volume 103, number 5 august 2, 2021

Volume 103, Number 5 � August 2, 2021

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TAX NOTES INTERNATIONAL, VOLUME 103, AUGUST 2, 2021 545

Volume 103 Number 5tax notes international®

CONTENTS

547 FROM THE EDITOR

HIGHLIGHTS

549 Final Regs Clarify PFIC Rules On Qualifying Insurance Companiesby Carrie Brandon Elliot

562 Digital and Space Taxation: How Pillar 1 Endangers the Next Frontierby Mindy Herzfeld

LETTERS TO THE EDITOR

567 Americans Abroad Should Also Pay For the Benefits of Citizenshipby Martin Lobel

COMMENTARY & ANALYSIS

569 U.S. Tax Review: International Tax Reform, Reverse Clawbacks, and GILTIby James P. Fuller and Larissa Neumann

573 Addressing an Opaque Foreign Income Subsidy With Expense Disallowanceby Stephen E. Shay

597 Amount A: The G-20 Is Calling the Tune, And U.S. Multinationals Will Pay The Piperby Kartikeya Singh

VIEWPOINT

603 Curtail U.S. PTEP Reporting Complexity: Know Your P’s and Q’sby Lewis J. Greenwald, Brainard L. Patton, and Brendan Sinnott

611 The Future of Transfer Pricingby Elizabeth J. Stevens and Niraja Srinivasan

TAX HUMOR

617 Tax Accounting Challengeby Peter Mason

COUNTRY DIGEST

Australia

619 Australia’s Crown Resorts Pays $45 Million Toward Tax Liability

Belgium

620 Belgium Sues U.S. Pension Plans Over Dividend Withholding Scheme

Canada

621 Canada to Examine Allegations of Bias In Charity Audits

European Union

622 EU Pushes Back Against Trading Partner Criticism of CBAM

Germany

623 Germany’s High Court Upholds Cum-Ex Convictions and Fines

Hungary

624 Hungary Flags Global Minimum Tax Base Plan Concerns

India

626 Indian Raids Uncover Alleged Tax Evasion on $94 Million of Income

627 India’s Income Tax Department Ramps Up Anti-Evasion Efforts

Ireland

628 Ireland Must Cut Capital Gains Tax Amid OECD Reforms, Group Says

ON THE COVER

558 The EU’s Cryptoasset Tax Strategy Needs Coordinationby Nana Ama Sarfo

Cover photo: [email protected]




CONTENTS

546 TAX NOTES INTERNATIONAL, VOLUME 103, AUGUST 2, 2021

Korea (R.O.K.)

629 South Korea Proposes Tax Breaks For Key Technology

Multinational

630 Latest Corporate Data Show Need For Global Tax Deal, OECD Says

632 Most Favored Nation Clauses Problematic for Developing Countries

633 OECD’s New Round of Action 14 Peer Reviews Reports Mixed Progress

634 Google Confirms New Fees Linked To Indian, Italian Digital Taxes

Singapore

635 Wealth Tax Could Lower Inequality, Singapore Monetary Head Says

Switzerland

636 Swiss Close Probe Into Alleged Russian Money Laundering

United Kingdom

637 HMRC May Challenge Compound Interest Claims, U.K. Court Finds

638 U.K. Tax Bodies Urge Caution On Tax Payments Reform

639 U.K. Government Urged To Simplify Brexit Support for SMEs

640 HMRC Clears Liquor Giant of £277 Million Bill From State Aid Case

641 Fewer Than 2 Million People Remain On HMRC’s Furlough Scheme

642 U.K. Court Denies Royal Mail Customers’ Demands for VAT Invoices

United States

644 Coming FTC Regs Will Be Divided In Two

645 Many Big U.S. Corporations Paid No Taxes After TCJA, Report Says

646 DOJ, Taxpayers Spar on Appeal Of Transition Tax Constitutionality

649 Tax Court Finds Fraud in UBS Document Disclosure

651 Second Computer Sciences Tax Court Dispute Centers on $30 Million NOL

652 Loss From LLC’s Related-Party Transaction Denied

654 Second Circuit Hands Government Win On Foreign Trust Penalties

656 IRS Authorized to Seek Records Regarding Panamanian Law Firm

657 TAX CALENDAR

THE LAST WORD

661 Should U.S. Manufacturers Worry About CBAM?by Robert Goulder





tax notes international®

FROM THE EDITOR

Tax Policy Can’t Keep Pace With TechnologyChanges in technology continue to outpace tax authorities’ ability to issue

regulations. For the IRS, the problem is twofold: Its own computer systems are outdated, and the agency is often a step behind on addressing tax issues related to digital innovations. In the European Union, tax reporting and enforcement is haphazard because of a lack of coordination of regulations across the bloc, especially those pertaining to the digital economy. The EU’s new consultation on cryptoassets could further muddy the waters.

