acquisition and the date of disposition, respectively. See Temp. Treas. Reg. § 1.987-3T(e), Example 11.

(i) Because assets and liabilities that give rise to § 988 transactions generally are historic items that have a spot rate as the historic rate under Temp. Treas. Reg. § 1.987-1T(c)(3)(i)(E), these assets and liabilities are translated at historic rates and do not give rise to § 987 gain or loss. Thus, when the general rules of § 988 transactions of a § 987 QBU apply, the owner will take into account foreign currency exposure with respect to a § 988 transaction of a § 987 QBU only to the extent of the owner’s economic exposure to fluctuations of its functional currency relative to the currency in which the § 988 transaction is denominated.

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(j) The temporary regulations confirm that certain transactions that are denominated in the owner’s functional currency are not subject to § 988. Specifically, Temp. Treas. Reg. § 1.987-3T(b)(4)(ii) provides that specified owner functional currency transactions, which are defined as transactions described in § 988(c)(1)(B)(i) or (ii) or § 988(c)(1)(C) that are denominated in the owner’s functional currency and not treated as § 988 transactions.

(k) Treasury and the IRS have also determined that allowing a taxpayer to mark-to-market foreign currency gain or loss with respect to qualified short-term § 988 transactions of a § 987 QBU will enhance administrability by aligning the timing for recognizing gain or loss with respect to these transactions with the financial accounting rules. Accordingly, a taxpayer may elect, on a QBU-by-QBU basis, under Temp. Treas. Reg. § 1.987-3T(b)(4)(iii)(C) to apply to foreign currency mark-to-market method of accounting to qualified short-term § 988 transactions.

(l) The temporary regulations also include a special rule for determining § 988 gain or loss with respect to qualified short-term § 988 transactions of a § 987 QBU that are accounted for under a mark-to-market method of accounting. Specifically, Temp. Treas. Reg. § 1.987-3T(b)(4)((iii)(A) provides that § 988 gain or loss with respect to qualified short-term § 988 transactions of a § 987 QBU, and certain related hedges, that are accounted for under a mark-to-market method of accounting under § 475, § 1256 or Temp. Treas. Reg. § 1.987-3T(b)(4)(iii)(C) is determined in, and by reference to, the functional currency of the § 987 QBU rather than the owner’s functional currency.

10. Application of § 987 to U.S. Dollar QBUs. A controlled foreign corporation that is the owner of a dollar QBU will recognize foreign currency gain or loss with respect to transactions of the dollar QBU that would be § 988 transactions if entered into directly by the owner. Specifically, Temp. Treas. Reg. § 1.987-1T(b)(6)(ii)(A) provides that the CFC owner of a dollar QBU will be subject to § 988 with respect to any item that is properly reflected on the books and records of the dollar QBU and that would give rise to a § 988 transaction if the items were acquired, accrued, or entered into directly by the owner of the dollar QBU.

11. Combinations and Separations of QBUs.

(a) Temp. Treas. Reg. § 1.987-2T(c)(9)(i) provides that the combination of two or more combining QBUs that have the same owner into a combined QBU does not give rise to a transfer of any combining QBU’s assets or liabilities to the owner. In addition, Temp. Treas. Reg. § 1.987-2T(c)(9)(i) provides that transactions

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between the combining QBUs occurring in the taxable year of the combination, which otherwise would give rise to transfers, do not result in a transfer of the combining QBU’s assets or liabilities to the owner.

(b) Similarly, Temp. Treas. Reg. § 1.987-2T(c)(9)(iii) provides that the separation of a separating QBU into two or more separated QBUs that have the same owner after the separation does not give rise to a transfer of any of the separating QBU’s assets or liabilities to the owner.

(c) The determination of net unrecognized § 987 gain or loss of combined QBUs and separate QBUs also is determined under the temporary regulations.

12. Translation of Foreign Taxes.

(a) Under the general rule of Treas. Reg. § 1.987-3(c)(1), the owner of a § 987 QBU uses the yearly average exchange rate to translate an item of income, gain, deduction or loss of a § 987 QBU into the owner’s functional currency. Alternatively, the owner of § 987 QBU may elect to use a spot rate for the day each item is taken into account.

(b) Under § 986(a)(1)(A), for purposes of determining the amount of its foreign tax credit, a taxpayer that takes foreign income taxes into account when accrued generally translates the amount of any foreign income taxes (and any adjustment thereto) into dollars using the average exchange rates for the taxable year to which the taxes relate. Sections 986(a)(1)(B) and (C) contain exceptions to this general rule, including for taxes that are not paid within two years of the close of the taxable year to which the taxes relate.

(c) Taking into account the translation rules of Treas. Reg. § 1.987-3(c) and § 986(a), a mismatch could arise between the owner functional currency value of income used to pay foreign income taxes and the owner functional currency of the foreign income taxes claimed as a credit. In the case of foreign income taxes deemed paid under § 902, § 78 generally prevents such a mismatch at the level of the domestic shareholder claiming the credit by requiring the domestic shareholder to include in income an amount equal to the taxes deemed paid. When a U.S. person claims a credit under § 901 that is not for taxes deemed paid under § 902 or 960, foreign income taxes and the income used to pay those taxes could be translated at different rates.

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(d) To address this potential mismatch, Notice 89-74, 1989-1 C.B. 739, provides that when a U.S. taxpayer with a foreign branch that has a functional currency other than a dollar claims a foreign tax credit with respect to a foreign tax, the taxpayer is required to translate a functional currency amount equal to the foreign taxes paid on the branch income using the exchange rate at the time of payment of the taxes.

(e) Consistent with Notice 89-74, Temp. Treas. Reg. § 1.987-3T(c)(2)(v) includes a special translation rule providing that income in the amount equal to the functional currency amount of the § 987 QBUs foreign income taxes claimed as a credit must be translated at the same rate used to translate the taxes. This translation rule applies to the owner of a § 987 QBU claiming a credit under § 901, other than income taxes deemed paid under § 902 or 960, that are properly reflected on the books of the § 987 QBU.

(f) Mechanically, this rule requires the owner to reduce the amount of § 987 taxable income or loss that would otherwise be determined under Treas. Reg. § 1.987-3 by an amount equal to the creditable tax amount, translated into U.S. dollars at the yearly average exchange rate for the taxable year in which the creditable tax is accrued, and then to increase the resulting amount by an amount equal to the creditable tax amount translated into U.S. dollars at the same exchange rate used to translate the creditable taxes into U.S. dollars under § 986(a).

13. A Partner’s Share of Assets and Liabilities.

(a) The final § 987 regulations apply an aggregate approach with respect to § 987 aggregate partnerships, which are defined in Treas. Reg. § 1.987-1(b)(5) as partnerships for which all the capital and profits interests are owned, directly or indirectly, by persons that are related within the meaning of §§ 267(b) or 707(b).

(b) The 2006 proposed regulations provided a rule for determining a partner’s share of the assets and liabilities of an eligible QBU that is owned indirectly through a § 987 aggregate partnership. Specifically, Prop. Treas. Reg. § 1.987-7(b) provided that a partner’s share of assets and liabilities reflected on the books and records of an eligible QBU owned through a § 987 aggregate partnership must be determined in a manner consistent with how the partners have agreed to share the economic benefits and burdens corresponding to partnership assets and liabilities, taking into account the rules and principles of Subchapter K.

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(c) Treasury and the IRS acknowledge the ambiguity in the 2006 proposed regulations regarding the manner in which assets and liabilities of a partnership are allocated to a partner’s indirectly owned § 987 QBU under the aggregate approach. Accordingly, the temporary regulations provide more specific rules for determining a partner’s share of the assets and liabilities reflected on the books and records of an eligible QBU owned indirectly through a § 987 aggregate partnership.

(d) Specifically, Temp. Treas. Reg. § 1.987-7T(b) provides that, in any taxable year, a partner’s share of each asset and liability of a § 987 aggregate partnership is proportional to the partner’s liquidation value percentage with respect to the aggregate partnership. A partner’s liquidation value percentage is defined as the ratio of the liquidation of the partner’s interest in the partnership to the aggregate liquidation value of all of the partners’ interests in the partnership.

(e) The liquidation value of a partner’s interest in a partnership is the amount of cash the partner would receive with respect to its interest if, immediately following the applicable determination date, the partnership sold all of its assets for cash equal to the fair market value of those assets (taking into account § 7701(g)), satisfied all of its liabilities (other than those described in Treas. Reg. § 1.754-7), paid an unrelated third party to assume all of its Treas. Reg. § 1.754-7 liabilities in a fully taxable transactions, and then liquidated.

(f) The determination date for determining a partner’s liquidation value is the date of the most recent event described in Treas. Reg. § 1.704-1(b)(2)(iv)(f)(5) or § 1.704-1(b)(2)(iv)(s)(i) (revaluation event), irrespective of whether the capital accounts of the partners are adjusted or if there has been no revaluation date, the date of the formation of the partnership.

14. Deferral of Certain § 988 Loss Realized by a Debtor.

(a) Section 267(a)(1) provides that no deductions allowed with respect to any loss from the sale or exchange of property, directly or indirectly between persons who have a relationship described in § 267(b). Section 267(f)(2) modifies the general rule of § 267(a)(1) in the case of a sale or exchange of property between corporations that are members of the same controlled group, generally providing that a loss realized upon such a sale or exchange is deferred until the property is transferred outside the group such that there will be recognition of loss under the consolidated return principles.

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(b) Section 267(f)(3)(C) provides that, to the extent provided in regulations, § 267(a)(1) does not apply to any loss sustained by a member of a controlled group on the repayment of a loan made to another member of the controlled group if the loss is payable or denominated in a foreign currency and attributable to a reduction in the value of that currency. Treas. Reg. § 1.267(f)-1(e) provides that § 267(a) generally does not apply to an exchange loss realized with respect to a loan of nonfunctional currency to another controlled group member if the transaction that causes the realization of the loss does not have as a significant purpose the avoidance of federal income tax.

(c) Treasury and the IRS believe that the policy considerations underlying § 267(f)(3)(C) with respect to creditors and loans to related persons also apply with respect to debtors on those loans and that there is no reason to distinguish between a creditor and a debtor with regard to the application of an anti-avoidance rule to the same transaction.

(d) Accordingly, Temp. Treas. Reg. § 1.988-2T(b)(16)(ii) provides that the exchange loss of a debtor with respect to a loan (original loan) from a person with whom the debtor has a relationship described in § 267(b) or § 707(b) is deferred if the transaction resulting in a realization of the loss has a principal purpose of avoiding federal income tax. The deferred loss will be recognized at the end of the term of the original loan.

15. Effective Date. The temporary § 987 regulations are generally effective regarding any deferral event or outbound loss event that occurs on or after January 6, 2017. If the event is undertaken with a principal purpose of recognizing a § 987 gain or loss (Notice 2017-07 says gain or loss; the regulation says loss), the effective date is December 7, 2016. Notice 2017-07 extends this to check-the-box elections after December 22, 2016 that are effective before December 7, 2016.

IX. OTHER DEVELOPMENTS.

A. Executive Order and Related Rules Regarding Regulations.

1. On January 30, 2017 President Trump issued an Executive Order regarding regulations that could have a significant impact on recently issued tax regulations. The EO provides that for every one new regulation issued, at least two prior regulations be identified for elimination. It also provides that for fiscal year 2017 (ending on Sept. 30) the total incremental cost of all new regulations, including repealed regulations, to be finalized this year will be no greater than zero. “Regulation” is defined

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broadly, and for tax purposes could include such guidance as IRS notices and revenue procedures in addition to Treasury Regulations.

2. The Congressional Review Act (“Act”) also permits regulations potentially dating back to 1996 to be invalidated by a (filibuster proof) majority of both houses of Congress and the President’s signature.

3. As discussed in the Wall Street Journal of January 26, 2017, the Act authorizes Congress to override all regulations issued within 60 legislative days of their issuance through an expedited review process. This goes back many calendar months. Moreover, the 60-legislative-day period does not begin until the promulgating agency submits a report to Congress regarding the subject regulation. To the extent this notification is not complied with, any regulations issued since the passage of the Act in 1996 are subject to Congressional invalidation. Once Congress overrides a rule, the agency cannot reissue it in “substantially the same form” unless specifically authorized to do so in future legislation.

4. In addition Code § 7805(e) provides that a temporary regulation expires (sunsets) within three years of issuance.

5. The potential tax impact of these cumulative rules is broad. For example, the § 385 regulations have received substantial criticism from the tax community and Republicans in Congress. They could be part of either a 2-for-1 trade or invalidated under the Act. The same could apply for recently issued regulations under §§ 987, 367(d), and 901(m).

6. Temporary regulations, such as the partnership regulations discussed above or the § 482 aggregation regulations issued in September 2015, could simply be permitted to sunset and therefore be invalided if not otherwise invalidated per the EO or the Act.

7. Time will tell what this means for Treasury and IRS regulations.

B. F Reorganizations.

1. The IRS published final regulations regarding F reorganizations. F reorganizations under § 368(a)(1)(F) involve a “mere change” in the identity, form, or place of organization of one corporation. F reorganizations can be wholly domestic, wholly foreign, or cross border.

2. The new regulations adopt regulations that were proposed in 2004. They also include rules on outbound F reorganizations (domestic transferor corporation and foreign acquiror corporation) by adopting, without substantive change, proposed regulations that were issued in 1990. These regulations, adopted as § 367 regulations, were previously in effect as temporary regulations.

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3. Based on prior caselaw, the 2004 proposed regulations would have imposed four requirements for a transaction to qualify as an F reorganization. First, all the stock of the resulting corporation, including stock issued before the transfer, would have had to be issued in respect of stock of the transferor corporation. Second, a change in the ownership of the corporation in the transaction would not have been allowed, except for a change that had no effect other than that of a redemption of less than all of the shares of the corporation. Third, the transferor corporation would have had to completely liquidate in the transaction, although it did not need to legally dissolve. Fourth, the resulting corporation would not have been allowed to hold any property or possess any tax attributes immediately before the transfer, other than a nominal amount of assets to facilitate its organization or to preserve its existence.

4. These requirements would have prevented a transaction that involves the introduction of a new shareholder or new equity capital into the corporation from qualifying as an F reorganization, with one exception: the proposed regulation would have allowed the resulting corporation to issue a nominal amount of stock not in respect of stock of the transferor corporation to facilitate the organization of the resulting corporation. This was intended to facilitate qualification of a transaction as an F reorganization in situations where, for example, the resulting corporation’s governing law requires two or more shareholders and the transferor corporation has only one shareholder.

5. The final regulations generally adopt the regulations proposed in 2004, but with certain changes. The preamble states that like the 2004 proposed regulations, the final regulations are based on the premise that it is appropriate to treat the resulting corporation in an F reorganization as the functional equivalent of the transferor corporation and to give its corporate enterprise roughly the same freedom of action as would be accorded a corporation that remains within its original corporate shell.

6. Under the final regulations, six requirements apply. Four of the six requirements are generally adopted from the 2004 proposed regulations. The fifth and sixth requirements address comments received with respect to the proposed regulations regarding “overlap transactions,” for example, transactions involving the transferor corporation’s transfer of its assets to a potential successor corporation other than the resulting corporation in a transaction that could also qualify for nonrecognition treatment under a different provision of the Code.

7. Under the fifth requirement, immediately after the F reorganization, no corporation other than a resulting corporation may hold property that was held by the transferor corporation immediately before the F reorganization if the other corporation would, as a result, succeed to and take into account the items of the transferor corporation described in § 381(c) (corporate

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attributes in a reorganization). The sixth requirement is that immediately after the F reorganization, the resulting corporation may not hold property acquired from a corporation other than a transferor corporation if the resulting corporation would, as a result, succeed to and take into account the items of the other corporation described in § 381(c).

8. F Reorganization “in a Bubble.”

(a) The 2004 proposed regulations also contained an independently important rule: an F reorganization may be a step, or series of steps, before, within, or after other transactions that effect more than a mere change, even if the resulting corporation has only a transitory existence following the mere change. In some cases, an F reorganization sets the stage for later transactions by alleviating non-tax impediments to a transfer of assets. In other cases, prior transactions may tailor the assets and shareholders of the transferor corporation before the commencement of the F reorganization.

(b) Treasury and the IRS concluded that step transaction principles generally should not apply to recharacterize the F reorganization in such a situation because F reorganizations involve only one corporation and do not resemble sales of assets. This view is consistent with an important previous ruling, Rev. Rul. 96-29, and is included in the final regulation.

(c) However, the preamble states that notwithstanding this rule, in a cross-border context, related events preceding or following an F reorganization may be related to the tax consequences under certain international provisions that apply to F reorganizations. For example, such events may be relevant for purposes of applying certain rules under § 7874 (inversions) and for purposes of determining whether stock of the resulting corporation should be treated as stock of a controlled foreign corporation for purposes of § 367(b). The preamble cites, for example, § 2.03(b)(iv), Example 2 in Notice 2014-52; and Rev. Rul. 83-23, 1983-1 C.B. 82. Notice 2014-52 is the controversial anti-inversion notice issued last fall.

(d) The final regulations also adopt a provision of the 2004 proposed regulations that the qualification of a reorganization as an F reorganization would not alter the treatment of other related transactions. For example, if an F reorganization is part of a plan that includes a subsequent merger involving the resulting corporation, the qualification of the F reorganization as such will not alter the tax consequences of the subsequent merger.

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9. Outbound F Reorganization.

(a) If a domestic corporation is the transferor corporation and the acquiring corporation is a foreign corporation in an F reorganization, then, under new Treas. Reg. § 1.367-1(e), the taxable year of the transferor corporation will end with the close of the date of the transfer and the taxable year of the acquiring corporation will end with the close of the date on which the transferor’s taxable would have ended but for the occurrence of the transfer. Treas. Reg. § 1.367-1(e) is retroactive to 1987.

(b) Further, under new Treas. Reg. § 367(a)-1(f), in every F reorganization where the transferor corporation is a domestic corporation and the acquiring corporation is a foreign corporation, there is considered to exist:

i. a transfer of assets by the transferor corporation to the acquiring corporation under § 361(a) in exchange for stock (or stock or securities) of the acquiring corporation and the assumption by the acquiring corporation of the transferor corporation’s liabilities;

ii. a distribution of stock (or stock or securities) of the acquiring corporation by the transferor corporation to the shareholders (or shareholders and security holders) of the transferor corporation; and

iii. an exchange by the transferor corporation’s shareholders (or shareholders and security holders) of their stock (or stock and securities) of the transferor corporation for stock (or stock and securities) of the acquiring corporation under § 354(a).

10. For purposes of this rule, it is immaterial that the applicable foreign or domestic law treats the acquiring corporation as a continuance of the transferor corporation. Treas. Reg. § 1.367(a)-1(f) is retroactive to 1985.

C. Domestic Disregarded Entities: New Reporting Rules.

1. Treasury and the IRS proposed regulations that would treat a domestic disregarded entity (“DRE”) wholly owned by a foreign person as a domestic corporation separate from its owner for the limited purposes of the reporting, record maintenance and associated compliance requirements that apply to 25% foreign-owned domestic corporations under § 6038A. The preamble states that these changes are intended to provide the IRS with improved access to information that it needs to satisfy its obligations under U.S. tax treaties, tax information exchange agreements and similar

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international agreements, as well to strengthen the enforcement of U.S. tax laws.

2. Some disregarded entities are not obligated to file a U.S. federal tax return or to obtain an employer identification number (“EIN”). The regulation’s preamble says that in the absence of a return filing obligation (and associated record maintenance requirements) or the identification of a responsible party as required in applying for an EIN, it is difficult for the U.S. to carry out the obligations it has undertaken in its tax treaties, tax information exchange agreements and similar international agreements.

3. Section 6001 provides that every person liable for any tax imposed by the Code, or for the collection thereof, shall keep records, render statements, make returns and comply with the rules and regulations as Treasury and the IRS may from time-to-time prescribe. In addition, whenever in the judgment of Treasury and the IRS it is necessary, they may require any person, by notice served on that person or by regulations, to make returns, render statements, or keep records as they deem sufficient to show whether or not that person is liable for tax.

4. The Code also requires many categories of persons to file returns, even if no tax is owed in a particular year. For example, all corporations organized in the U.S. must file annual income tax returns, which may include schedules requiring the identification of owners exceeding specified ownership thresholds. Moreover, foreign corporations engaged in a trade or business in the U.S. must file annual income tax returns.

5. The preamble states that all entities, including disregarded entities, must have an EIN to file a required return. An entity also must have an EIN in order to elect to change its classification. An entity that accepts its default classification and is not required to file a return need not obtain an EIN. Because a domestic single-member LLC is classified as a disregarded entity by default rather than by election and has no separate federal tax return filing requirements, there is typically no federal tax requirement for it to obtain an EIN.

6. Thus, as noted above, the proposed regulations would amend Treas. Reg. § 301.7701-2(c) (part of the check-the-box regulations) to treat a domestic disregarded entity that is wholly owned by one foreign person as a domestic corporation separate from its owner for the limited purposes of the reporting and record maintenance requirements under § 6038A.

7. Because the proposed regulations would treat the affected domestic entities as foreign-owned domestic corporations for the specific purposes of § 6038A, they would be reporting corporations within the meaning of § 6038A. Consequently, they would be required to file Form 5472 with

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respect to reportable transactions between the entity and its foreign owner or other foreign related parties.

8. To ensure that these entities report all transactions with foreign related parties, the proposed regulations specify as an additional reportable category of transaction for these purposes any transaction within the meaning of Treas. Reg. § 1.482-1(i)(7) (with these entities being treated as separate taxpayers for the purpose of identifying transactions and being subject to requirements under § 6038A) to the extent not already covered by another reportable category. The term “transaction” is defined in Treas. Reg. § 1.482-1(i)(7) to include any sale, assignment, lease, license, loan, advance, contribution, or other transaction of any interest in or a right to use any property or money, as well as the performance of any services for the benefit of, or on behalf of, another taxpayer.

9. For example, under the proposed regulations, contributions and distributions would be considered reportable transactions with respect to these entities.

10. The penalty provisions associated with failure to file Form 5472 and failure to maintain records would apply to these entities as well.

11. The regulations are proposed to be applicable for taxable years ending on or after the date that is 12 months after the date the regulations are published as final regulations.

D. Section 245.

1. ILM 201640018 involves a US-parented corporate structure in which Sub E owns Sub 1, which owns Sub 2, which owns Sub 3, which owns Sub 4. Sub 4 owns Sub 5 and Sub 6. All are U.S. corporations. Under a plan, Sub 4 and Sub 5 were redomiciled in Country U and Sub 6 became a RIC (regulated investment company).

2. The purpose of the plan was to increase the U.S. Group’s after-tax return on Business O investments by claiming an 80% dividends-received deduction (“DRD”) with respect to income attributable to certain interest and capital gain derived from the investments. The taxpayer calculated the post-transaction yield on the investments at 130% of the pre-transaction yield, with the increased yield due to a decrease in the taxpayer’s U.S. federal income tax liability. However, the revised structure would result in an improved after-tax yield only if a DRD were allowed. If a DRD were not allowed, the taxpayer’s after-tax return would decrease because of the costs associated with the restructuring.

3. Under the plan, Sub 6 RIC would not pay U.S. federal income tax. It would invest in Business O investments and make distributions to its sole shareholder, Sub 4, during Year Y. Thus Sub 6 RIC would not pay U.S.

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federal income tax on its interest or capital gain income because its income would be offset by a dividends-paid deduction under §§ 852(b)(2)(D) and 852(b)(3)(A).

4. Sub 4 would not pay U.S. federal income tax. It will be a foreign corporation. It would not be subject to federal income tax on the distributions that it received from Sub 6 RIC, and Sub 6 would not be required to withhold tax on its distributions to Sub 4 during Year Y. §§ 871(k) and 881(e).

5. Sub 3 would not pay U.S. federal income tax. Sub 3 would not have an inclusion under § 951(a)(1) with respect to Sub 4 as a result of the distributions from Sub 6 RIC. The Sub 6 RIC distributions received by Sub 4 would constitute Subpart F income. However, Sub 3 would dispose of its Sub 4 stock before the close of a Sub 4’s taxable year ending in Year Y and Sub 4 would remain a CFC after the disposition.

6. Sub 2 would pay, at most, a small amount of U.S. federal income tax. Sub 2 would have a Subpart F inclusion with respect to Sub 4 in Year Y because Sub 2 would hold all of the stock of Sub Y on the last day of Sub 4’s taxable year. However, Sub 2’s pro rata share of Sub 4’s Subpart F income would be reduced by the amount of Sub 4’s distribution to Sub 3 during Year Y.

7. Sub 3 would claim an 80% DRD. Sub 4 would distribute the amounts that it received from Sub 6 RIC to Sub 3 during Year Y before Sub 3 disposed of its Sub 4 stock. Sub 3 would include the distribution in income as a dividend, and treat the entire amount as a U.S.-source dividend for purposes of § 245. Thus, Sub 3 would offset the dividend income with an 80% DRD. §§ 245 and 861(a)(2)(B).

8. Sub 4 (a Country U corporation) would change its taxable year at the outset of the transaction so that its taxable year would differ from the U.S. Group’s taxable year.

9. On Date X in Year Y, Sub 6 RIC would distribute its Year X and Year Y income to Sub 4, and, in turn, Sub 4 would distribute the funds to Sub 3. Thus, by changing Sub 4’s taxable year to a year different from the U.S. Group’s taxable year, the US. Group would be able to defer including the income attributable to Sub 6 RIC’s Year X earnings in the U.S. Group’s income until Year Y.

10. The taxpayer asserted that its U.S. federal income tax position is consistent with the form of the transaction and the literal language of the Code. The taxpayer stated that its business purpose for the transaction was to maximize the return on its investments.

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11. Section 245 allows a corporation a DRD on dividends received from qualified foreign corporations. Section 316 generally defines the term “dividend” as any distribution of property made by a corporation to its shareholders out of earnings and profits. Treas. Reg. § 1.312-6(b) provides that income exempted from taxation by statute is included in E&P. Sub 4 increased its E&P by the amount of the distributions it received from Sub 6 RIC. The taxpayer asserted that Sub 4’s distributions to Sub 3 were dividends within the meaning of § 316 because the distributions were made out of E&P and that the dividends qualified for the § 245 DRD.

12. Section 245(a)(1) limits the amount of the § 245 deduction to an amount equal to the percent (specified in § 243) of the U.S. source portion of the dividends. The U.S. source portion of any dividend is an amount which bears the same ratio to the dividends as the post-1986 undistributed U.S. earnings bears to the total the post-1986 undistributed earnings.

13. During the years that the taxpayer engaged in the transaction, § 245 did not contain an explicit limitation that would have prevented distributions from a RIC from being taken into account in determining the “U.S.-Source Portion” of a dividend paid by a qualified 10-percent owned foreign corporation. Section 326 of the Protecting Americans from Tax Hikes Act of 2015 added § 245(a)(12) to the Code to provide that, with respect to dividends received on or after December 18, 2015, for purposes of the definition of post-1986 undistributed U.S. earnings in § 245(a)(5)(B), a domestic corporation does not include a RIC or a real estate investment trust. Accordingly, distributions from Sub 4 attributable to distributions from Sub 6 RIC explicitly would not be eligible for the § 245 DRD under the revised statute. The Joint Committee on Taxation stated that “no inference is intended with respect to the proper treatment under § 245 regarding dividends received from RICs or REITs before that date.”

14. Section 245(a)(5) limits the definition of “post-1986 undistributed earnings” to:

(a) income of the foreign corporation which is effectively connected with the conduct of a trade or business within the United States and is subject to tax under the Code, or

(b) any dividend received (directly or through a wholly-owned foreign corporation) from a domestic corporation at least 80% of the stock of which (by vote and value) is owned (directly through the wholly-owned foreign corporation) by the qualified 10-percent owned foreign corporation.

15. The funds that Sub 4 received from Sub 6 RIC are not “post-1986 undistributed U.S. earnings” within the meaning of § 245(a)(5)(A)

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because Sub 4 did not have income that was effectively connected with the conduct of a trade or business within the United States, and subject to U.S. federal income tax.

16. Pursuant to § 245(a)(5)(B), post-1986 undistributed U.S. earnings includes a dividend received from a domestic corporation. Section 854(a) states that a capital gain dividend received from a RIC shall not be considered a dividend for purposes of determining whether a shareholder is entitled to the DRD under § 243.

17. Section 854(b)(1) applies to distributions from a RIC other than those to which § 854(a) applies. It states that in computing any deduction under § 243, there shall be taken into account only the portion of the dividend reported by the RIC as eligible for the deduction in written statements furnished to its shareholders.

18. The shareholder of a RIC is only eligible for the § 243 DRD with respect to those distributions that are designated by the RIC as dividends eligible for such a deduction. The amount that a RIC designates for a taxable year generally cannot exceed the amount of dividends the RIC receives from domestic corporations that would be eligible for the DRD if RICs were permitted to claim the DRD. Sub 6 RIC generally held only debt instruments and its income therefore constituted interest income and capital gain rather than dividends.

19. Sub 6 RIC did not issue a statement to Sub 4 that qualified any of the Sub 6 RIC distributions as dividends eligible for a DRD. Accordingly, Sub 4 could not claim a § 243 DRD with respect to Sub 6 RIC’s distribution due to the application of §§ 854(a) and (b). If Sub 3 had directly held the Sub 6 RIC shares, it could not have claimed the § 243 DRD, either. Because Sub 3 would have been precluded from claiming a DRD under § 243 on direct distributions from Sub 6 RIC, the taxpayer inserted a foreign corporation between Sub 3 and Sub 6 RIC in order to claim a DRD under § 245 regarding dividends attributable to the Sub 6 RIC distributions. Section 854 does not discuss whether or not RIC distributions are taken into account in calculating the amount of dividends eligible for the DRD under § 245.

20. Although the Sub 6 RIC distributions to Sub 4 were not dividends eligible for the DRD under § 243, Sub 4 treated them as dividends received from a domestic corporation in calculating Sub 4’s post-1986 undistributed U.S. earnings for purposes of § 245(a)(5)(B). According to the taxpayer, even though a member of the U.S. Group would not have been eligible to claim a DRD with respect to the interest income and capital gains derived from the Business O investments if it had received it directly, and likewise would not have been eligible to claim a DRD if it had received distributions from Sub 6 RIC attributable to that income, distributions

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attributable to the income are dividends eligible for the 80% § 245 DRD if funneled through Sub 4.

21. In addition to the general principles of Treas. Reg. § 1.1502-13(a) of the consolidated return regulations, Treas. Reg. § 1.1502-13(h) provides that if a transaction is engaged in or structured with a principal purpose to avoid the purposes of Treas. Reg. § 1.1502-13 (including, for example, by avoiding treatment as an intercompany transaction), adjustments must be made to carry out the purposes of Treas. Reg. § 1.1502-13.

22. In the subject transaction, as in example 1 of Treas. Reg. § 1.1502-13(h), instead of carrying out a direct transaction, the consolidated group carried out a multiple-step plan that included an intercompany transaction in order to alter the group’s consolidated taxable income. In each case, the taxpayer used a combination of steps to get a tax result that distorted the intended results of the consolidated return regulations.

23. The legal memorandum then discussed a number of cases involving economic substance and concluded that the taxpayer failed to satisfy the objective prong of the economic substance test. Moving Sub 4 to Country U, funneling funds to Sub 4 as a Country U corporation, and moving Sub 4 stock from Sub 3 to Sub 2, did not give the taxpayer any reasonable expectation of economic profit over and above the profit it could expect if a member of the U.S. Group directly invested in Business O investments or invested in a RIC that invested in the Business O investments. The taxpayer took these steps to avoid the application of § 854, which prevents Sub 3 from offsetting its income attributable to Sub 6 RIC’s distributions with respect to the § 243 DRD and to avoid an inclusion under § 951 with respect to Sub 3.

24. The legal memorandum states that the Service also concluded, in the alternative, that the taxpayer failed to satisfy the objective prong of the economic substance test regarding its funneling of investment funds and its investment returns through a Country U corporation. The taxpayer did this to circumvent the application of § 854. Routing funds through Sub 4 did not give the taxpayer any reasonable expectation of economic profit over and above the profit it could expect if a member of the U.S. Group directly invested in Business O investments or invested in a RIC that invested in Business O investments.

25. The Service also held that the taxpayer failed to satisfy the business-purpose prong of the economic substance test. The taxpayer’s stated business purpose for the transaction was to invest in Business O investments so as to maintain safety and soundness. However, the taxpayer did not provide a plausible business purpose for moving Sub 4 to Country U, funneling funds through Sub 4 as a Country U corporation, and moving the Sub 4 stock from Sub 3 to Sub 2.

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26. Funneling the funds and investments through a Country U corporation also did not enhance the taxpayer’s profit potential on the Business O investments (other than through tax savings) and did not serve any other non-tax business purpose.

27. The legal memorandum also discussed the step-transaction doctrine, including utilizing a conduit analysis.

E. ETI.

1. DreamWorks Animation SKG, Inc. v. the United States, ___ Fed. Cl. ____ (Ct. Cl. 2016), involved the question as to whether DreamWorks was entitled to continue tax benefits under Section 101(d) of the American Jobs Creation Act of 2004 (“AJCA”) regarding extraterritorial income DreamWorks recognized in 2007, 2008 and 2009 from a licensing agreement that it entered into in 2006.

2. From the 1970s to the 2000s, Congress provided tax exemptions for domestic corporations like DreamWorks that sold products abroad. The tax exemptions were challenged before the World Trade Organization as protectionist. In 2004, the extraterritorial income tax exemption was repealed by the AJCA.

3. Congress included several provisions in AJCA regarding implementing the repeal of the extraterritorial income tax exemption. AJCA § 101(c), titled “Effective Date,” provided that the repeal would apply to “transactions after December 31, 2004.”

4. Congress also included a transition provision titled “Transition Rule for 2005 and 2006.” AJCA § 101(d) stated that “in the case of transactions during 2005 or 2006, the amount includable in gross income by reason of the amendments made by this section shall not exceed the applicable percentage of the amount which would have been so included but for this subsection.”

5. Finally, AJCA included a “grandfather” or “savings” provision in § 101(f) which stated that “the amendments made by this section shall not apply to any transaction … which occurs pursuant to a binding contract … which is in effect on September 17, 2003 and at all times thereafter.”

6. DreamWorks argued that the transition rule in § 101(d) applied to extraterritorial income generated from any transaction entered into during 2005 and 2006 regardless of when the income was recognized. Thus, DreamWorks argued that the extraterritorial income it recognized in 2007, 2008 and 2009 from a licensing agreement that it entered into in 2006 was covered by the transition rule.

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7. The government argued in its motion for summary judgment that the transition rule did not provide for the continued tax benefit DreamWorks sought. According to the government, the transition provision was intended to provide only for the orderly implementation of the repeal of the extraterritorial income tax exemption for a period of two years only and it was not intended to provide a long-term tax break. Put another way, the government argued that the transition rule was not intended to serve as a savings provision for extraterritorial income generated from transactions entered into in 2005 and 2006 and recognized in later years in order to protect taxpayers from AJCA’s repeal of the extraterritorial income tax exemption. Rather, the government asserted that the extraterritorial income benefits under the transition rule expired at the end of 2006. As such, the government argued that DreamWorks was not entitled to refunds based on extraterritorial income that it recognized in 2007, 2008, and 2009.

8. The Court held for the government, and rejected DreamWorks’ motion for summary judgment. The Court felt that the legislative history confirmed that the government was right.

F. Dividend Equivalent Regulations.

1. Treasury and the IRS issued final and temporary § 871(m) dividend-equivalent regulations that were published in the Federal Register on January 19, 2017.

2. They finalize previous temporary and proposed regulations that were issued on September 18, 2015. Notice 2016-42, 2016-29 IRB 67, provided guidance for complying with the final and temporary § 871(m) regulations in 2017 and 2018.

3. The new regulations were discussed in an excellent report by Emily Foster and Marie Sapirie in Tax Notes of February 6, 2017. As they report, the changes made in issuing the new regulations largely reflect industry comments and thus are generally helpful. However, they state that challenges persist.

4. They quote Mark Leeds of Mayer Brown, for example, as stating “what the IRS has done here appears to be so far beyond the congressional mandate that they have created a nightmare of a regulatory regime to capture very little revenue and [that] could have a deleterious effect on U.S. capital markets.”

5. The final regulations retain the delta threshold of 0.8 for simple contracts to determine whether a transaction is a specified NPC or a specified equity-linked instrument is subject to withholding.

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6. Per Notice 2016-42, the final regulations provide a phased-in transition, with the § 871(m) rules applying to Delta one transactions in 2017 and to all other transactions beginning in 2018.

7. For additional details and discussion about these new regulations (with the preamble, the typed regulations package is 87 pages in length), we refer the reader to Foster’s and Sapirie’s excellent report.

X. TREATIES.

A. Competent Authority Statistics.

1. The IRS released its annual competent authority statistics for 2015. Part 1 presents statistics concerning cases involving the allocation and attribution of business profits, and Part 2 presents statistics under all other treaty articles.

2. During 2015, 193 APMA allocation cases were resolved, an unusually high number. Foreign-initiated cases (171) accounted for nearly 90% of the total, a skewing significantly higher than in the two previous years.

3. Excluding the 5 cases that were withdrawn by the taxpayer, 97% of the remaining 188 APMA cases resulted in full relief. Only 3 cases were resolved with less than full relief, and only 3 resulted in no relief.

4. Of the 171 foreign-initiated APMA cases, the taxpayer withdrew its case in 4, there was no relief in 2, and partial relief in 3. In each of the other 162 cases, full relief resulted. In 25, the foreign country withdrew the adjustment.

5. Of the 22 U.S.-initiated APMA cases, the taxpayer withdrew its case in 1, there was no relief in 1, and in each of the other 20, full relief resulted. In 9, IRS Exam withdrew its adjustment.

6. Processing time for APMA cases increased over previous three years to 27.7 months for U.S.-initiated adjustments and 32.7 months for foreign-initiated adjustments.

B. Starr International: Treaty Issue – Part I8

1. A federal district court held in Starr International Co. v. United States, ___ F. Supp. 2d ____ (D.D.C. 2015), that the IRS’s decision to deny discretionary treaty benefits in the form of a lower dividend withholding tax rate was judicially reviewable, finding that the decision is not committed exclusively to the agency’s discretion. This is an important case of first impression.

8 After reading the facts, the reader should fast forward to Starr – Part II.

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2. Starr transferred its insurance business to AIG in the 1970s and became the largest holder of AIG common shares. At that time Maurice Greenberg was the chairman of the board of both companies, and AIG’s CEO. For the next several decades, Starr funded discretionary compensation plans for AIG executives. In 2004, Starr moved its headquarters from Bermuda to Ireland and began to take advantage of the U.S.-Ireland tax treaty, which reduced Starr’s U.S. withholding tax rate on AIG dividends to 15%.

3. The next year, amidst an investigation by New York’s Attorney General, Greenberg stepped down as CEO of AIG, and Starr ceased funding AIG’s executive compensation plan. Starr relocated its headquarters to Switzerland, allegedly to protect its assets from an AIG lawsuit claiming that Starr was contractually obligated to continuing funding the plan. In fact, a lawsuit did arise with AIG unsuccessfully claiming ownership of the AIG shares held by Starr. 648 F. Supp. 2d 546 (S.D.N.Y. 2009).