Nana Ama Sarfo examines the EU’s upcoming DAC8 proposal, which seeks to extend EU tax reporting rules to cryptoassets (p. 558). The consultation raises basic questions, such as how to define cryptoassets for legal purposes. A bigger problem is one of coordination: How would DAC8 fit alongside similar efforts underway at the OECD and the Financial Action Task Force? A related issue is how the cryptoassets regulation would complement the anti-money-laundering and anti-tax-evasion directives.

Mindy Herzfeld addresses a similar theme this week (p. 562). She argues that the solutions for updating the international tax rules for digital transactions will soon be outdated as other technologies emerge. She believes that Jeff Bezos’s recent foray into space provides a window into the future, and urges tax policymakers to begin thinking about how to tax income from space activities.

Also in this issue, Kartikeya Singh analyzes how the scoping criteria of amount A under the OECD’s pillar 1 proposal would affect U.S. and non-U.S. multinational enterprises (p. 597). Lewis J. Greenwald, Brainard L. Patton, and Brendan Sinnott consider changes to U.S. documentation requirements for previously taxed earnings and profits, and suggest how to lessen the compliance burden (p. 603).

The future is bright for transfer pricing professionals. Elizabeth Stevens and Niraja Srinivasan review a new educational outreach program for students interested in pursuing transfer pricing careers (p. 611).

Innovated [email protected]






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HIGHLIGHTS

NEWS ANALYSIS

Final Regs Clarify PFIC Rules On Qualifying Insurance Companiesby Carrie Brandon Elliot

New regs issued under sections 1291, 1297, and 1298 (T.D. 9936) clarify whether a foreign corporation is treated as a passive foreign investment company and whether a U.S. person that indirectly owns stock in a PFIC is treated as a shareholder.

Final regs issued January 15 (and corrected on March 5 and March 10) retained the basic approach and structure of proposed regs issued on July 11, 2019 (REG-105474-18). The final regs contain revisions to several of the rules, including the rules that clarify when an exception to passive income applies to insurance businesses. Proposed regs also issued January 15 (not yet finalized) contain additional revisions to the insurance exception rules in reg. section 1.1297-4, -5, and -6 (REG-111950-20).

Passive Foreign Investment Companies

PFICs are defined and taxed under sections 1291-1298. If a foreign corporation meets the definition of a PFIC, its U.S. shareholders must pay tax and interest on income from PFIC distributions or gain from PFIC stock dispositions as if it were distributed ratably on each day of the shareholder’s holding period.

PFICs are generally foreign corporations with at least 75 percent passive income or at least 50 percent of total assets generating passive income. The PFIC regime was enacted in 1986 to eliminate tax deferral on passive earnings of foreign corporations whether or not closely held. Without a qualified electing fund election, PFIC status can discourage distributions. Under the PFIC code provisions:

• section 1291 imposes an interest charge on a PFIC’s tax deferral;

• section 1293 addresses taxation on income of QEFs;

• section 1294 provides an election to extend time for payment of tax on undistributed earnings;

• section 1295 contains guidance on QEFs;• section 1296 contains a mark-to-market

election for PFIC stock;• section 1297 defines PFIC; and• section 1298 contains an assortment of

special PFIC rules.

The new regs amend existing regs and add new ones that:

• clarify ownership attribution rules in reg. section 1.1291-1(b) that treat U.S. persons as shareholders of PFICs;

• clarify the definition of a PFIC in reg. section 1.1297-1;

• provide rules related to look-through subsidiaries and partnerships in reg. section 1.1297-2;

• clarify treatment of qualifying insurance corporations (QICs) in reg. section 1.1297-4;

• clarify the exception to passive income treatment for active insurance income in reg. section 1.1297-5 and -6; and

• provide guidance on treatment of foreign corporations owning stock in 25-percent-owned domestic corporations in reg. section 1.1298-4.

Reg. section 1.1297-4(g) provides that these rules generally apply to shareholder tax years beginning on or after January 14, 2021. However, a shareholder may apply these rules for any open year beginning after December 31, 2017, and before January 14, 2021, if it consistently applies reg. section 1.1297-4 and -6 for that earlier year and all subsequent years.

This article will address the rules in reg. section 1.1297-4 that clarify the exception to passive income of QICs in section 1297(f). The final regs reserve reg. section 1.1297-5 and include reg. section 1.1297-6(a)-(f). The 2021 proposed regs revise the provisions in prop. reg. section 1.1297-5 and reg. section 1.1297-4 and -6.

Before its amendment by the Tax Cuts and Jobs Act, section 1297(b)(2)(B) generally provided




HIGHLIGHTS


that passive income did not include investment income derived in the active conduct of an insurance business by a corporation that was predominantly engaged in an insurance business and that would be subject to tax under subchapter L if it were a domestic corporation. Congress was concerned about a lack of clarity and precision in the PFIC insurance exception that made it difficult to enforce, especially in terms of the amount of insurance or reinsurance business a company must conduct to qualify for the exception.