4. Under the U.S.–Swiss treaty, a Swiss company receiving dividends from a U.S. company is automatically entitled to halve its withholdings under certain enumerated circumstances, such as when the Swiss company does significant business in Switzerland or is listed on a recognized stock exchange. This is the treaty’s Limitation on Benefits article. If a company is not automatically entitled to those benefits under the treaty it “may, nevertheless, be granted the benefits of the Convention if the competent authority of the State in which the income arises so determines after consultation with the competent authority of the other Contracting State.”

5. In 2007, Starr requested benefits under this discretionary relief provision by a letter to the U.S. competent authority. In doing so, Starr acknowledged that it was not entitled to treaty benefits under any of the enumerated, mandatory categories. In March 2010, not having received a response to its letter but wishing to preserve its right to a refund, Starr sent a 2007 tax return form to the IRS contending that it had overpaid $38 million in taxes. In October 2010, the U.S. competent authority denied Starr’s request to apply the treaty to reduce Starr’s 2007 withholding tax. Curiously, Starr was later issued a treaty-based refund for its 2008 withholding taxes.

6. Starr filed in court in September 2014, claiming the IRS had erroneously denied its request for benefits under the treaty. Starr contends that the IRS abused its discretion because (1) Starr was not treaty shopping when it relocated to Switzerland, (2) the IRS failed to consult with the Swiss competent authority for denying Starr’s request, and (3) the IRS had no legal basis for issuing Starr a 2008 refund while denying its 2007 refund based on the same material facts.

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7. The IRS has raised two main defenses to Starr’s claims: that the U.S. competent authority’s decision is committed to agency discretion by law and, alternatively, that the court lacks jurisdiction under the political-question doctrine.

8. Analysis.

(a) Before deciding whether the committed-to-agency-discretion exception to judicial review barred the court from hearing Starr’s claim, the court said it needed to decide whether the exception even applied. Starr brought its case under provisions of the United States Code and not the Administrative Procedure Act (“APA”). The question was whether the committed-to-agency-discretion exception is limited to suits brought under the APA.

(b) The committed-to-agency-discretion exception is linked closely to language in the APA, which states that agency action is generally reviewable “except to the extent that…it is committed to agency discretion by law.” The IRS cited this provision of the APA claiming that denials of the tax benefits in issue are “committed to agency discretion by law.”

(c) The court held that the exception is not limited to suits brought under the APA and that the IRS may thus attempt to invoke. The APA does explicitly carve out an exception to judicial review for action that is committed to agency discretion by law. Under these principles, “A matter committed to agency discretion is not reviewable because courts lack judicially manageable standards by which to evaluate it.”

(d) Other courts have considered the committed-to-agency-discretion exception in the context of tax disputes not brought under the APA. Specifically, courts have applied this exception – and found judicial review unavailable – in interest-abatement suits, in which taxpayers sought reductions in interest on late taxes by arguing that the IRS caused any delays.

(e) Starr cited Tax Analysts & Advocates v. Shultz, 376 F. Supp. 889 (D.D.C. 1974), in arguing that an IRS decision to deny tax-treaty benefits is judicially reviewable. There an interest group challenged an IRS revenue ruling related to gift-tax treatment of contributions to political organizations, and the IRS claimed that its ruling was committed to the sole discretion of the agency unless challenged in a refund suit. Acknowledging that the committed-to-agency-discretion exception is a very narrow exception, the court rejected the IRS’s defense because it cited no law which commits IRS action to IRS discretion.

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(f) Tax Analysts thus held that the committed-to-agency-discretion exception to judicial review does not categorically apply to all IRS decisions, but it did not foreclose the possibility that the exception could apply to some IRS decisions.

(g) Having found that the committed-to-agency-discretion exception to judicial review may be invoked in tax-refund suits, the court next addressed whether the treaty at issue precludes judicial review. Absent an express statutory prohibition on judicial review, courts have been extremely hesitant to find such a bar. The mere fact that a statute grants broad discretion to an agency does not render the agency’s decision completely non-reviewable under the committed-to-agency-discretion exception unless the statutory scheme, taken together with other relevant materials, provides absolutely no guidance on how that discretion is to be exercised.

(h) Having found that the discretionary provision of the treaty is not categorically non-justiciable, the court turned to its “language, structure and history.” The court stated that the treaty text alone left entirely open what the competent authority may consider when she “so determines” whether to grant or deny the benefits. Such broadly permissive language may indicate an intent to render agency action unreviewable.

(i) Many statutes, however, afford agencies significant autonomy while remaining subject to judicial review. Permissive language alone may not be enough to demonstrate that a decision has been committed to agency discretion. Without such clear and convincing evidence, the general presumption favoring judicial review of administrative action is controlling.

(j) Neither Starr nor the IRS considered the discretion a provision in a vacuum: both looked to the Treasury Department’s Technical Explanation of the treaty. The court said that technical explanations serve as an analog to legislative history for treaty ratification, and courts consult these explanations when construing treaty language.

(k) Here, the Technical Explanation provided that the

“[discretionary] provision is included in recognition of the fact that, with the increasing scope and diversity of international economic relations, there may be cases where significant participation by the third country residents in an enterprise of a Contracting State is warranted by sound business practice or long-standing business structures and does not necessarily indicate a motive of attempting to derive unintended Convention benefits.”

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(l) In other words, stated the court, the treaty is designed to ensure that legitimate Swiss and U.S. businesses do not pay full taxes in both countries, while also preventing companies from “treaty shopping” by changing their citizenship purely to obtain preferential tax treatment. The Technical Explanation thus clarifies, to a large degree, the applicable legal standard when the Treasury evaluates a claim for benefits under the discretionary provisions. The Technical Explanation, which was transmitted to the Senate before it consented to the treaty, thus put the Senate on notice of how the IRS would endeavor to exercise its authority under the discretionary provision.

(m) So, too, the testimony offered to the Senate Foreign Relations Committee by the Treasury Department’s Deputy Assistant Secretary for International Tax Affairs. He said that, when implementing the discretionary provision, the IRS would seek to determine whether entities “can establish a substantial non-treaty-shopping motive for establishing themselves in their country of residence.

(n) Moreover, the IRS effectively acknowledged in its formal letter denying Starr’s refund for the 2007 tax year that it relies on the standard described in the Technical Explanation to make determinations under the discretionary provision.

(o) Although the treaty does not expressly preclude judicial review, the discretionary provision may still be nonjusticiable if any standards the court might apply are so broad and vague that judicial review would be “conceptually equivalent to … no review at all.” While the discretionary provision says that the competent authority “may” grant benefits if she “so determines,” the Technical Explanation elaborates that she “will base a determination … on whether the establishment, acquisition or maintenance of the person seeking benefits under the Convention, or the conduct of such person’s operations, has or had one of its principal purposes the obtaining the benefits under the Convention.”

(p) The court stated that courts routinely face somewhat amorphous and open-ended standards. The D.C. Circuit has held the phrase “in the interest of justice” provides sufficient guidance to allow at least some minimal judicial review.

(q) Put simply, the committed-to-agency-discretion exception to judicial review is extremely narrow where, as here, no presumption of unreviewability applies. The Technical Explanation provides meaningful standards that would enable the court to determine

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whether the IRS abused its discretion in denying treaty benefits. Because this inquiry is not directionless, the court held that denials of tax benefits under the discretionary provision are not committed to the IRS’s unreviewable discretion.

(r) The IRS also argued that the court may not review the U.S. competent authority’s decision to deny Starr benefits under the treaty because to do so would run afoul of the political-question doctrine. That doctrine, like the committed-to-agency-discretion principle, is a “narrow exception” to the federal courts’ duty to decide cases properly before them.

(s) The Supreme Court recently explained that a political question exists where there is “a textually demonstrable constitutional commitment of the issue to a coordinate political department; or a lack of judicially discoverable and manageable standards for resolving it.’” The court stated that it had already determined that the discretionary provision—read in conjunction with the Technical Explanation—provided a sufficiently manageable standard for judicial review. That being so, the propriety of denying Starr’s request for benefits under the treaty is also not committed to the Executive Branch’s unfettered discretion.

(t) The IRS argued that judicial review under the discretionary provision’s consultation requirement would impinge on the Executive Branch’s allegedly exclusive authority to “formulate and implement foreign policy.” The court said that requirement is not presently implicated, because the treaty does not condition the denial of treaty benefits on prior consultation with Swiss officials. The relevant treaty official needs “consult with the competent authority of the other contracting state” only when a claimant would be “granted the benefits of the convention.”

(u) The decision to award or deny tax-treaty benefits does not require a policy determinations or diplomatic value judgments. Assessing litigants’ entitlement to relief under federal law is, rather, “a familiar judicial exercise.”

(v) The case will next proceed to a determination as to whether the U.S. competent authority abused its discretion in denying Starr the requested relief.

C. Starr International – Part II

1. In Starr International – Part II, the government asked the court to reconsider its prior ruling. The government contended that the court misapprehended a key aspect of the treaty provision at issue: the

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requirement that the IRS “consult” with its Swiss counterparts prior to any final decision to grant treaty benefits. The government argued that separate-of-powers principles prevent the court from forcing the IRS to consult with the Swiss authorities or dictating the outcome of any consultation because doing so would impinge on the Executive’s authority to conduct foreign relations.

2. The court agreed to revisit certain aspects of its prior ruling. The court’s earlier decision focused primarily on whether the treaty and surrounding materials supplied a manageable standard for assessing whether Starr met certain criteria required to obtain treaty benefits. The court reaffirmed its holding that such a standard exists and that, therefore, the IRS’s determination that Starr did not meet the applicable criteria is subject to judicial review. The court also stood by its ruling that interpreting the terms of the treaty in a manner necessary to determine whether Starr met the applicable criteria would not offend the political-question doctrine. ____ F. Supp. ____ (D.D.C. 2016).

3. The court previously found that the “consultation” requirement was not presently implicated because consultation is required only before a decision to grant treaty benefits whereas here the IRS denied benefits to Starr.

4. With the benefit of additional briefing and argument on what treaty consultation typically entails, however, the court nonetheless concluded that justice required it to revise its finding. The court said it was not particularly swayed by the government’s argument that the court cannot force the IRS to consult with its Swiss counterparts. The government had never represented that the IRS would refuse to consult were the court to determine that it abused its discretion in denying Starr treaty benefits. As government counsel acknowledged at oral argument “That is not going to happen.” Thus, the court stated that its power in that regard was beside the point.

5. The court said that more persuasive was the government’s contention that the court lacked the power to dictate the outcome of the consultation process. As the court now understood it, treaty consultation is a diplomatic exchange that can affect the ultimate outcome of a decision whether to award benefits, and the extent of those benefits, in numerous ways. As such, it would impinge upon the Executive’s prerogative to engage in that process if the court were to render consultation meaningless or dictate its outcome. The court stated that ordering the IRS to issue Starr a specific monetary refund would do precisely that.

6. Starr was not left without a potential remedy, however. Anticipating that it might reach today’s result, the court sought supplemental briefing on whether Starr could pursue a claim to set aside the IRS’s decision to deny

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treaty benefits under the judicial-review provision of the Administrative Procedure Act (“APA”). The court then held that Starr may bring such a claim. Accordingly, the court granted in part the government’s motion for reconsideration; vacated its order granting Starr’s motion to strike the government’s defenses and denying the government’s motion to dismiss the complaint; and dismissed Starr’s complaint without prejudice.

7. Although the court found that Starr may not pursue monetary relief, it stated that it would allow Starr to amend its complaint to seek to have the IRS’s decision set aside under the APA. In the interests of efficiency, the court also granted in part the government’s motion for a scheduling order on its counterclaim against Starr, which alleges that the IRS erroneously issued a refund for the 2008 tax year on the basis of an improperly submitted return.

D. New U.S. Model treaty.

1. On February 17, 2016, Treasury released its revised 2016 Model Income Tax Treaty, which is the baseline text Treasury will use when it negotiates future tax treaties. The U.S. model income tax convention was last updated in 2006. A draft version of these new model treaty provisions was released for public comment in May 2015. As a result of comments, Treasury made a number of significant revisions to the proposed model treaty provisions.

2. Special Tax Regimes.

(a) Treasury received several comments on the proposed rules that would deny reductions in withholding taxes under a treaty for deductible related-party payments when the beneficial owner of the payment pays little or no tax on the related income as a result of a “special tax regime” (“STR”).

(b) Some countries have implemented preferential regimes to attract highly mobile income by allowing resident companies to pay no or very little tax on their net income. Consistent with the BEPS initiative, the STR provisions are intended to mitigate instances of double non-taxation in which a taxpayer uses provisions in a tax treaty, combined with STRs, to pay no or very low tax in either treaty country. The preamble to the model treaty states that the new STR provisions also reflect the U.S.’s preference for addressing BEPS concerns through changes to objective rules that apply on a prospective basis, rather than introducing subjective standards that could call into question agreed treaty benefits or applying wholly new concepts to prior years.

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(c) Comments on the May 2015 Draft expressed concern that the proposed definition of STR was too broad and would result in uncertainty as to when treaty benefits would be denied. In response to these comments the STR provisions have been significantly revised to both limit and clarify their application:

The scope of when the STR provisions can apply has been narrowed to cases in which the resident benefits from an STR with respect to a particular related-party interest payment, royalty payment, or guarantee fee that is within the scope of Article 21 (Other Income).

The definition of STR has been tightened to provide an exclusive list of the circumstances in which a statute, regulation, or administrative practice will be treated as an STR. The regime must provide preferential treatment to interest, royalties, or guarantee fees as compared to income from sales of goods or services.

This preferential treatment must be in the form of either a preferential rate for the income, a permanent reduction in the tax base with respect to the income (as opposed to preferences that merely defer the taxation of income for a reasonable period of time), or a preferential regime for companies that do not engage in an active business in the residence state.

Regimes that provide “notional interest deductions” (“NIDs”) with respect to equity are no longer treated as STRs. Instead, Article 11 (Interest) includes a new rule that would allow a treaty partner to tax interest in that country in accordance with the domestic law if the interest is beneficially owned by a related person that benefits from an NID.

A country seeking to invoke the STR provisions must consult with the other country first and then notify the other country of its intention through a diplomatic note and issue a written public notification.

In response to comments on how to determine when a payee that benefits from an STR is “related to the payor” of an item of income, the 2016 Model provides that the STR provisions will only apply when the payee is a “connected person” with respect to the payor of the income and provides a definition of that term.

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The exceptions from the STR provisions for collective investment vehicles such as U.S. regulated investment companies and U.S. real estate investment trusts that are designed to achieve a single level of current tax (at either the entity level or the shareholder level) were clarified.

The 2016 Model provides an exception for preferential regimes that are generally expected to result in a rate reduction that is at least 15%, or 60% of the general statutory rate of company tax in the source country, whichever is lower. The model treaty also provides language that would be included in an instrument reflecting an agreed interpretation between the two treaty countries.

3. Payments by Expatriated Entities.

(a) The 2016 Model Treaty contains provisions that would reduce the benefits of corporate inversions by denying treaty benefits for U.S. withholding taxes on U.S. source dividends, interest, royalties and certain guarantee fees paid by U.S. companies that are “expatriated entities,” as defined under the Internal Revenue Code.

(b) In response to comments, Treasury made several revisions to the proposed version of these provisions. First, the 2016 Model provisions will apply only when the beneficial owner of a dividend, interest payment, royalty, or guarantee fee characterized as other income is a connected person with respect to the expatriated entity.

(c) Second to provide certainty about the scope of the rule notwithstanding any future changes to U.S. law, the model treaty fixes the definition of “expatriated entity” to the meaning it has under § 7874(a)(2)(A) as of the date the bilateral treaty is signed.

(d) Third, the 2016 Model provides that, under certain circumstances, pre-existing U.S. subsidiaries of the foreign acquiror will not be considered expatriated entities for purposes of the treaty.

4. Revised Limitation on Benefits (“LOB”) Article.

(a) The 2015 Draft included a number of proposed changes to Article 22 dealing with the LOB provisions. The 2016 Model contains significant revisions to the proposed changes in response to comments.

(b) LOB rules are designed to prevent “treaty shopping.” While protecting the U.S. treaty network from abuse is the overarching objective of Article 22, Treasury also recognizes that

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multinationals often have operations disbursed in many subsidiaries around the globe. Accordingly, the 2015 Draft proposed to include for the first time in the U.S. model a “derivative benefits” test as an additional method of satisfying the LOB provisions. The 2016 Model retains a version of this test that was modified in response to comments and adds a second new test, a “headquarters company” test. In addition, a number of the pre-existing LOB provisions were tightened to prevent abuse by third-country residents.

i. Active-Trade-or-Business Test

(a) The May 2015 Draft proposed a new limitation on the ability of connected entities to aggregate their activities for purposes of satisfying the LOB test regarding income that is derived by a company in connection with the active conduct of a trade or business in its country of residence (the active-trade-or-business test).

(b) The change to the active-trade-or-business test in the Draft was motivated by a concern that the existing active-trade-or-business test can, in certain circumstances, allow third-country residents to treaty shop through an entity that has an active trade or business in a treaty country with respect to income, in particular intra-group dividends and interest, that does not in fact have a nexus to the activities of the treaty partner.

(c) After further consideration, Treasury determined that the treaty-shopping concern is not driven by the division of activities among connected persons. Rather, states the preamble, the concern arises from the standard applied to determine whether income is “derived in connection with” an active trade or business in the residence country.

(d) To more directly address this concern, the active-trade-or-business test of the 2016 Model requires a factual connection between an active trade or business in the residence country and the item of income for which the benefits are sought. Specifically, the 2016 Model requires that the treaty-benefitted income “emanates from, or is incidental to,” a trade or business that is actively conducted by the resident in the residence state.

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(e) The technical explanation of the 2016 Model, which Treasury plans to release this spring, will provide guidance on when an item of income, in particular an intra-group dividend or interest payment, is considered to emanate from the active conduct of a trade or business of a resident. Treasury is considering an example that involves dividends and interest paid by a commodity-supplying subsidiary that was acquired by a company whose business in the residence state depends on a reliable source for the commodity supplied by the subsidiary. The dividends and interest would be considered to emanate from the active trade or business of the parent. The preamble states that another possible example could involve dividends and interest paid by a subsidiary that distributes products that were manufactured by the parent country in its state of residence. In contrast, the mere fact that two companies are in similar lines of business would not be sufficient to establish that dividends or interest paid between them are related to the active conduct of a trade or business.

(f) Treasury invited comments regarding additional examples for potential inclusion in the technical explanation that would illustrate dividend or interest income that should be considered to emanate from an active trade or business in the residence state.

ii. Derivative Benefits

(a) The 2016 Model allows companies to qualify for treaty benefits under a “derivative benefits” test, which is based on a broader concept of the longstanding “ownership-and-base erosion” test. While a form of derivative benefits is included in most U.S. treaties with countries in the European Union, those treaties limit third-party ownership to seven or fewer “equivalent beneficiaries,” which generally must be resident in a member country of the European Union or the North America Free Trade Area.

(b) In contrast, the derivative benefits rule in the 2016 Model contains no geographic restriction, instead requiring only that 95% of the tested company’s

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shares be owned directly, or indirectly, by seven or fewer persons that are equivalent beneficiaries.

(c) In response to comments received on the 2015 Draft, the 2016 Model allows certain categories of qualified persons in the state of source to be treated as equivalent beneficiaries provided that these persons in the aggregate do not own more than 25% of the tested company.

(d) The treaty would restrict intermediate ownership to companies resident in the same state as the company seeking benefits or in a country that has a comprehensive income tax treaty in force with the source country that contains rules addressing STRs and NIDs that are analogous to the rules in the 2016 Model Treaty.

(e) Derivative benefits provisions in existing U.S. treaties require, in order to qualify as an equivalent beneficiary with respect to income referred to in Article 10 (Dividends), 11 (Interest), or 12 (Royalties), that the third-country resident must be entitled, either under a comprehensive convention for the avoidance of double taxation between its country of residence and the source country or otherwise, to a rate of tax with respect to the particular category of income that is less than or equal to the rate applicable under the tax treaty pursuant to which benefits are being claimed.

(f) Companies that fail to satisfy this rate comparison test today are not entitled to treaty benefits, and therefore are generally subject to a 30-percent gross basis withholding tax on U.S. source payments of dividends, interest (other than interest of a portfolio nature), and royalties. Treasury received comments suggesting the elimination of this so-called “cliff effect.” In response to these comments, the 2016 Model removes the cliff effect, and instead entitles a resident of the treaty partner to the highest rate of withholding to which its third-country resident owners would be entitled.

(g) Under existing treaties that include a derivative benefits test, subsidiaries of private companies are unable to qualify for benefits regarding dividends

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under the derivative benefits test because individual shareholders are only entitled to a 15% rate on dividends, and therefore the cliff effect described above would preclude any reduction in dividend withholding.

(h) The 2016 Model allows certain companies relying on derivative benefits to qualify for the 5% rate of withholding on dividends even if the company’s shareholders are individuals who would not be entitled to the 5% rate. To achieve this, the definition of equivalent beneficiary in the 2016 Model has been modified to allow individual shareholders to be treated as companies for purposes of the rate comparison test with respect to dividends, provided that the company seeking to qualify under the derivative benefits has sufficient substance in its residence country to indicate that the individual shareholders are not simply routing income through a corporate entity in order to benefit from the lower company rate.

iii. Headquarters Companies

(a) Comments on the 2015 Draft requested that the LOB article include a rule that would entitle companies to claim treaty benefits in situations in which they serve as the active headquarters company of a multinational corporate group. In response, the 2016 Model treaty LOB provision includes a headquarters-company rule that is based on analogous tests found in some existing U.S. tax treaties, but with important modifications.

(b) Most significantly, the 2016 Model requires the headquarters company to exercise primary management and control functions (and not just supervision and administration) in its residence country regarding itself and its geographically diverse subsidiaries. The new provision also differs from existing headquarters company provisions by including a base erosion test.

(c) Furthermore, a headquarters company is only entitled to benefits regarding dividends and interest paid by members of its multinational corporate group. In the case of interest, the benefit is limited

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to a 10% cap on withholding in the source state, which is consistent with the general rate of withholding on interest that is permitted under the OECD’s model income tax convention.

(d) The new headquarters company test is analogous to the active-trade-or-business test, which (as described above) generally entitles a company to treaty benefits without regard to the residence of its owners when the company derives income from the source state that emanates from, or is incidental to, the company’s trade or business in the residence state. Treasury concluded that locating the strategic, financial, and operational policy decision-making for a multinational group in a country establishes sufficient nexus to that country regarding interest and dividends paid by members of the multinational corporate group for the company to qualify for treaty benefits, as well as equivalent-beneficiary status for purposes of the derivative benefits test regarding dividend and interest income.

iv. Rules for Intermediate Ownership. Comments requested that the rules for intermediate ownership contained in various ownership-based LOB tests in the 2015 Draft be relaxed. In response to these comments, Treasury modified the intermediate ownership rules for subsidiaries of publicly-traded companies and the general ownership-base erosion test in the 2016 Model. They permit as an intermediate owner any company that is a resident of a country that has in effect a comprehensive tax treaty that contains rules addressing STRs and NIDs.

5. Mandatory Binding Arbitration. Article 25 (Mutual Agreement Procedure) of the 2016 Model contains rules requiring that certain disputes between tax authorities be resolved through mandatory binding arbitration. The “last-best offer” arbitration approach in the 2016 Model is substantially the same as the arbitration provision that is found in four U.S. treaties in force and three additional U.S. tax treaties that await the advice and consent of the Senate.

6. Subsequent Changes in Law.

(a) Article 28 (Subsequent Changes in Law) was added to the 2016 Model to address situations in which, after the treaty is signed, one of the treaty partners changes its overall corporate tax system to no

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longer impose significant tax on cross-border income of resident companies.

(b) In response to comments, the scope of Article 28 has been narrowed to address only changes in the laws governing the taxation of companies. To address concerns regarding individuals, the 2016 Model contains discrete rules in other articles that address the availability of tax treaty benefits for individuals who are taxed on a remittance, fixed fee, “forfeit,” or similar basis.

(c) Article 28 requires the treaty partners to consult to determine if amendments to the treaty are necessary to restore an appropriate allocation of taxing rights between the two countries, consistent with the purpose of the treaty to eliminate double taxation without creating opportunities for non-taxation.

(d) The 2016 Model explicitly provides that it is only after these consultations fail to progress that a treaty partner may issue a diplomatic note stating that it will cease to grant certain benefits under the treaty for payments to companies.

(e) The 2015 Draft provided that the rule would be triggered if the general rate of company tax fell below 15%. In order to better effectuate the policy underlying Article 28, the 2016 Model provides that Article 28 is triggered if a treaty partner’s general rate of company tax falls below the lesser of 15%, or 60% of the other country’s general statutory rate of company tax.

7. BEPS.

(a) A number of the key recommendations regarding bilateral income tax treaties in the BEPS reports have been fundamental parts of U.S. tax treaty policy for many years. For example, U.S. tax treaties have long contained robust LOB provisions and rules at determining when treaty benefits should be available for payments to fiscally transparent entities.

(b) The 2016 Model incorporates certain other BEPS recommendations for the first time:

A revised preamble for tax treaties that makes clear the intentions of the treaty partners that the purpose of the tax treaty is the elimination of double taxation with respect to taxes on income without creating opportunities for non-taxation or reduction in taxation through tax evasion or avoidance.

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A rule intended to protect against contract-splitting abuses of the 12-month permanent establishment threshold for building sites or construction or installation projects.

A 12-month ownership requirement for the 5% withholding rate for direct dividends, with refinements in the 2016 Model to impose a 12-month residence requirement to prevent companies from circumventing the ownership period as well as to allow the payee company to take into account certain prior ownership.

(c) The 2016 Model did not adopt other BEPS recommendations regarding the permanent establishment threshold, notably the revised rules relating to dependent and independent agents and the exception for preparatory and auxiliary activities. Treasury is working with the other OECD countries to create a common global understanding regarding profit attribution that will address the concerns raised by the BEPS permanent establishment recommendations. Treasury also is interested in developing ways to mitigate the compliance burdens on business and tax administrations that the new permanent establishment rules could create.

8. Other Provisions. There is a new “tested group” provision in the 2016 Model Treaty and rules regarding gross income in the LOB article. The tested group rules apply to the base erosion tests under certain treaty provisions. A tested group includes members in a tax consolidation, fiscal unity or similar regime that requires the group to share profits, and group relief or other loss sharing regimes. Under the LOB gross income provision, gross income generally does not include dividends that are effectively exempt from tax, whether through deductions or otherwise. Further, a tested group’s gross income generally does not take into account transactions between companies in a tested group.

E. Creditable Tax: Treaty Interpretation.

1. In Eshel v. Commissioner, ____ F.3d ____ (D.C. Cir. 2016), reversed and remanded a Tax Court decision regarding creditability of a French social security tax. The Tax Court erred in finding that the taxpayer was precluded by § 317(b)(4) of the Social Security Amendments of 1977 (“SSA”) from claiming foreign tax credits for those taxes. The court said that the lower court resorted to American dictionaries rather than analyzing the text of the relevant totalization agreement and the shared expectations of the contracting governments in reaching its decision.

2. With Congress’s blessing, U.S. presidents have entered into so-called “totalization agreements” with foreign governments to limit social-

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security taxing rights to the country where the work is being done. The agreements allow overseas workers from both countries to obtain social security benefits based on the period for which they make social security contributions to foreign governments.

3. Eshel involves the totalization agreement between the U.S. and France. Specifically, the issue on appeal was whether two French taxes enacted into law after the totalization agreement was adopted “amend or supplement” the French social security laws covered by the agreement, and thus fall within the agreement’s ambit.

4. In 1987, the U.S. and France entered into the totalization agreement in issue. The agreement identifies the laws of each country under which qualifying taxes may be paid. It also covers taxes paid under “legislation which amends or supplements the laws specified.” The first tax in issue was enacted in 1990 and the other in 1996.

5. The Tax Court granted summary judgment for the Commissioner. The Tax Court turned to four American dictionaries to define “amend” and “supplement,” and on the basis of those dictionaries concluded that the phrase should mean formally altering on or more of these laws by striking out, inserting, or substituting words; adding something to make up for a lack or deficiency in one or more of those laws; or adding something to extend or strengthen the French social security system as a whole.

6. A totalization agreement, however, is not a domestic statute. It is an executive agreement with a foreign country, initiated by the State Department, negotiated by the Social Security Administration, signed by the president and a foreign government, and effective only after submission to Congress.

7. International executive agreements and treaties are primarily “compacts between independent nations,” and it is “[a court’s] responsibility to read them in a manner consistent with the shared expectations of the contracting parties.”

8. The Tax Court should have started with the totalization agreement’s plain text. The appellate court said that, here, the agreement’s text provides powerful evidence of its meaning. Article 1 defines certain terms, but does not define “amends or supplements.” For undefined terms, Article 1 directs that “Any term not defined in its Article shall have the meaning assigned to it under the laws which are being applied.” The agreement defines “laws,” as the “laws and regulations specified in Article 2.” Article 2 laws are the laws covered by the agreement: the eight enumerated types of French laws, two U.S. laws, and “legislation which amends or supplements the laws specified.”

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9. Thus, whether the 1990 and 1996 legislation “amends or supplements” the enumerated French laws is fundamentally an inquiry into the content and meaning of the Article 2 laws, in this case, the French laws. For that reason, determining the meaning of “amending or supplementing” the French laws should have at least in part been informed by French law.

10. The court stated that the problems with the Tax Court’s approach did not stop there. The Tax Court also improperly divorced “amends and supplements” from its textual object. Rather than asking whether the newer laws amend or supplement “the laws specified” in Article 2, the Tax Court considered whether those new taxes amend or supplement the “French social security system as a whole.”

11. In resolving difficult questions of foreign law and in attempting to ascertain the views of a foreign government on an agreement to which it is a party, courts are empowered to “insist on a complete presentation by counsel.” If the litigant’s submissions come up short, the court may choose to “request a further showing by counsel, or engage in its own research, or direct that a hearing be held, with or without oral testimony, to resolve the issue.” Courts also may request amicus submissions from the United States providing its official position on the interpretation of an agreement with a foreign government, and can ask the State Department to provide the views of the foreign government.

F. The new BEPS 2016 Multilateral Instrument is discussed in the section on “BEPS: 2016 Developments.”

XI. INVERSIONS.

A. New Regulations.

1. The IRS issued final and temporary inversion regulations that adopted the rules of Notices 2014-52 and 2015-27 as regulations. We will not cover these regulations to the extent they simply incorporate the previous notices into a regulatory format.

2. The new regulations, however, also attack serial inversion acquisitions, something that was not covered in the previous notices. The new temporary regulations provide an example that explains the new rules. Individual A owns 70 shares of the stock of DC1, a domestic corporation. Individual B owns 30 shares of stock of F1, a foreign corporation that is subject to tax as a resident of Country X. Pursuant to a reorganization, DC1 transfers all of its properties to F1 solely in exchange for 70 newly issued voting shares of F1 stock (the “DC1 acquisition”) and distributes the F1 stock to Individual A in liquidation pursuant to § 361(c).

3. Pursuant to a plan that includes the DC1 acquisition, F2, a newly formed foreign corporation that is also subject to tax as a resident of Country X,

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acquires 100% of the stock of F1 solely in exchange for 100 newly issued shares of F2 stock (the “F1 acquisition”). After the F1 acquisition, Individual A owns 70 shares of F2 stock, Individual B owns 30 shares of F2 stock, F2 owns 100 shares of F1 stock, and F1 owns all the properties held by DC1 immediately before the DC1 acquisition.

4. The DC1 Acquisition is a domestic-entity acquisition, and F1 is a foreign-acquiring corporation because F1 directly acquires 100% of the properties of DC1. In addition, the 70 shares of F1 stock received by A pursuant to the DC1 acquisition in exchange for Individual A’s DC1 stock are stock of a foreign corporation that is held by reason of holding stock in DC1. As a result, those 70 shares are included in both the numerator and the denominator of the ownership fraction when applying § 7874 to the DC1 acquisition.

5. The DC1 acquisition is also an initial acquisition because it is a domestic entity acquisition that, pursuant to a plan that includes the F1 acquisition, occurs before the F1 acquisition. Thus, F1 is the initial acquiring corporation.

6. The F1 acquisition is a subsequent acquisition because it occurs, pursuant to a plan that includes the DC1 acquisition, after the DC1 acquisition and, pursuant to the F1 acquisition, F2 acquires 100% of the stock of F1 and therefore is treated as indirectly acquiring all the properties held directly or indirectly by F1. Thus, F2 is a subsequent acquiring corporation.

7. The F1 acquisition is treated as a domestic-entity acquisition, and F2 is treated as a foreign-acquiring corporation. In addition, the 70 shares of F2 stock received by Individual A pursuant to the F1 acquisition in exchange for Individual A’s F1 stock are stock of a foreign corporation that is held by reason of holding stock of DC1. As a result, those 70 shares are included in both the numerator and the denominator of the ownership fraction when applying § 7874 to the F1 acquisition.

8. In addressing the 2014 notice’s non-ordinary course distributions (“NOCD”) rules, the temporary regulations provide, consistent with the approach recommended in comments received, that the amount of a distribution (including with respect to property distributed in a redemption of stock) is determined based on the value of the property distributed at the time of the distribution. This is a helpful change. In a given case it could be important.

9. Under the same NOCD rules, the regulations address a comment that stated that in cases in which a foreign corporation will acquire only a portion of a domestic corporation’s properties, different results may arise under the NOCD rule depending on how the parties structure the acquisition and related transactions. The comment explained that in

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certain cases the direction of a spin-off, if respected for purposes of the NOCD rules (which business is distributed in the spin-off), then transactions that are substantively the same could give rise to vastly different results.

10. Treasury and the IRS agreed with these concerns. As a result, the temporary regulations include a special provision that, for purposes of the NOCD rules, creates parity between certain transactions regardless of the direction of the spin-off.

11. The special rule applies when a domestic corporation (domestic distributing corporation) distributes stock of another domestic corporation (controlled corporation) in a § 355 spin-off, and immediately before the distribution, the value of the distributed stock represents more than 50% of the value of the domestic distributing corporation.

12. When the special rule applies, the controlled corporation is deemed for purposes of the NOCD rule to have distributed the stock of the distributing corporation. The value of the deemed distribution is equal to the fair market value of the distributing corporation (but not taking into account the fair market value of the stock of the controlled corporation) on the date of the distribution.

B. Business Groups Challenge Inversion Regulation.

1. The U.S. Chamber of Commerce and the Texas Association of Business commenced an action in U.S. Federal District Court challenging a § 7874 anti-inversion regulation asserting that adoption of the rule violates the Administrative Procedure Act. The Chamber is the world’s largest federation of businesses and associations, directly representing 300,000 members and indirectly representing the interests of more than three million U.S. businesses and professional organizations. The Texas Association of Business is the state chamber of commerce for Texas, representing more than 4,000 businesses and their more than 600,000 employees.

2. Treasury and the IRS have issued a number of § 7874 anti-inversion notices and regulations that many practitioners believe exceed the government’s authority under § 7874. They represent a concerted government effort to limit inversions. The particular focal point of the business associations’ lawsuit is the so-called “multiple domestic entity acquisition rule” set forth in regulations issued on April 4, 2006. In our view, this regulation does clearly exceed the government’s authority under the statute. It was widely believed that the regulation caused the Pfizer/Allergan transaction to be terminated.

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3. In the Pfizer/Allergan transaction, Allergan shareholders would have owned 44% of the new corporation following the merger. However, Treasury’s and the IRS’s new multiple acquisition rule would have treated those shareholders treated as owning under 20%. This would leave Pfizer shareholders treated as owning over 80% of the new corporation. Thus, it would have been treated as a domestic corporation under § 7874.

4. To ensure that Allergan and Pfizer could not abandon the merger and then enter into a new transaction once the multiple acquisition rules’ three-year window no longer applied to Allergan’s prior domestic acquisitions, the new regulations specify that the three-year window would look back from any “substantially similar acquisition” that had previously been terminated “with a principal purpose of avoiding § 7874.”

5. The complaint filed in court quoted Representative Sander Levin, a supporter of Treasury’s action, acknowledging that the multiple acquisition rule, “in many ways was targeting Pfizer/Allergan,” and that “what the Treasury did was take the history of the inversions by Allergan” and then gerrymander a regulation to support rejection of the Pfizer transaction.

6. The complaint asserts that the Administrative Procedure Act forbids agency action “in excess of statutory jurisdiction, authority or limitations.” It also forbids action that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law.” Finally, it forbids agency action that is “without observance of procedure required by law,” specifically notice and an opportunity for comment by those affected by the action.

7. The case could be an extremely important one. In a report by Andrew Velarde at 2016 TNT 151-1, he quotes practitioners discussing Treasury’s and the IRS’s “increasing use of in terrorem rulemaking.” One practitioner is quoted saying that the suit could be a harbinger of future pre-enforcement challenges, particularly to the sweeping § 385 regulations once they are finalized.

8. Interestingly, in the preamble to the regulation under challenge, Treasury and the IRS decreed, with no explanation, that it has “been determined that § 553(b) of the Administrative Procedure Act” -- which requires agencies to notify regulated parties of a proposed substantive rule so that they have a chance to comment before it goes into effect -- “does not apply to th[is] regulation [].” As the complaint notes, they did so even though their prior claims to immunity from the APA had been repeatedly rebuked by the judiciary.

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XII. COUNTRY-BY-COUNTRY REPORTING.

A. New U.S. CbC Reporting Regulations.

1. Treasury and the IRS originally issued proposed regulations on December 23, 2015, regarding country-by-country (“CbC”) reporting under BEPS Action 13. Prop. Treas. Reg. § 1.6038-4 generally incorporated the CbC report template proposed in BEPS Action 13.

(a) The preamble to the proposed regulations stated that Treasury and the IRS have determined that the information required under the proposed regulations will assist in better enforcement of the federal income tax laws by providing the IRS with greater transparency regarding operations and tax positions taken by U.S. multinational groups. In addition to this direct benefit expected from collecting U.S. CbC reports, pursuant to income tax conventions and other conventions and bilateral agreements relating to the exchange of tax information, a U.S. CbC report filed with the IRS may be exchanged by the U.S. with other tax jurisdictions in which the U.S. multinational group operates that have agreed to provide the IRS with foreign CbC reports filed in their jurisdiction by foreign multinational corporate groups that have operations in the U.S.

(b) In particular, states the preamble, it is expected that CbC reports filed by both U.S. multinational groups and foreign multinational groups will help the IRS perform high-level transfer pricing risk identification and assessment. The information in a CbC report will not itself constitute conclusive evidence that transfer pricing practices are or are not consistent with the arm’s length standard.

(c) Accordingly, the information in a CbC report will not be used as a substitute for an appropriate transfer pricing determination based on a best method analysis (including a full comparability analysis of factors such as functions performed, resources employed and risks assumed) as required by the arm’s length standard set forth in the § 482 regulations. Thus, transfer pricing adjustments will not be based solely on a CbC report.

(d) However, a CbC report may be used as a basis for making further inquiries into transfer pricing practices or other tax matters in the course of an examination of a member of a multinational group, and adjustments may be based on additional information developed through those inquires in accordance with applicable law.

2. On June 29, 2016, the IRS issued final regulations (T.D. 9773) under new Treas. Reg. § 1.6038-4 that require annual country-by-country reporting by certain U.S. persons that are the ultimate parent entity of a

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multinational enterprise group. The final regulations affect U.S. persons that are the ultimate parent of a group that has annual revenue for the preceding annual accounting period of $850 million or more. The new CBCR regulations are effective for taxable years beginning on or after June 30, 2016, as expected.

(a) The preamble to the final regulations discusses many of the comments that Treasury and the IRS received. They responded to a number of these comments in a very helpful manner.

(b) The most important modification is that Treasury and the IRS announced it would provide a procedure for the voluntary filing of CbC reports with the IRS for annual accounting periods beginning on or after January 1, 2016 (see discussion of Rev. Proc. 2017-23 below). Some foreign countries have adopted rules that require reporting for periods beginning on or after that date. This voluntary procedure is to be provided in separate, forthcoming guidance.

(c) The preamble to the final regulation states that Treasury is working to ensure that foreign jurisdictions implementing CbC reporting requirements will not require constituent entities of U.S. multinational groups to file a CbC report with the foreign jurisdiction if the U.S. multinational group files a CbC report with the IRS pursuant to this voluntary procedure and the CbC report is exchanged with that foreign jurisdiction pursuant to a competent authority arrangement.

(d) In response to requests for clarification regarding partnerships and stateless entities, the final regulations provide that the tax jurisdiction of residence information with respect to stateless entities (including a partnership that does not own or create a permanent establishment in any jurisdiction) is provided on an aggregate basis for all stateless entities in a U.S. MNE group, and that each stateless entity-owner’s share of the revenue and profit of its stateless entity is also included in the information for the tax jurisdiction of residence of the stateless entity-owner. This rule applies irrespective of whether the stateless entity-owner is liable to tax on its share of the stateless entity’s income in the owner’s tax jurisdiction of residence. The final regulations also clarify that distributions from a partnership to a partner are not included in the partner’s revenue.

(e) In the case in which a partnership creates a permanent establishment for itself or its partners, the CbC information with respect to the permanent establishment is not reported as stateless,

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but instead is reported as part of the information on the CbC report for the permanent establishment’s tax jurisdiction of residence.

(f) Whereas the proposed regulations specified that employees should be reflected on the CbC report in the tax jurisdictions in which the employees performed work for the U.S. MNE, the final regulations follow the approach contained in the Final BEPS Report, providing that employees of a constituent entity are reflected in the tax jurisdiction of residence of a constituent entity. This is a helpful change and eliminates the burdensome task of determining the work location of employees for U.S. MNE groups and having to deal with traveling employees.

(g) The final regulations do not require the ultimate parent entity to create and maintain records to reconcile the information reported in the CbC report to consolidated financial statements or to tax returns. According to the preamble, this approach provides flexibility for U.S. MNE groups to use the available data for each constituent entity without imposing the potential burden of a need to reconcile information on the CbC report with accounts that may not even be finalized when the CbC report is compiled and is consistent with the Final BEPS Report. However, this does not affect the requirement to maintain records to support the information provided in the CbC report.

(h) Citing IRS resource constraints, Treasury and the IRS declined to adopt a request that the final regulations allow a foreign-parented MNE group with a U.S. business entity to designate that U.S. business entity as a surrogate parent entity and allow that entity to file a CbC report with the IRS for purposes of satisfying the MNE group’s country-by-country reporting obligations in other tax jurisdictions.

(i) The final regulations identify new Form 8975, Country-by-Country Report, as the required reporting form to be filed with a taxpayer’s income tax return.

(j) The preamble notes that multiple comments were received requesting that taxpayers be permitted to file a CbC report up to one year from the end of the ultimate parent entity’s taxable year or accounting period, in order to facilitate a taxpayer’s ability to use statutory accounts or tax records of constituent entities to complete the CbC report. Although Treasury and the IRS did not adopt this recommendation, the preamble notes that the final regulations provide that Form 8975 may prescribe an alternative time and manner for filing the CbC report.

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(k) Information reported on Form 8975 is tax return information under § 6103. That section imposes strict confidentiality rules with respect to all return information. Section 6103(k)(4) allows the IRS to exchange return information with a competent authority of a tax jurisdiction only to the extent provided in, and subject to the terms and conditions of, an information exchange agreement. The preamble states that U.S. intends to enter into competent authority arrangements for the automatic exchange of CbC reports with jurisdictions with which the U.S. has an income tax treaty tax information exchange agreement.

(l) Although the final regulations do not contain specific limitations on the use of CbC report information, the preamble sates that Treasury and the IRS intend to limit the use of the CbC report information and intend to incorporate this limitation into the competent authority arrangements pursuant to which CbC reports are exchanged.

(m) Consistent with established international standards, all the information exchange agreements to which the U.S. is a party require the information exchanged to be treated as confidential by both parties, and disclosure and use of the information must be in accordance with the terms of the relevant information exchange agreement.

(n) Accordingly, under the terms of information exchange agreements, neither tax jurisdiction is permitted to disclose the information received under the information exchange agreement or use such information for any non-tax purpose. Under the competent authority agreements for the exchange of CbC reports, the competent authorities of the U.S. and other tax jurisdictions intend to further limit the permissible uses of exchanged CbC reports to assessing high-level transfer pricing and other tax risks, and where appropriate, for economic and statistical analysis.

(o) In order to conclude an information exchange agreement with another tax jurisdiction, Treasury and the IRS must be satisfied that the tax jurisdiction has the necessary legal safeguards in place to protect exchanged information, the protections are enforced, and adequate penalties apply to any breach of that confidentiality.

(p) If the U.S. determines that a tax jurisdiction is not in compliance with the confidentiality requirements, data safeguards, and the appropriate use standards provided for under the information exchange agreement or the competent authority arrangement, the U.S. will pause automatic exchange of CbC reports with that tax jurisdiction until the U.S. is satisfied that the jurisdiction is

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meeting its obligations under the applicable information exchange or competent authority agreement or arrangement.

(q) The preamble states that Treasury and the IRS intend to establish a procedure to report suspected violations of confidentiality and other misuses of CbC report information.

3. The U.S. has opted to not participate in the OECD’s Multilateral Competent Authority Agreement for the automatic exchange of CbC reports, opting instead to sign bilateral agreements with other countries.

(a) The preamble to the final CbC reporting regulations states that the U.S. intends to enter into competent authority arrangements for the automatic exchange of CbC reports with jurisdictions with which the U.S. has an income tax treaty or tax information exchange agreement. The preamble also states that Treasury is committed to entering into bilateral competent authority arrangements with respect to CbC reports in a timely manner.

(b) The preamble to the final CbC reporting regulations states that CbC reports that are filed with the IRS and exchanged pursuant to a competent authority arrangement benefit from the confidentiality requirements, data safeguards, and appropriate use restrictions in the competent authority arrangement. According to the preamble, the ability of the U.S. to pause exchanges where a foreign tax jurisdiction fails to meet the confidentiality requirements and other restrictions creates an additional incentive for foreign tax jurisdictions to uphold the confidentiality requirements, data safeguards, and appropriate use restrictions in the competent authority arrangement.

(c) The preamble also states that Treasury and the IRS anticipate that information about the existence of competent authority arrangements for CbC reports will be made publicly available, but the manner in which such information would be made publicly available has not yet been determined.

(d) Although the IRS has stated that it expects to complete its negotiations of information exchange agreements in a timely manner, taxpayers have expressed concerns regarding the absence, to date, of signed competent authority agreements for the exchange of CbC information with treaty partners. As noted by Douglas O’Donnell, IRS LB&I commissioner, if the U.S. does not enter into competent authority agreements regarding the notification and filing requirements imposed by each foreign jurisdiction, U.S. companies may face requirements in jurisdictions where they have

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affiliates that will force them to prepare and file multiple CbC reports. See 2017 TNT 47-7.

(e) However, Bob Stack, formerly of Treasury, notes that Treasury worked with the State Department to develop a bilateral form that can be signed by the U.S. and its treaty partners. Stack notes that unlike the intergovernmental agreements on FATCA, the bilateral competent authority agreements are generally form documents that are between the U.S. and the treaty partner, and therefore are not expected to require extensive negotiations.

(f) On April 6, 2017, the IRS published two model competent authority agreements for the exchange of CbC reports. One model agreement is designed to be exchanged on the basis of a double tax convention, and a second model agreement is designed to be exchanged on the basis of a tax information exchange agreement. Similar in content, the model CAAs are being used in the U.S.’s negotiations with its tax treaty partners and tax information exchange agreement partners to implement reciprocal automatic exchanges of CbC reports.

(g) The model CAAs contemplate the exchange of CbC reports beginning with fiscal years commencing on or after Jan. 1, 2016, with such reports to be exchanged as soon as possible and no later than 18 months after the last day of the fiscal year. CbC reports for fiscal years commencing on or after Jan. 1, 2017 are intended to be exchanged as soon as possible and no later than 15 months after the last day of the fiscal year.

(h) Section 2 of the model CAA states that each competent authority intends to exchange with the other competent authority annually on an automatic basis the CbC report received from each reporting entity that is resident for tax purposes in its jurisdiction, provided that, on the basis of the information provided in the CbC report, one or more constituent entities of the MNE group of the reporting entity are resident for tax purposes in the jurisdiction of the other competent authority, or are subject to tax with respect to the business carried out through a permanent establishment situated in the jurisdiction of the other competent authority.

(i) Section 5 of the model CAAs impose confidentiality protections, data safeguards, and restrictions on appropriate use of the CbC reports. The CAAs state that information exchanged by means of the CbC report should be used by a tax administration for assessing high-level transfer pricing risks, base erosion and profit shifting related risks, and, where appropriate, for economic and statistical analysis. This information should not be used by tax

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administrations as a substitute for detailed transfer pricing analysis of individual transactions and prices based on a full functional analysis and a full comparability analysis.

(j) Under Section 8 of the model CAAs, a competent authority may provide notice to the other competent authority that it is temporarily suspending the exchange of information under the agreement based on its determination that the other competent authority is or has been acting inconsistently with provisions of the competent authority arrangement.

4. The IRS has released draft versions of Form 8975 and Schedule A, and draft accompanying instructions. Form 8975 lists identifying information of the filer, while Schedule A sets forth the tax jurisdiction and constituent entity information. A separate Schedule A will be required for each tax jurisdiction in which a U.S. multinational group has a constituent entity. The draft forms and instructions are available at the IRS’s website: IRS.gov/draftforms.

(a) Part I of Form 8975 asks for information for the reporting entity (i.e., the ultimate parent entity of the U.S. MNE). Part II of Form 8975 provides space for entering any additional information related to the MNE group, which according to the draft instructions can include a narrative description of the overall business operations and structure of the group or an overall assumption or convention that is used which might have an effect on the report.

(b) Schedule A is used to report aggregate tax jurisdiction information and constituent entities within the tax jurisdiction. Part I of Schedule A asks for financial amounts and number of employees as an aggregate of the information for the constituent entities resident in that tax jurisdiction. Information required by Part I includes the separate reporting of unrelated and related revenues, the aggregate profit or loss, and the aggregate amount of income tax paid on a cash basis to all tax jurisdictions by the constituent entities listed in Part II.

(c) Part II of Schedule A asks for information for each constituent entity, including identification of the nature of the main business activity of the constituent entity in the relevant tax jurisdiction by selecting an appropriate code or category. The specified activities included in the current draft instructions are listed below:

i. Research and development

ii. Holding or managing intellectual property

iii. Purchasing or procurement

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iv. Manufacturing or production

v. Sales, marketing, or distribution

vi. Administrative, management, or support services

vii. Provision of services to unrelated parties

viii. Internal group finance

ix. Regulated financial services

x. Insurance

xi. Holding shares of other equity instruments

xii. Dormant

xiii. Other

(d) Part III of Schedule A provides space for a taxpayer to enter any relevant information or explanation that a taxpayer deems necessary or that would facilitate the understanding of the information provided in Parts I and II. This information may be used to explain the tax jurisdiction financial and employee information in Part I.

(e) The instructions for Schedule A clarify that if a constituent entity in the group is the owner of another constituent entity that is stateless, then the owner’s share of such stateless entity’s revenues and profits should be aggregated with the information for the owner’s tax jurisdiction of residence. At each level, the owner entity includes its share of the stateless entity’s revenue and profits in the owner’s tax jurisdiction of residence only if the owner has a tax jurisdiction of residence (i.e., only if the owner is not stateless). The instructions provide the following example to illustrate this rule:

i. Example. Assume US Corp is the ultimate parent entity of a U.S. MNE group. US Corp owns 90% of partnership P1 which in turn owns 80% of partnership P2. Both P1 and P2 do not have a tax jurisdiction of residence, each earn $100 of revenue and has no expenses (P1’s $100 of revenue does not include its allocable share of P2’s revenue), and neither creates a permanent establishment in any tax jurisdiction. Assume US Corp earns $100 of revenue, not including its share of P1’s revenue, and has no expenses.

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ii. P2 has $100 of revenue and profit that is reflected on the stateless Schedule A revenue and profit lines. P1 has $100 of revenue and profit that is reflected on the stateless Schedule A revenue and profit lines. Since P1 is stateless, it does not include its share of P2’s revenue and profit again on the stateless Schedule A revenue or profit lines. The total revenue and profit on the stateless Schedule A is $200.

iii. US Corp has $100 of revenue and profit, not including any allocations from other constituent entities. Since US Corp has a tax jurisdiction of residence, it includes its share of P1’s revenue and profit on the Schedule A for the United States. P1’s revenue and profit, of which US Corp is allocated 90%, includes any allocations from stateless entities that P1 owns, even if such allocations were not included on the stateless Schedule A revenue or profit lines. P1’s revenue and profit when determining US Corp’s allocable share is $180 (P1’s own $100 of revenue and profit plus 80% of P2’s revenue and profit, or $80). US Corp is allocated 90% of $180, or $162, of revenue and profit due to its ownership of P1. The total revenue and profit on the United States Schedule A revenue and profit lines is US Corp’s own revenue and profit of $100 plus its allocation of $162 of revenue and profit from P1, or $262.

5. As promised in the preamble to the final CbC regulations, the IRS has issued Rev. Proc. 2017-23 providing procedures for the filing of Form 8975 by ultimate parent entities of U.S. MNE groups for reporting periods beginning on or after January 1, 2016, but before the applicability date of the final CbC reporting regulations.

(a) Rev. Proc. 2017-23 provides that beginning on September 1, 2017, Form 8975 may be filed for an early reporting period with the income tax return or other return as provided in the instructions to Form 8975 for the taxable year of the ultimate parent entity of the U.S. MNE group with or within which the early reporting period ends.

(b) In order to file Form 8975 for an early reporting period, an ultimate parent entity that files (or has filed) an income tax return for a taxable year that includes an early reporting period without a Form 8975 attached must follow the procedures for filing an amended income tax return and attach the Form 8975 to the amended return within 12 months of the close of the taxable year that includes the early reporting period. Filing an amended income tax return solely to attach Form 8975 in accordance with Rev.

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Proc. 2017-23 will have no effect on the statute of limitations for the income tax return.

(c) Treasury officials have stated that the U.S. is confident that other countries will accept the voluntary CbC reporting under Rev. Proc. 2017-23. Brian Jenn, an attorney-adviser in the Treasury Office of Tax Policy, has stated that “It’s more than a hope. It’s an expectation.”

6. On the same day that Treasury and the IRS released final CbC reporting regulations, the OECD issued guidelines recommending that other countries accept for years beginning on January 1, 2016 reports filed voluntarily in the U.S. and other countries that do not yet require reports. Under the BEPS Action 13 report, countries can require reporting for multinationals with a foreign parent entity if that parent’s country of residence does not require CbC reporting or fails to exchange reports. The OECD’s report recommends accepting voluntarily filed CbC reports, subject to a list of conditions. It identifies the United States, Japan and Switzerland as countries that will likely satisfy those requirements.

B. Country-By-Country Reporting – Additional Developments.

1. On December 5, 2016 the OECD released further guidance regarding the global implementation of Country-by-Country Reporting (CbC reporting). The additional guidance provides information on steps to take if a notification to the tax administration is required to identify the reporting entity within a multinational entity group. During this first filing period when jurisdictions are still working on implementing CbC reporting, multinational entity groups may not yet have the information needed. The guidance states that jurisdictions can therefore be flexible with the due dates for these notifications.

(a) Accordingly, several countries have delayed the requirement for large companies to notify their governments that they will file reports of their global tax and profits for 2016. For countries that maintained the OECD’s original implementation date, requiring reporting for tax years beginning on or after January 1, 2016, the first filing requirement would be a December 31, 2016 deadline to notify relevant tax administrations of the “reporting entity” of a corporate group.

(b) Normally, a corporate group would report through its parent entity. A CbC report would be filed in the parent’s home country. The CbC report would then be transmitted by the home-country tax administration to other jurisdictions where the corporate group has a presence. If the home jurisdiction does not cooperate with the CbC reporting rules a local-country surrogate entity must be

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chosen. However, as BEPS CbC reporting continues to develop, the December 31 deadline may be premature for many taxpayers.

(c) The Netherlands, Belgium, the Czech Republic, Finland, Portugal, Sweden and Switzerland have adopted first-year of delays for reporting.

2. On April 6, 2017, the OECD issued additional guidance for the implementation of CbC reporting. The additional guidance clarifies several interpretation issues related to the data to be included in the CbC report as well as to the application of the model legislation contained in the final Action 13 report. Five specific issues are addressed in the updated guidance: (1) the definition of revenues, (2) the accounting principles/standards for determining the existence of and membership in a group, (3) the definition of total consolidated group revenue, (4) the treatment of major shareholdings, and (5) the definition of related party for purposes of completing Table 1 of the CbC report.

3. The OECD website maintains a high level summary on its website of CbC reporting implementation by jurisdiction (currently listing 54 jurisdictions as of April 18, 2017), including the first taxable periods that will be covered. This information is available here: http://www.oecd.org/tax/automatic-exchange/country-specific-information-on-country-by-country-reporting-implementation.htm.

(a) Countries listed as providing for a delayed implementation of the CbC reporting requirement include Argentina, Switzerland, Hong Kong, Singapore, Malaysia, and Russia.

4. As of January 26, 2017, 57 countries have signed the Multilateral Competent Authority Agreement (MCAA), providing for the automatic exchange of CbC reports across tax jurisdictions in which a multinational enterprise operates. The first exchanges will start in 2017 and 2018 with respect to FY2016 information.

5. Increased transparency?

(a) The G-20 leaders approved an automatic exchange of information by 2018. This was at the September 2016 Hangzhou Summit. The G-20 leaders also endorsed the OECD’s proposed criteria for identifying and listing those that do not cooperate regarding the tax transparency standard.

(b) On April 12, 2016, the European Commission issued a draft directive on public CbC reporting. Under the draft directive, the ultimate parent of an EU-parented group would be required to file a CbC report, and also publish the report on its website. In the absence of an ultimate EU parent, the EU subsidiaries or branches

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of the group would be required to file the report and publish the report on their websites.

(c) The UK government adopted a proposal to publish CbC reports, but said that international agreement on a reporting model is important. Pursuant to an amendment to the U.K.’s 2016 Finance Act, the U.K. Treasury possesses the authority, if it so chooses, to issue regulations that would compel public U.K. companies to publish annual statements that could include the CbC reports. See 85 Tax Notes Int’l 835 (2/27/17).

(d) On December 8, 2016, the French Constitutional Council ruled that public CbC reporting contained in a bill was unconstitutional because it could disproportionately affect the freedom of enterprise.

(e) On December 19, 2016, the EU presidency issued a scaled back proposal intended to serve as a compromise for public CbC reporting. The compromise proposal is intended to address certain challenges posed against public CbC reporting, including permitting companies to omit information that would be “seriously prejudicial” to the commercial position of the undertakings to which it relates. Any such omission is required to be disclosed in the report. Further, the compromise proposal provides that an EU subsidiary or branch of a non-EU parented group is required to report information only to the extent that the information is available to the subsidiary or branch. However, where the information is not available, the subsidiary or branch is to request the non-EU parent to provide the subsidiary or branch with information required to meet its reporting obligation. If the information is not provided by the non-EU parent, the report is to contain an explanation as to why the information is not available to the subsidiary or branch.

(f) Under the current proposal, companies with annual turnover of at least €750 million would be required to publicly report their affiliated group’s headcount, related and unrelated party revenue, pretax profit, income tax accrued, and income tax expenses on a country-specific basis for EU member states and for non-EU member states that appear on the EU’s tax haven blacklist. For other non-EU countries, aggregated data would be required.

(g) The European Commission’s legal basis for its public CbC reporting proposal is currently being debated by EU members. A number of states have expressed strong reservations toward the stated legal basis of the proposal. Currently, the proposal to require public reporting of certain CbC information is being made

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via proposed amendments to the accounting directive, which would require the approval of only a qualified majority of member states to enact the proposal. However, a number of members states and the EU Council Legal Service argue that the proposal should be viewed as tax legislation, which would require the unanimous approval of members states for the proposal to be enacted. (See article by Eloide Lamer, 2017 WTD 61-4.)

(h) Critics of the proposals to make CbC reporting public point out that the confidentiality of CbC data was expressly incorporated in the Action 13 documents and was part of the negotiations between stakeholders. Some observers point out the potential for competitors to obtain and use information reported in the CbC report to determine how to better compete or identify locations where they could be more successful. (See report by Rita McWilliams, 2017 WTD 6-1).

(i) Pascal Saint-Amans, director of the OECD’s Centre for Tax Policy and Administration, has stated that he would not push for public CbC reporting because that was not what was negotiated at the OECD and G-20. Pascal noted that if countries had advocated for public CbC reporting, countries such as the U.S. and Japan would not have agreed to CbC reporting at all. See 2016 WTD 238-7.

(j) Stack has stated that the U.S. would halt the exchange of CbC information to a jurisdiction that makes the CbC reports public. According to Stack, “There is no circumstance in which the U.S. CBC information that’s given by the IRS can be made public as a general matter, or as a matter of compliance for some other legislative rule. If they take IRS information and make it public, we will stop sending it, because it violates our treaties.”

(k) Notwithstanding Treasury’s clear stance on the matter, Treasury officials have acknowledged that if public CbC reporting becomes law in Europe, there may be little that the U.S. can do to intervene. (See report by Ben Stupples, BNA Daily Tax Report, Feb. 1, 2017). Stack has acknowledged that taxpayers should be prepared for the political process in the EU to ultimately result in EU countries requiring companies to publicly report some CbC information. (See report by Rita McWilliams, 2017 WTD 6-1).

6. Peer Review of Action 13 CbC Reporting.

(a) In February 2017, the OECD issued peer review documents for BEP Action 13 on CbC reporting. As one of the four BEPS minimum standards, Action 13 is subject to peer review to ensure timely and accurate implementation.

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(b) The peer review is intended to be a review of the legal and administrative framework put in place by a jurisdiction to implement the CbC reporting standard. This peer review is a separate exercise to the 2020 review to evaluate whether modifications to the CbC reporting should be made.

(c) The peer review process will used a stage process to review three key aspects of the CbC reporting standard that a jurisdiction must meet:

i. The domestic legal and administrative framework,

ii. The exchange of information framework, and

iii. The confidentiality and appropriate use of CbC reports.

(d) With respect to the confidentiality and appropriate use of CbC reports, the peer review documents provide that jurisdictions should ensure that CbC reports are kept confidential and used appropriately. This requires that jurisdictions have international exchange of information mechanisms which provide that any information received shall be treated as confidential and, unless otherwise agreed by the jurisdictions concerned, may be disclosed only to persons or authorities concerned with the assessment or collection of, the enforcement or prosecution in respect of, or the determination of appeals in relation to, the taxes covered by the exchange of information clause. Jurisdictions should also have in place and enforce legal protections of the confidentiality of the information contained in CbC reports which are received by way of local filing.

7. Master File.

(a) Although not discussed in great length in the final Action Item 13 report, the master file is significant component of the OECD’s recommended 3-tier transfer pricing documentation approach. New rules will require multinational enterprises to provide tax administrations with high-level information regarding their global business operations and transfer pricing policies in a master file that is to be available to all relevant tax administrations.

(b) The master file is intended to provide a blueprint of the multinational group and contains relevant information in five categories: (1) organizational structure, (2) description of the business, (3) intangibles, (4) intercompany financial activities, and (5) financial and tax positions.

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(c) The concept of a master file, as set forth in the Action Item 13 report, was intended to be a single consistent document containing standardized information. However, various countries are adopting a master file requirement that would require the reporting of additional specified information beyond what is contained in the OECD’s guidance. For example, China has adopted a special items file for value chain reporting which requires multinational companies to describe the flow of goods and cash within the group, as well as allocation principles used and the results of group profit allocations within the global value chain. Mexico has proposed requiring taxpayers to report more in-depth information concerning business activities and intangibles.

(d) The master file presents both challenges and opportunities for taxpayers, even for taxpayers based in countries that do not specifically adopt a master file requirement (such as the U.S.). Although the U.S. has not implemented a master file requirement, it is reasonable to expect that IRS examiners may request to review a company’s master file (prepared in compliance with foreign filing requirements) as part of a U.S. transfer pricing audit. It will thus be important for taxpayers to prepare the master file, local files, and CbC report in a consistent manner and based on a consistent set of transfer pricing policies.

XIII. OTHER RECENT BEPS DEVELOPMENTS.

A. BEPS: Arm’s Length Standard.

1. Andrew Hickman, the former head of the OECD’s transfer pricing unit, spoke July 21 at a Transfer Pricing Symposium in Washington, D.C. His comments were reported by Ryan Finley at 2016 TNT 141-5 and further discussed in an article by Mindy Herzfeld at 2016 WTD 147-1.

2. Hickman defended the guidance provided in the OECD’s BEPS report on Actions 8-10 against claims that it fails to uphold the arm’s-length principle. The report’s emphasis on control of risk when allocating the returns from intangibles is viewed by critics is inappropriate because it is the investors – not those with operational control – who are entitled to a company’s residual profits in arm’s-length dealings.

3. Hickman was quoted as stating “perhaps [critics] will say we fudged it, but I would say it’s a pragmatic fudge.” He added that “It may be that we haven’t got a pure version of the arm’s-length principle, but perhaps we’re looking for something that is just as equitable and might work.”

4. We agree very much with the critics. However, there is an even bigger problem if, as Hickman implies or believes, the BEPS approach is not a

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pure arm’s length approach. The arm’s-length standard has long been the bedrock of transfer pricing adjustments in the United States, and prior to BEPS, had evolved into a nearly worldwide standard for allocating income among members of multinational enterprises. In the U.S., Treas. Reg. § 1.482-1(b)(1) makes clear that the boundary of the IRS’s authority under § 482 is the arm’s length standard which must be applied “in every case.” Determining whether the arm’s length standard has been met necessarily requires some sort of evidence as to how unrelated parties price transactions. See Xilinx v. Commissioner, 598 F.3d 1191 (9th Cir. 2010), aff’g 125 T.C. 37 (2005); Altera Corp. v. Commissioner, 145 T.C. No. 3 (2015). It would appear the U.S. has no intention to revise § 482 or the § 482 regulations as a result of BEPS Actions 8-10, which is good.

5. Further, United States tax treaties contain language requiring use of the arm’s length method. Article 9 of the U.S.-U.K. Treaty, for example, provides that in the case of conditions made or imposed between two related enterprises in their commercial or financial relations that differ from those that would be made between independent enterprises, then any profits that, but for those conditions, would have accrued to one of the enterprises, but by reason of those conditions have not so accrued, may be included in the profits of the enterprise and taxed accordingly. The United States Treasury Department Technical Explanation states that “This article incorporates in the convention the arm’s-length principle reflected in the U.S. domestic transfer pricing provisions, particularly Code § 482.”

6. Most or all U.S. tax treaties provide for a similar application of the arm’s length principle. Presumably, the United States has no plan to renegotiate its treaties to change the application of this principle.

7. If key persons such as Hickman believe that BEPS does not set forth a pure version of the arm’s-length principle, then BEPS presents especially serious problems. The U.S. and its treaties require the arm’s-length method. Countries that signed those treaties also are required to use the arm’s-length method, at least to the extent of their dealings with the U.S. Other than that, under Hickman’s view, a less than pure version of the arm’s-length method apparently can exist. Can it be that where a U.S. parent company owns a U.K. subsidiary both of which sell goods to a related French company, two different transfer pricing regimes will co-exist?

8. As discussed in Herzfeld’s article, Hickman’s comments leave the impression that the BEPS changes to the OECD Transfer Pricing Guidelines have not solved the problems they were intended to solve, but instead have left the field in a state of confusion. Herzfeld states that neither the professionals who tried to interpret the rules at the seminar nor the officials who drafted them seemed able to explain them.

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9. This same sentiment was conveyed in comments by Michael MacDonald, a Treasury economist and chair of OECD Working Party 6, who observed that it is still unclear whether key transfer pricing goals set out by the OECD’s base erosion and profit-shifting plan have been accomplished by changes in the OECD’s transfer pricing guidelines. Acknowledging that the new guidelines are lengthy and can sometimes be read contradictory, MacDonald noted that OECD delegates don’t necessarily share a common vision of the goal, which reflects the tension between articulating clear rules for applying the arm’s length standard versus having a more flexible tool to combat perceived aggressive tax planning. See article by Amanda Athanasiou, 2016 WTD 183-1.

10. Herzfeld notes that U.S. Treasury officials have expressed the view that the revised transfer pricing guidelines do not constitute a substantive change to the arm’s-length standard and instead reflect best practices under the old guidelines. Many practitioners disagree. The idea that the residual return on intangibles should go to a management company rather than to the investor and owner of intangibles is a violation of fundamental economic principles. Residual profits inure to the investor of capital, who bears the economic risk, and control over the risk has virtually no correlation with profits in the real world.

11. Herzfeld expressed the view that the new guidelines also are unlikely to provide the results that their advocates -- countries that feel victimized by multinationals’ use of transfer pricing rules to maximize profits in low-tax jurisdictions -- have hoped for. Policy officials have pointed to two types of egregious structures in justifying the need for the new rules: the cashbox and supply chain restructuring. She says the revised guidelines are unlikely to produce the outcomes many countries want. The focus on control of risk means the return on that risk might belong in the United States. For many high-tech companies, management decisions – that is, the control of risk – take place there. Reallocating profits to the United States is probably not the result the advocates of the new rules want. And unless the United States changes its controlled foreign corporation rules to assert tax jurisdiction over those profits, the profits will remain trapped in the cashbox company.

12. In the case of supply chain restructuring, such as with a principal company structure and low-risk distributors, the risk controllers here, too, would seem not to be based in the countries that advocated for the new rules.

B. GAO Report Assessing Impact on IRS and U.S. Multinationals.

1. In January 2017, the GAO issued a report assessing the potential impact on the IRS and U.S. multinationals from the revised transfer pricing guidelines and the new transfer pricing documentation rules. Specifically, the GAO examined (1) how likely it is that the action would reduce base

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erosion and profit shifting, (2) what is known about the potential administrative and compliance costs of the action, and (3) what is known about the potential effects the actions could have on the U.S. economy.

2. Transfer Pricing Guidance:

(a) The GAO report concludes that the OECD’s revised transfer pricing guidance may reduce BEPS if it encourages MNEs and tax authorities to ensure that transfer prices are based on real economic activity. However, the report states that the application of the arm’s length principle is problematic because related parties cannot transfer risk the way unrelated parties can, and the guidance does not account for all the ways that entities can bear risk. Without addressing the application of the arm’s length principle under these situations, uncertainty about the correct transfer prices may allow for continued based erosion and profit shifting.

(b) The GAO notes that the IRS believes the administration costs of implementing the revised transfer pricing guidelines will be minor because the IRS’s transfer pricing reviews are consistent with the revised guidance. According to Treasury and IRS officials, the expanded guidance on risk allocations under the OECD guidelines is consistent with, but more detailed than, the current U.S. transfer pricing regulations under § 482. The GAO report concludes that taxpayer compliance costs are uncertain because they will depend on how MNEs respond to the revisions.

(c) The GAO report concludes generally that U.S. employment and investment are unlikely to be significantly affected because the transfer pricing guidance affects a relatively narrow area of the tax code. However, the report also notes that because the revised guidelines emphasize the importance of real business functions, such as employment and investment, they may encourage MNEs to better align their actual business activities with their reported profits.

(d) The net effect on the U.S. economy would depend on whether MNEs adjust actual activities to support current profit allocations, move reported profits to where their business activities are occurring, or choose to make no adjustment. Furthermore, the effect also would depend on whether these shifts happen among foreign countries or between the U.S. and other countries.

(e) Because the revised guidance focuses on the location of decision making as support for allocating risk and profits, MNEs may be encouraged to decentralize decision making from the parent company to multiple jurisdictions to ensure that risk could be

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attributed to low-tax countries. This could result in some U.S. employees being relocated to tax-favored jurisdictions and reduced demand for employment in the U.S.

(f) Although the GAO found no estimates of the effect of revisions to transfer pricing guidance on investment, employment, or revenue, the GAO noted that studies generally show that the shifting of profits by corporations in response to tax rates is generally low. Studies suggest that a 1 percentage point reduction in a country’s tax rate could lead to an increase in profits reported in that country by up to 5 percent, but the actual amount is likely to be much lower. The responsiveness of businesses’ allocation of investment to changes in tax rates is also likely to be low, according to the studies reviewed by the GAO. One study found that a 1 percent reduction in a host country’s tax rates leads to an increase of total foreign direct investment between 0.3 percent and 1.8 percent.

(g) The GAO report states that there may still be an effect on U.S. tax revenue even if MNEs make no significant adjustments to their activities. Any increased foreign taxes that could result from an increased focus on economic function and risk would reduce U.S. revenues in two ways: (1) by increasing foreign tax credits when the income from that country is repatriated, and (2) reducing U.S. shareholder’s capital gains taxes due to reduced MNE profits.

3. Transfer Pricing Documentation and Reporting:

(a) With respect to the new transfer pricing documentation and reporting rules, the GAO report states that CbC reporting may decrease base erosion and profit shifting because more consistent information will be available to tax authorities on the worldwide activities of MNEs.

(b) Whereas the OECD’s transfer pricing documentation consists of a three-tiered approach (master file, local file, and CbC reporting), the U.S. is implementing only CbC reporting, due to the belief that current U.S. documentation and reporting requirements are sufficient for transfer pricing administration. Treasury will not be requiring MNEs to submit master and local files. However, IRS officials stated that the information the OECD recommends for inclusion in the master or local file is generally available to the IRS upon request.

(c) According to IRS officials, CbC implementation costs are uncertain at this time, but can be mitigated by using existing IRS systems and processes. However, MNE compliance costs are likely to increase due to new data system needs.

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(d) Although the OECD specifies that MNEs do not need to reconcile the information reported in their CbC reports with similar information reported for other purposes, stakeholders pointed out that if global CbC information is not reconciled with master and local file information, tax authorities might misinterpret the information or request additional information for clarification.

(e) The economic effect of CbC reporting is uncertain because it depends on the extent to which MNEs move business functions to low-tax countries in response to the potential increased scrutiny of BEPS.

C. BEPS: Conforming Amendments Regarding Business Restructurings. This “document for public review” contains conforming changes to Chapter IX of the transfer pricing guidelines entitled “Transfer Pricing Aspects of Business Restructurings.” The purpose is to conform the OECD transfer pricing guidelines to the BEPS changes incorporated elsewhere in the OECD transfer pricing guidelines. The document is not entitled “Discussion Draft.” It seems simply to be a request to review amendments that are proposed to be made to the transfer pricing guidelines. Accordingly, we will not cover this document further here.

D. BEPS: Profit Splits.

1. On July 4, 2016, the OECD issued a BEPS discussion draft on profit splits. The BEPS writers’ last attempt at a discussion draft on profit splits seemed more to be a discussion draft on the subject of formulary apportionment. It was roundly criticized. The new discussion draft is an improvement, but still leaves a lot to be desired. Curiously, it states that it does “not represent consensus views” but is intended to provide stakeholders with substantive proposals for analysis and comment.

2. The discussion draft starts by stating that the transactional profit-split method seeks to eliminate the effect on profits of special conditions made or imposed in controlled transactions by determining the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions. The transactional profit-split method first identifies the profits to be split for the associated enterprises. It then splits those combined profits on an economically valid basis. It seems to us that these statements emphasize the problems with the proposed profit-split rules rather than a solution or an application of workable rules.

3. Splitting profits on an economically valid basis can be described in two broad ways. The discussion draft states that one approach is splitting profits using anticipated profits. A second approach involves combining and splitting actual profits. Application in both cases is performed in a manner that is similar to that which the associated enterprises would have

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experienced, i.e., on the basis of information known or reasonably foreseeable by the associated enterprises at the time when the transactions were entered into, and hindsight must be avoided.

4. The second section of the discussion draft addresses strengths and weaknesses of utilizing a profit-split method. The main strength is stated to be that this method can offer a pricing solution in circumstances in which the accurate delineation of the actual transaction shows that two or more associated enterprises undertake activities involving the sharing of economically significant risks. This may happen in highly integrated operations in which the parties each perform similar functions, and in some instances share core assets used to the produce the income stream.

5. On the other hand, the sharing of economically significant risks is not likely to occur where one party to the transaction performs only simple functions and does not make any significant unique contribution. In these cases, use of a transactional profit split of actual profits would not be appropriate.

6. Other strengths are stated to be that the method offers flexibility by taking into account specific, possibly unique, facts and circumstances that are not present in independent transactions, and that it is less likely that either party to the controlled transaction will be left with an extreme and improbable profit result.

7. The discussion draft states that a weakness of the transactional profit split method relates to difficulties in its application. On first review, the transactional profit split method may appear readily accessible to both taxpayers and tax administrations because it tends to rely less on information about independent enterprises. However, associated enterprises and tax administrations alike may have difficulty accessing information from foreign affiliates. In addition, it may be difficult to measure combined revenue and costs for all the associated enterprises participating in the controlled transactions. This would require identifying from the financial records of the parties to the transaction the revenues, costs and profits arising from the transaction and separating them from the parties’ other activities.

8. The way in which profits are split may also require detailed analyses of past, current, and expected expenditures relating to the combined profits from the transactions concerned. For example, the profit split between a global manufacturer and a regional distributor, in circumstances where both enterprises contribute intangibles, would require the combined profits for the products manufactured by the global manufacturer to be identified and separated from its other activities, and where the regional distributor sells other products or performs additional activities, similar separation would be required.

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9. A third section discusses when profit split may be the most appropriate method. The discussion draft states that a lack of comparables alone is insufficient to warrant use of a transactional profit split of actual profits under the arm’s length principle. It also says a sharing of risks by parties to a transaction may be accompanied by a high degree of integration of functions or the making of unique and valuable contributions by each of the parties. However, it says the contribution alone of an intangible or rights in an intangible by one of the parties is not sufficient to justify the splitting of combined actual profits of the parties to the transaction under a transactional profit split of actual profits. A transactional profit split of anticipated profits does not require the level of integration or risk sharing required for a transactional profit split of actual profits.

10. In a section entitled “Highly Integrated Operations,” a series of new undefined terms is used. It says the accurate delineation of the actual transaction may determine that multiple parties share significant risks in relation to a transaction in cases in which the transaction is part of a “highly integrated business operation” of the parties. The discussion draft states that although most business operations taken by a multinational group are integrated to some degree, a “high degree of integration” means that the way in which one party to the transaction performs functions, uses assets and assumes risks is “interlinked with,” and cannot reliably be evaluated in isolation from, the way in which another party to the transaction performs functions, uses assets and assumes risks.

11. The discussion draft says that in some cases there will be a “high degree of commonality” in the functions performed, the assets used and risks assumed. This commonality is more likely to be the case where there is “parallel integration” by the associated enterprises in the “value chain,” rather than “sequential integration.” In the case of sequential integration, in which the parties perform discrete functions in an integrated value chain, it will often be the case that it is possible to find reliable comparables for each stage or element in the value chain since the functions, assets and risks involved in each discrete stage may be comparable to those involved in uncontrolled arrangements.

12. In contrast, where parallel integration occurs, multiple parties to the transaction are involved in the same stage of the value chain. For example, the parties may each contribute intangibles, share functions in jointly developing products, and exploit the marketing of those products together. In the case of parallel integration, it may be the case that the accurate delineation of the actual transaction determines that each party shares economically significant risks, and a transactional profit split, using an approach that splits actual profits, may be found to be the most appropriate method.

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13. Another section states that the transactional profit split may be the most appropriate method where multiple parties to a transaction make unique and valuable contributions, such as unique and valuable intangibles.

14. Other sections discuss group synergies, value chain analyses, guidance for application, various approaches for splitting profits and measures of profits.

15. Grace Perez-Navarro, deputy director for taxes at the OECD, stated that the current draft report is intended to be a discussion-starter, rather than an indication of consensus. The OECD is considering feedback to be incorporated in a second draft this summer.

(a) One particular issue that the OECD would like to resolve is how the guidance would apply, given that only a handful of countries currently follow the AOA on profit attribution. Perez-Navarro said the working party is attempting to provide rules that would apply both to countries that have adopted the AOA, and those that don’t.

(b) Perez-Navarro also stated that while she doesn’t expect dramatic changes in the upcoming draft, the new draft will provide further clarification on when profit split methods are the most appropriate method and how they should be applied, with additional examples. See BNA Daily Tax Report, I-1 (3/14/17).

E. BEPS: Attribution of Profits to PEs.

1. The BEPS discussion draft entitled “Additional Guidance on the Attribution of Profits to Permanent Establishments,” dated July 4, 2016, states that an important issue that now needs to be taken into account regarding the PE rules is the effect of the transfer pricing work under BEPS Actions 8-10. The discussion draft states that it is important to note that the issue arises regardless of whether one is dealing with a PE arising from the post-BEPS version of Article 5(5) or from its pre-BEPS equivalent.

2. The practical effect of the changes made to Article 5(4) and the addition of the anti-fragmentation rule is to restrict the scope of the exceptions currently found in Article 5(4). To take one example, under pre-BEPS version of Article 5, an associated enterprise of one state that operates, through its own employees, a warehouse situated in another state for the purposes of the storage and delivery of goods and merchandise belonging to third parties is not entitled to the exception of Article 5(4) unless that activity is merely preparatory or auxiliary. As a result of the changes in report on Action 7, the same will now be true if the enterprise carries on identical storage in delivery functions at a similar location with respect to its own goods or merchandise. It is not clear what is the difference

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between these two cases that would require additional guidance in relation to the issue of attribution of profits.

3. The discussion draft states that the same can be said with respect to the splitting-up of contracts. These changes do not create a new type of PE; they merely deny, in certain limited cases, the application of the exception of Article 5(3), which applies to an Article 5(1) permanent establishment that is a “building site or construction or installation project” provided that the permanent establishment does not meet the time threshold provided in Article 5(3).

4. At this point one might ask what guidance and/or practical changes would result from the new discussion draft? One commentator noted that it’s an unusual discussion draft in that it is not clear that any new guidance on determining the amount of profits attributable to a permanent establishment is currently needed.

5. The discussion draft, however, states “This is not to say that there is no need for additional guidance on the attribution of profit issues. … The aim of the additional guidance covered is therefore, to illustrate how the rules for the attribution of PEs apply, taking into account both the changes made in the Report on Action 7 and the changes made to the transfer pricing guidelines.” Thus, as opposed to new rules, the discussion draft proposes to illustrate the new transfer pricing rules’ application to PEs.

6. The discussion draft sets forth potentially helpful examples. The examples are built on the assumption that a PE exists, either under Article 5(1) or Article 5(5), considering the revisions to the definition of PE introduced by the BEPS Report on Action 7.

7. It states that for purposes of its analysis the approach is performed by reference to Article 7 in the 2010 version of the Model Tax Convention (“MTC”), and under the principles in the 2010 commentary to the MTC, and the 2010 Report on the Attribution of Profit to Permanent Establishments, which endorses and attributes profits to a PE under the “Authorized OECD Approach (“AOA”). The AOA mandates that tax authorities use transfer pricing to determine the proper profit allocation to a PE as though it were a separate entity.

8. The discussion draft notes, however, that relatively few treaties include the new provisions of Article 7, and that through reservations and positions included in the OECD model, a number of OECD and non-OECD countries have expressly stated their intention not to include the new version of Article 7 in their treaties. Inclusion of the new version of the Article in the U.N. model has also been expressly rejected by the U.N. Commission on Experts and International Cooperation in Tax Matters.

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9. The four examples illustrating the attribution of profits to a dependent agent permanent establishment (“DAPE”) present the following fact patterns:

(a) In Example 1, the non-resident enterprise acting as a principal engages an associated enterprise resident in the host jurisdiction to perform activities that give rise to a DAPE under Article 5(5). This example illustrates the attribution of profits to the DAPE under the AOA in a fact pattern in which an analysis under Article 9 is also required.

(b) In Example 2, the non-resident enterprise acting as a principal engages an associated resident in the host jurisdiction to perform activities that give rise to a DAPE under Article 5(5). The difference in this example compared with Example 1 is that the Article 9 analysis results in the allocation of risk not to the party contractually assuming the risk, but to the party that has control over the risk and that has a financial capacity to assume the risk. This example illustrates the impact that such an allocation of risk may have for the AOA analysis.

(c) In Example 3, the facts are the same as in Example 2, except that the non-resident enterprise acting as a principal sends an employee to the host country to perform activities that give rise to a DAPE under Article 5(5). This example illustrates the attribution of AOA profits to the DAPE in a fact pattern in which an analysis under Article 9 is not required.

(d) In Example 4, based on the facts in Example 2, the analysis focuses in on the activities related to the provision of credit to customers performed by the dependent agent enterprise and the non-resident enterprise. This example illustrates the consequences for the attribution of profits to the DAPE resulting from the attribution of risk under the AOA and the allocation of risk under Article 9.

10. In a separate section of the guidelines entitled “Guidance on the Attribution of Profits to Permanent Establishments Arising from Activities Not Covered by Specific Exceptions in Article 5(4),” an example, termed “Example 5,” considers a fixed PE arising from the use of facilities, a warehouse, solely for purpose of storage, display or delivery of goods or merchandise belonging to a non-resident enterprise, and not qualifying as preparatory or auxiliary to the overall business activity of the enterprise.

11. The discussion draft states that given the difficulties of identifying profits when the warehousing activity is carried out as a cost center representing only one aspect of the multinational group’s activities, this example first

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supposes that the warehousing activities are conducted as a profit center by a multinational group specializing and providing warehouse services to third party customers.

12. Profiling the warehouse in this manner provides a basis for developing guidance on the approach for determining the profits arising from the arrangements when carried out as a cost center as part of the multinational group’s total activities.

13. According to Bob Stack, formerly with Treasury, the U.S. argued against the separation of the new proposed PE rules from the OECD’s profit attribution work. According to Stack, “There will be cases in which the finding of a PE, if there’s the right income in the subsidiary to begin with, does not find additional income for the local jurisdiction.” See BNA Daily Tax Report, G-1 (3/7/17). In this regard, Michael McDonald, an economist at Treasury, stated that the U.S. is concerned that the new proposed PE rules could result in finding PEs with very little profits, and consequently the U.S. does not plan on adopting the OECD position in the MLI.

F. BEPS: Group-wide Ratio Limitation for Interest Expense.

1. The BEPS Report on Action 4, “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments,” indicated that the OECD would continue to conduct detailed work on the design and operation of the group ratio rule, to be completed in 2016. On December 22, 2016, the OECD issued an update to the final Action 4 report – Limiting Base Erosion Involving Interest Deductions and Other Financial Payments. The updated reported is divided into 3 parts. Part I the updated report simply contains the text of the 2015 report issued in October 2015. Parts II and III are new, and contain the results of further work that was performed in 2016.

2. Part II of the updated report is titled “Elements of the design and operation of the group ratio rule,” and it focuses on approaches to calculate a group’s net third-party interest expense, a definition of group-EBIDTA, and approaches to deal with the impact of losses on the operation of the group ratio rule.

3. Part III of the updated report is titled “Approaches to address BEPS involving interest in the banking and insurance sectors,” and explores elements of the banking and insurance sectors that can impose constraints on a group’s ability to use interest for BEPS purposes. However, the report also identifies certain risks that can exist for banking and insurance groups in certain countries and sectors, and considers how appropriate rules may be designed.

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G. BEPS Branch Mismatches.

1. The OECD issued a BEPS Discussion Draft on Branch Mismatch Structures. It provides recommendations for rules targeting payments made by or to a hybrid entity that give rise to one of three types of mismatches. The Discussion Draft identifies five basic types of branch mismatch arrangements. It includes specific recommendations, and 25 separate questions for public consultation. The document does “not necessarily reflect the consensus views of Working Party 11.”

2. The Discussion Draft focuses on three types of mismatches:

(a) Deduction/No Inclusion (D/NI) outcomes, where the payment is deductible under the rules of the payor jurisdiction but not included in the ordinary income of the payee;

(b) Double Deduction (DD) outcomes, where the payment triggers two deductions in respect of the same payment; and

(c) Indirect Deduction/No Inclusion (Indirect D/NI) outcomes, where the income from a deductible payment is set-off by the payee against a deduction under a hybrid mismatch arrangement.

3. The five basic types of branch mismatch arrangements addressed in the discussion document are:

(a) Disregarded branch structures where the branch does not give rise to a permanent establishment (PE) or other taxable presence in the branch jurisdiction;

(b) Diverted branch payments where the branch jurisdiction recognizes the existence of the branch, but the payment made to the branch is treated by the branch jurisdiction as attributable to the head office, while the residence jurisdiction exempts the payment from taxation on the grounds that the payment was made to the branch;

(c) Deemed branch payments where the branch is treated as making a notional payment to the head office that results in a mismatch in tax outcomes under the laws of the residence and branch jurisdictions;

(d) DD branch payments where the same item of expenditure gives rise to a deduction under the laws of both the residence and branch jurisdictions; and

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(e) Imported branch mismatches, where the payee offsets the income from a deductible payment against a deduction arising under a branch mismatch arrangement.

4. An example of the first category, a disregarded branch structure, is illustrated in the Discussion Draft by describing the type of structure that the European Commission has used as a basis for attacking Luxembourg. The U.S. and Luxembourg have also agreed to a protocol to their tax treaty that would eliminate this type of structure. Under the structure, A Co (Luxembourg) has a branch in B Country (the U.S.). A Co lends money to C Co (a related company) through the branch located in Country B. Country C permits C Co to claim a deduction for the interest payment. Country A exempts or excludes the interest payment from taxation on the grounds that it is attributable to a foreign branch. The interest income is not, however, taxed in Country B because A Co does not have a sufficient presence in Country B.

5. An example of the second category, a diverted branch payment, is illustrated with the same basic structure described above. A Co has a branch in County B. A Co lends money to C Co. In this example, both the residence and branch jurisdictions recognize the existence of the branch. The mismatch arises due to the fact that the branch treats the interest payment as if it were paid directly to the head office in Country A, while the head office continues to treat the payment as made to the branch. As a consequence, the payment is not subject to tax in either jurisdiction.

6. The third category, deemed branch payment, again, is illustrated with the same basic structure. A Co has a branch in B. However, in this example, A Co supplies services to a related company (C Co) through the branch located in Country B. The services supplied by the branch exploit underlying intangibles owned by A Co. Country B attributes the ownership of those intangibles to the head office and treats the branches as making a corresponding arm’s-length payment to compensate A Co for the use of those intangibles. This deemed payment is deductible under Country B law, but is not recognized under Country A law (because Country A attributes the ownership of the intangibles to the branch). The service income received by the branch is exempt from taxation under Country A law due to an exemption or exclusion for branch income in Country A.

7. The fourth category, DD branch payments, is illustrated with A Co, a company established and resident in Country A, that has lent money to a customer located in Country A (Customer A). A Co borrows additional funds from a bank and uses those funds to make a loan to a customer located in Country B (Customer B) through a branch established in that Country B. Income attributable to the branch is exempt or excluded from Country A taxation under Country A domestic law or under the Country

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A–B tax treaty. A DD results because Country A applies a fungibility approach to the deduction of interest expense, which results in half the amount of the interest expense on the bank loan being deductible under Country A law, and the domestic law of Country B allows the branch to apply a tracing approach which results in the full amount of the interest expense being deductible under Country B law.

8. The fifth and last category is imported branch mismatches. The related example starts with A Co that has a Country B branch. A Co also has a subsidiary, C Co. C Co pays a fee for services to the branch. As a consequence, the deductible service fee paid by C Co (which is treated as exempt under Country A law) is offset against a deduction under a branch mismatch arrangement resulting in an indirect D/NI outcome because B branch is treated as paying a deemed royalty to A Co. A Co is not subject to tax in its country on the deemed royalty payment, which is not recognized in Country A.

9. The new Discussion Draft’s expansion of the BEPS Action 2 Report’s rules will add even more complexity to the already very complex hybrid-mismatch area. The BEPS Action 2 Report itself was an amazing 454 pages in length.

H. Mutual Agreement Procedures. The OECD released BEPS-related documents that will form the basis of the Mutual Agreement Procedure (MAP) peer review and monitoring process under BEPS Action 14. The OECD will also publish updated MAP profiles of all members. The actual peer reviews will be conducted in batches, starting in December 2016.

I. Common Reporting Standard. The OECD also announced that the first series of bilateral automatic exchange relationships were established among the first batch of jurisdictions committed to the automatic exchange of information as of 2017 pursuant to the Common Reporting Standard (CRS). The announcement also said there are now more than 1,000 bilateral relationships in place across the globe, most of them based on the Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information (the CRS MCAA).

J. BEPS Multilateral Instrument.

1. Background.

(a) BEPS Action 15 Report, “Developing a Multilateral Instrument to Modify Bilateral Tax Treaties,” concluded that a multilateral instrument (“MLI”), providing an innovative approach to enable countries to swiftly modify their bilateral treaties to implement BEPS measures, is desirable and feasible, and that negotiations for such an instrument should be convened quickly.

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(b) An Ad Hoc group was open to all interested parties participating on an equal footing and 99 countries participated in the group. The substance of the tax-treaty-related BEPS measures (under BEPS Actions 2, 6, 7 and 14) was agreed as a part of the final BEPS reports. The Action 14 report also provided that a mandatory binding mutual agreement procedure arbitration provision would be developed as part of the negotiations of the treaty. Accordingly, the Ad Hoc group established a sub-group on arbitration for this purpose in which 27 countries participated as members.

(c) The development of the BEPS measures that are implemented by the MLI also included the development of commentary which was intended to be used in the interpretation of those provisions. While the MLI’s Explanatory Statement is intended to clarify that the MLI is intended to modify covered tax agreements, it is not intended to address the interpretation of the underlying BEPS measures (except with respect to mandatory binding arbitration). Accordingly, the provisions in the MLI should be interpreted in accordance with the ordinary principle of treaty interpretation, which is that a treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of its object and purpose.

(d) The MLI operates to modify tax treaties between two or more parties to the MLI. It will not function in the same way as an amending protocol to a single existing treaty, which would directly amend the text of the covered tax agreement. Instead, it will be applied alongside existing treaties, modifying their application in order to implement the BEPS measures. As discussed below, it is possible for contracting jurisdictions to agree subsequently to modifications of their covered tax agreements different from those foreseen in the MLI.

(e) The purpose of the MLI thus is to swiftly implement the tax-treaty-related BEPS measures. The MLI should enable all parties to meet the treaty-related minimum standards that were agreed as part of the final BEPS reports, which are the minimum standard for the prevention of treaty abuse under Action 6 and the minimum standard for the improvement for dispute resolution under Action 14. However, the MLI is flexible enough to accommodate the positions of different countries and jurisdictions. It does not give preference to a particular way of meeting a minimum standard.

(f) Further, where a substantive provision does not reflect the minimum standard, a party is generally given the flexibility to opt out of that provision entirely (or, in some cases, out of part of that

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provision). This is accomplished through the mechanism of reservations. Where a party uses a reservation to opt out of a provision, that provision will not apply as between the reserving party and all other parties to the MLI. The MLI also incorporates a number of alternatives or optional provisions that generally will apply only if both contracting jurisdictions to a covered tax agreement affirmatively choose to apply them.

2. Hybrid Mismatches.

(a) The Action 2 Report, “Neutralizing the Effects of Hybrid Mismatch Arrangements,” addresses income earned through transparent entities. Article 3, paragraph 1 of the MLI reads:

“For the purposes of a Covered Tax Agreement, income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting Jurisdiction shall be considered to be income of a resident of a Contracting Jurisdiction but only to the extent that the income is treated, for purposes of taxation by that Contracting Jurisdiction, as income of a resident of that Contracting Jurisdiction.”

(b) This provision will replace treaty provisions addressing whether income derived through entities or arrangements that are treated as fiscally transparent under the laws of a contracting jurisdiction will be treated as income of a resident of a contracting state. A provision on fiscally transparent entities is not required in order to meet a minimum standard. Thus, a party may opt out of this article entirely.

(c) The BEPS Action 2 Report also describes three alternative ways in which countries may address problems arising from the inclusion of the exemption method in treaties with respect to items of income that are not taxed in the state of source. A party is permitted to choose Option A, Option B, or Option C, or to choose to apply none of the options. Where the contracting jurisdictions to a covered tax agreement each choose different options, then by default, each contracting jurisdiction would be permitted to apply its chosen option with respect to its own residents.

(d) Option A, as set forth in Article 5, paragraph 2, provides:

“Provisions of a Covered Tax Agreement that would otherwise exempt income derived or capital owned by a resident of a Contracting Jurisdiction from tax in that Contracting Jurisdiction for the purpose of eliminating double taxation shall not apply where the other

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Contracting Jurisdiction applies the provisions of the Covered Tax Agreement to exempt such income or capital from tax or to limit the rate at which such income or capital may be taxed. In the latter case, the first-mentioned Contracting Jurisdiction shall allow as a deduction from the tax on the income or capital of that resident an amount equal to the tax paid in that other Contracting Jurisdiction. Such deduction shall not, however, exceed that part of the tax, as computed before the deduction is given, which is attributable to such items of income or capital which may be taxed in that other Contracting Jurisdiction..”

(e) Option B allows the contracting jurisdictions not to apply the exemption method with respect to dividends that are deductible in the contracting jurisdiction of the payor. Option B reflects new drafting, as no provision implementing this option was drafted during the course of the work under BEPS Action 2. Option B, as set forth in Article 5, paragraph 4, provides:

“Provisions of a Covered Tax Agreement that would otherwise exempt income derived by a resident of a Contracting Jurisdiction from tax in that Contracting Jurisdiction for the purpose of eliminating double taxation because such income is treated as a dividend by that Contracting Jurisdiction shall not apply where such income gives rise to a deduction for the purpose of determining the taxable profits of a resident of the other Contracting Jurisdiction under the laws of that other Contracting Jurisdiction. In such case, the first-mentioned Contracting Jurisdiction shall allow as a deduction from the tax on the income of that resident an amount equal to the income tax paid in that other Contracting Jurisdiction. Such deduction shall not, however, exceed that part of the income tax, as computed before the deduction is given, which is attributable to such income which may be taxed in that other Contracting Jurisdiction.”

(f) Option C reflects the credit method for the elimination of double taxation. Option C is set forth in Article 5, paragraph 6, and reads as follows:

“(a) Where a resident of a Contracting Jurisdiction derives income or owns capital which may be taxed in the other Contracting Jurisdiction in accordance with the provisions of a Covered Tax Agreement (except to the extent that these provisions allow taxation by that other Contracting Jurisdiction solely because the income is also income derived by a resident of that other

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Contracting Jurisdiction), the first-mentioned Contracting Jurisdiction shall allow:

(i) as a deduction from the tax on the income of that resident, an amount equal to the income tax paid in that other Contracting Jurisdiction;

(ii) as a deduction from the tax on the capital of that resident, an amount equal to the capital tax paid in that other Contracting Jurisdiction.

“Such deduction shall not, however, exceed that part of the income tax or capital, as computed before the deduction is given, which is attributable to the income or the capital which may be taxed in that other Contracting Jurisdiction.

“(b) Where in accordance with any provision of the Covered Tax Agreement income derived or capital owned by a resident of a Contracting Jurisdiction is exempt from tax in that Contracting Jurisdiction, such Contracting Jurisdiction may nevertheless, in calculating the amount of tax on the remaining income or capital of such resident, take into account the exempted income or capital.”

3. Treaty Abuse.

(a) Purpose of a Covered Tax Agreement

i. The minimum standard for protection against the abuse of tax treaties under BEPS Action 6 requires countries to include in their tax treaties an express statement that their common intention is to eliminate double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including through treaty-shopping arrangements. This could be done by including such a statement in the preamble of tax treaties:

“Desiring to further develop their economic relationship and to enhance their co-operation in tax matters,

“Intending to eliminated double taxation with respect to taxes covered by this agreement without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this agreement for the indirect benefit of residents of third jurisdictions),”

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(b) Prevention of Treaty Abuse.

i. The Action 6 BEPS report includes three alternative rules to address situations of treaty abuse. The first of these alternatives is a generally anti-abuse rule based on the principal purpose of transactions or arrangements. In addition to the principal purpose test (“PPT”), the Action 6 report provides two versions (a simplified and a detailed version) of a specific anti-abuse rule, the limitation on benefits (“LOB”) provision, which limits the availability of treaty benefits to persons that meet certain conditions.

ii. The explanatory statement to the convention states that because that PPT is the only approach that can satisfy the minimum standard on its own, it is presented as the default option. Parties are then permitted pursuant to paragraph 6 to supplement the PPT by choosing to apply a simplified LOB provision. Given that the detailed LOB provision requires substantial bilateral customization, which would be challenging in the context of a multilateral instrument, the MLI does not include a detailed LOB provision. Instead, parties that prefer to address treaty abuse by adopting a detailed LOB provision are permitted to opt out of the PPT and agree instead to endeavor to reach a bilateral agreement that satisfies the minimum standard.

iii. The PPT provision in Article 7, paragraph 1, states:

“Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.”

(c) Dividend Transfer Transactions. Article 8, paragraph 1 requires that a minimum shareholding period be satisfied in order for a company to be entitled to a reduced rate of dividends from a subsidiary. This is based on the BEPS Action 6 Report, and adds a minimum shareholding period to provisions that exempt or limit taxation on dividends where the recipient holds more than a certain amount of the capital or voting power of the company paying the dividends.

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(d) Capital Gains from the Alienation of Immovable Property. Article 9, paragraph 1 is based on Article 13(4) of the OECD Model Tax convention, and provides:

“Provisions of a Covered Tax Agreement providing that gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or other rights of participation in an entity may be taxed in the other Contracting Jurisdiction provided that these shares or rights derived more than a certain part of their value from immovable property (real property) situated in that other Contracting Jurisdiction (or provided that more than a certain part of the property of the entity consists of such immovable property (real property)):

a) shall apply if the relevant value threshold is met at any time during the 365 days preceding the alienation; and

b) shall apply to shares or comparable interests, such as interests in a partnership or trust (to the extent that such shares or interests are not already covered) in addition to any shares or rights already covered by the provisions.”

(e) PEs in Third Jurisdictions.

i. Article 10 contains a provision addressing permanent establishments situated in third jurisdictions based on the BEPS Action 6 Report and finalized in the course of follow-up work by that working group:

“1. Where

“(a) an enterprise of a Contracting Jurisdiction to a Covered Tax Agreement derives income from the other Contracting Jurisdiction and the first-mentioned Contracting Jurisdiction treats such income as attributable to a permanent establishment of the enterprise situated in a third jurisdiction; and

“(b) the profits attributable to that permanent establishment are exempt from tax in the first-mentioned Contracting Jurisdiction,

“the benefits of the Convention shall not apply to any item of income on which the tax in the third jurisdiction is less than 60% of the tax that would be imposed in the first-mentioned Contracting Jurisdiction on that item of income if that permanent establishment were situated in the first-mentioned Contracting Jurisdiction. In such a case, any income to which the provisions of this

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paragraph apply shall remain taxable according to the domestic law of the other Contracting Jurisdiction, notwithstanding any other provisions of the Covered Tax Agreement.

“2. Paragraph 1 shall not apply if the income derived from the other Contracting Jurisdiction described in paragraph 1 is derived in connection with or is incidental to the active conduct of a business carried on through the permanent establishment (other than the business of making, managing or simply holding investments for the enterprise’s own account, unless these activities are banking, insurance or securities activities carried on by a bank, insurance enterprise or registered securities dealer, respectively).”

ii. The competent authority of the non-residence state may nevertheless grant these benefits if justified. The competent authority will consult with the other competent authority before doing so.

(f) Savings Clause.

i. Article 11, “Application of Tax Agreements to Restrict a Party’s Right to Tax Its Own Residents,” provides a so-called “saving clause” which preserves the right of a contracting state to tax its own residents, and is based on Article 1(3) of the OECD Model Tax Convention.

4. Avoidance of Permanent Establishment Status.

(a) The work on BEPS Action 7 led to changes to the definition of permanent establishment to prevent the artificial avoidance of permanent establishment status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions. The BEPS Action 7 Report also addresses the splitting-up of contracts.

(b) MLI Article 12, paragraph 1 states:

“Notwithstanding the provisions of a Covered Tax Agreement that define the term “permanent establishment”, but subject to paragraph 2, where a person is acting in a Contracting Jurisdiction to a Covered Tax Agreement on behalf of an enterprise and, in doing so, habitually concludes contracts, or habitually plays a principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are:

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“(a) in the name of the enterprise; or

“(b) for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that enterprise has the right to use; or

“(c) for the provision of services by that enterprise,

“that enterprise shall be deemed to have a permanent establishment in that Contracting Jurisdiction in respect of any activities which that person undertakes for the enterprise unless these activities, if they were exercised by the enterprise through a fixed place of business of that enterprise situated in that Contracting Jurisdiction, would not cause that fixed place of business to be deemed to constitute a permanent establishment included in the Covered Tax Agreement (as it may be modified by this Convention).”

(c) Paragraph 2 is also based on the BEPS Action 7 Report:

“Paragraph 1 shall not apply where the person acting in a Contracting Jurisdiction to a Covered Tax Agreement on behalf of an enterprise of the other Contracting Jurisdiction carries on business in the first-mentioned Contracting Jurisdiction as an independent agent and acts for the enterprise in the ordinary course of that business. Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent within the meaning of this paragraph with respect to any such enterprise.”

(d) Given that the provisions addressing artificial avoidance of permanent establishment status through commissionaire arrangements and similar strategies are not required in order to meet a minimum standard, parties are allowed to reserve the right not to apply the entirety of Article 12 to its covered tax agreements.

(e) Article 13, “Artificial Avoidance of Permanent Establishment Status through the Specific Activity Exemptions,” includes a list of exceptions (the “specific activity exemptions”) to permanent establishment status where a place of business is used solely for specifically listed activities. The work on BEPS Action 7 led to changes in the text to explicitly state that the activities listed therein will be deemed not to constitute a permanent establishment only if they are of a preparatory or auxiliary character. Some states are of the view that these activities are intrinsically

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preparatory or auxiliary and, in order to provide greater certainty for both tax administrations and taxpayers, believe that these activities should not be subject to the condition that they be of a preparatory or auxiliary character. They believe that the concern about the inappropriate use of the specific activity exemptions can be addressed through the anti-fragmentation rules.

(f) As a result there are two optional provisions. Option A, set forth in Article 13, paragraph 2, provides:

“Notwithstanding the provisions of a Covered Tax Agreement that define the term “permanent establishment”, the term “permanent establishment” shall be deemed not to include:

“a) the activities specifically listed in the Covered Tax Agreement (prior to modification by this Convention) as activities deemed not to constitute a permanent establishment, whether or not that exception from permanent establishment status is contingent on the activity being of a preparatory or auxiliary character;

“b) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any activity not described in subparagraph a);

“c) the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) and b),

“provided that such activity or, in the case of subparagraph c), the overall activity of the fixed place of business, is of a preparatory or auxiliary character.”

(g) Option B, set forth in Article 13, paragraph 3, provides:

“Notwithstanding the provisions of a Covered Tax Agreement that define the term “permanent establishment”, the term “permanent establishment” shall be deemed not to include:

“a) the activities specifically listed in the Covered Tax Agreement (prior to modification by this Convention) as activities deemed not to constitute a permanent establishment, whether or not that exception from permanent establishment status is contingent on the activity being of a preparatory or auxiliary character, except to the extent that the relevant provision of the Covered Tax Agreement provides explicitly that a specific activity shall be deemed not to constitute a permanent

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establishment provided that the activity is of a preparatory or auxiliary character;

“b) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any activity not described in subparagraph a), provided that this activity is of a preparatory or auxiliary character;

“c) the maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) and b), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.”

(h) Paragraph 4 addresses fragmentation of activities between closely related parties, and provides as follows:

“A provision of a Covered Tax Agreement (as it may be modified by paragraph 2 or 3) that lists specific activities deemed not to constitute a permanent establishment shall not apply to a fixed place of business that is used or maintained by an enterprise if the same enterprise or a closely related enterprise carries on business activities at the same place or another place in the same Contracting Jurisdiction and:

“(a) that place or other place constitutes a permanent establishment for the enterprise or the closely related enterprise under the provisions of a Covered Tax Agreement defining a permanent establishment; or

“(b) the overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, is not of a preparatory or auxiliary character,

“provided that the business activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, constitute complementary functions that are part of a cohesive business operation.”

(i) Article 15 defines a person closely related to an enterprise as follows:

“For the purposes of the provisions of a Covered Tax Agreement that are modified by paragraph 2 of Article 12 (Artificial Avoidance of Permanent Establishment Status through Commissionaire Arrangements and Similar Strategies), paragraph 4 of Article 13 (Artificial Avoidance

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of Permanent Establishment Status through the Specific Activity Exemptions), or paragraph 1 of Article 14 (Splitting-up of Contracts), a person is closely related to an enterprise if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same persons or enterprises. In any case, a person shall be considered to be closely related to an enterprise if one possesses directly or indirectly more than 50 per cent of the beneficial interest in the other (or, in the case of a company, more than 50 per cent of the aggregate vote and value of the company’s shares or of the beneficial equity interest in the company) or if another person possesses directly or indirectly more than 50 per cent of the beneficial interest (or, in the case of a company, more than 50 per cent of the aggregate vote and value of the company’s shares or of the beneficial equity interest in the company) in the person and the enterprise.”

5. Improving Dispute Resolution.

(a) The BEPS Action 14 Report contains a commitment by the jurisdictions engaged in the work to implement a minimum standard for improving dispute resolution. The Action 14 minimum standard is complemented by a set of best practices, and some elements of the Action 14 minimum standard can be satisfied and some best practices can be implemented by incorporating specific provisions into tax treaties. MLI Articles 16(1) through (3) read as follows:

“1. Where a person considers that the actions of one or both of the Contracting Jurisdictions result or will result for that person in taxation not in accordance with the provisions of the Covered Tax Agreement, that person may, irrespective of the remedies provided by domestic law of those Contracting Jurisdictions, present the case to the competent authority of either Contracting Jurisdiction. The case must be presented within three years from the first notification of the action resulting in taxation not in accordance with the provisions of the Covered Tax Agreement.

“2. The competent authority shall endeavor, if the objection appears to be justified and if it is not itself able to arrive at a satisfactory solution, to resolve the case by mutual agreement with the competent authority of the other Contracting Jurisdiction, with a view to the avoidance of taxation which is not in accordance with the Covered Tax Agreement. Any agreement reached shall be implemented notwithstanding any time limits in the domestic law of the Contracting Jurisdictions.

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“3. The competent authorities of the Contracting Jurisdictions shall endeavor to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of the Covered Tax Agreement. They may also consult together for the elimination of double taxation in cases not provided for in the Covered Tax Agreement.”

(b) BEPS Action 14 requires as a minimum standard the inclusion of MLI Articles 16(1) through (3). Article 16(5), however, recognizes that parties are permitted to implement the minimum standard through administrative measures. Thus, Article 16(5) provides reservations from Articles 16(1) and (2) to reflect this variation.

(c) Article 16(5) also allows a party to opt out of replying the first sentence of Article 16(1), and thus to not modify the relevant covered tax agreement to allow the taxpayer to present a case to the competent authority of either Contracting Jurisdiction. Such a reservation is allowed only on the basis that for the purposes of each of its covered tax agreements, the taxpayer may present its case to the competent authority of the Contracting Jurisdiction of which it is a resident and that Contracting Jurisdiction will implement a bilateral notification or consultation process with the competent authority of the other Contracting Jurisdiction for cases presented by the taxpayer to its competent authority in which its competent authority does not consider the taxpayer’s objection to be justified.

(d) Article 17 implements the minimum standard requirement that jurisdictions should provide access to the mutual agreement procedure in transfer pricing cases and should implement the resulting mutual agreements by making appropriate adjustments to the tax assessed. The BEPS Action 14 Report noted that it would be more efficient if jurisdictions also had the possibility to provide for corresponding adjustments unilaterally in cases in which they find the objection of the taxpayer to be justified.

(e) Part VI of the MLI is intended to apply only between parties that explicitly choose to apply it. In Part VI, Article 19 deals with mandatory binding arbitration.

(f) Paragraph 1 contains the core arbitration provision. It provides that, where the competent authorities are unable to reach an agreement on a case pursuant to the mutual agreement procedure in the covered tax agreement within a period of two years, unresolved issues will, at the request of the person who presented the case, be submitted to arbitration. The mutual agreement procedure is

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available to taxpayers irrespective of the judicial and administrative remedies provided by the domestic law of the Contracting Jurisdictions.

(g) An arbitration decision will be binding on both Contracting Jurisdictions except in three situations: (1) if a person directly affected by the case does not accept the mutual agreement that implements the arbitration decision; (2) if the arbitration decision is held to be invalid by a final decision of the courts of one of the Contracting Jurisdictions; and (3) if a person directly affected by the case pursues litigation in any court or administrative tribunal on the issues which were resolved in the mutual agreement implemented in the arbitration decision.

(h) Article 20 sets forth basic rules for the composition of an arbitration panel and the appointment and qualifications of the arbitrators. Article 21 is entitled “Confidentiality of Arbitration Proceedings.” Article 23 describes the “Type of Arbitration Process.” By default, a “final offer” arbitration process (otherwise known as “last best offer” arbitration) will apply, except to the extent that the competent authorities mutually agree on different rules.

6. Other.

(a) The remaining MLI provisions, set forth in Part VII, deal with matters such as signature and ratification, acceptance or approval, reservations, notifications, subsequent modifications of covered tax agreements, interpretations and implementation, and entry into force.

7. Adoption of the MLI.

(a) On November 24, 2016, the OECD announced that more than 100 jurisdictions had concluded negotiations on the MLI. According to the announcement, the MLI will transpose the results from the OECD/G20 BEPS project into more than 2,000 tax treaties worldwide. A signing ceremony is to be held in June 2017.

(b) The MLI is now open for signature (as of December 31, 2016). By its terms, the MLI will enter force after ratification by at least five countries. Once in effect, the MLI will affect the operation of existing bilateral treaties that are explicitly designated, provided the respective treaty partners have ratified the MLI, and satisfied any domestic ratification or approval requirements.

(c) Angel Gurria, the OECD Secretary-General, stated that “having more than 100 jurisdictions on board will help ensure consistency

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in the implementation of the BEPS Project, which will result in more certainty and predictability for businesses, and a better functioning international tax system for the benefit of our citizens.”

(d) Despite the laudable goals of the MLI, it remains to be seen just how much consistency and predictability can be achieved via the MLI. By necessity, the MLI was structured to provide a fair amount flexibility in terms of offering minimum standards, options, and the ability for countries to opt out of certain provisions. This flexibility, while a necessary consequence of having to accommodate the wide ranging views and positions of the participating countries, will undoubtedly reduce the level of consistency and predictability that the OECD is hoping to achieve.

(e) Responding to questions regarding the adoption of the MLI by countries, Pascal Saint-Amans noted that the core of the MLI is Action 6 on treaty abuse, and that all countries are expected to take steps on Action 6. However, the rest of the MLI is considered optional, and subject to the choice of individual countries. Although Pascal noted that the overall response appeared to be fairly positive from what he has seen so far, that will have to be confirmed in the coming weeks as countries get more specific with their reservations on the MLI. (See report by Stephanie Soong Johnston, 2017 WTD 18-1).

(f) The OECD recently held a “speed dating” event at which 55 nations met with treaty partners in over 300 meetings to discuss different options available under the MLI. According to Grace Perez-Navarra of the OECD, additional discussions are now being held remotely in advance of the signing ceremony planned for June 7, 2017. Although the total number of participants of the MLI won’t be clear until the June 7 signing ceremony, the OECD expects at least 60 countries to sign the MLI.

(g) According to Gita Kothari, a senior legal advisor with the OECD, more than 25 countries have agreed to apply the mandatory binding arbitration provision in the MLI.

(h) The U.S. is not expected to sign the MLI, due to limited interest in the provisions included in the MLI, and expected difficulty in gaining ratification in the Senate. Michael McDonald, an economist at Treasury, stated in particular that the U.S. is concerned that the MLI’s changes to the PE rules could result in finding PEs with very little profits, and consequently the U.S. does not plan on adopting the OECD position in the MLI.

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(i) The U.K. has decided to reserve on the new changes to the PE rules. Timothy Power from the UK treasury agency stated that the U.K. does not plan to adopt the majority of the rule changes regarding avoidance of PE.

(j) Developing countries may view certain aspects of the MLI with suspicion, and may be less inclined to sign onto certain aspects of the MLI and BEPS action items. (See article by Ryan Finley, 2017 WTD 51-4).

i. According to an analysis released by the BEPS Monitoring Group, which has argued that the BEPS recommendations are inadequate and favor developed countries, developed countries should generally follow the MLI in their bilateral tax treaties, but should opt out of the articles on transfer pricing adjustments and mandatory binding arbitration.

ii. The paper sharply criticizes countries pushing for mandatory binding arbitration, which is optional under the MLI and has been a point of disagreement between developed and developing countries. The proposed arbitration process will systematically advantage developed countries with more resources and sophistication, and the confidentiality of the proceedings undermines the legitimacy of the process.

iii. According to the paper, the requirement that states allow a corresponding downward adjustment to offset an upward transfer pricing adjustment in other contracting states, which seems reasonable at first glance, in practice will prevent developing countries from setting transfer pricing rules best-situated to their needs and potentially force them into dispute resolution procedures that favor developed countries.