To address these concerns, the TCJA modified the PFIC insurance exception so that passive income does not include investment income derived in a QIC’s active insurance business. For tax years beginning after December 31, 2017, the PFIC insurance exception provides that a foreign corporation’s income attributable to an insurance business will not be passive income if:

• the foreign corporation is a QIC as defined in section 1297(f);

• the foreign corporation is engaged in an insurance business; and

• the income is derived from the active conduct of that insurance business.

The new regs that clarify the insurance business exception accompany section 1297. Section 1297(a) defines a PFIC as a foreign corporation if:

• 75 percent or more of the corporation’s gross income for the tax year is passive income; or

• at least 50 percent of the corporation’s assets (as determined under section 1297(e)) during the tax year produce passive income or are held to produce passive income.

Section 1297(b)(1) defines passive income as any income that would be foreign personal holding company income as defined in section 954(c) for subpart F. The section 1297(b)(2)(A)-(D) four exceptions to passive income are:

• income from a banking business;• income from an insurance business;• interest, dividends, rents, or royalties from a

related person that are allocable to non-passive income; and

• export trade income of an export trade corporation.

Specifically, passive income does not include income derived in the active conduct of an

insurance business by a QIC (as defined in section 1297(f)). Section 1297(f)(1)-(4) defines QIC for the section 1297(b)(2)(B) second exception to passive income for insurance businesses.

Section 1297(f)

Section 1297(f)(1) defines a QIC as a foreign corporation:

• that would be subject to tax under subchapter L (sections 801-848) if it were a domestic corporation; and

• that has applicable insurance liabilities that constitute more than 25 percent of its total assets (as reported on the corporation’s applicable financial statement).

Section 1297(f)(2) provides an alternative facts and circumstances test for corporations that fail to qualify as QICs solely because their applicable insurance liabilities constitute 25 percent or less of their total assets. U.S. persons that own stock in these corporations may elect to treat them as QICs if:

• their applicable insurance liabilities constitute at least 10 percent of their total assets; and

• based on the applicable facts and circumstances:• the corporation is predominantly engaged

in an insurance business; and• its failure to meet the more-than-25-

percent threshold is only because of runoff-related or rating-related circumstances involving the insurance business.

Section 1297(f)(3) defines applicable insurance liabilities for both tests to mean the loss and reserve expenses of life or property and casualty insurance. More specifically, applicable insurance liabilities include:

• loss and loss adjustment expenses;• reserves for life and health insurance risks

(other than deficiency, contingency, or unearned premium reserves); and

• reserves for life and health insurance claims from contracts providing coverage for mortality or morbidity risks.

Section 1297(f)(3)(B) limits applicable insurance liabilities to the lesser of:




HIGHLIGHTS


• the amount reported to the applicable insurance regulatory body in the applicable financial statement;

• the amount required by applicable law or regulation; or

• the amount prescribed in regulations.

Finally, section 1297(f)(4) defines applicable financial statement and applicable insurance regulatory body.

Under section 1297(f)(4)(A), an applicable financial statement is a financial reporting statement prepared under the following ordering rules:

• first, made under generally accepted accounting principles;

• second, made under international financial reporting standards, but only if there is no statement that meets the GAAP requirement; or

• third, except as otherwise provided in regs, the annual statement filed with the applicable insurance regulatory body, but only if there is no statement which meets the GAAP or IFRS requirements.

Finally, section 1297(f)(4)(B) defines applicable insurance regulatory body to mean the entity established by law to license, authorize, or regulate insurance businesses and to which the applicable financial statement is provided.

Reg. Section 1.1297-4

Reg. section 1.1297-4(a)-(g) supplements the insurance exception rules in section 1297(f)(1)-(4). Reg. section 1.1297-4(a) contains a useful overview that describes reg. section 1.1297-4 rules for determining whether a foreign corporation is a QIC for section 1297(f). The guidance includes:

• the general rule for determining whether a foreign corporation is a QIC;

• a description of the 25 percent test in section 1297(f)(1)(B);

• rules for applying the alternative facts and circumstances test in section 1297(f)(2);

• rules limiting the amount of applicable insurance liabilities for both the 25 percent test and the alternative facts and circumstances test;

• definitions; and• the applicability date.

This article focuses on the provisions in the final regs that clarify the section 1297(f)(1) 25 percent test.

Reg. section 1.1297-4(b)(1) and (2) define QIC by repeating the language in section 1297(f)(1) and (2). This QIC definition applies for section 1297(b)(2)(B) and reg. section 1.1297-4 (QIC definition), -5 (active conduct of an insurance business), and -6 (qualifying domestic insurance corporations). A QIC is a foreign corporation that is an insurance company as defined in section 816(a) that would be subject to tax under subchapter L if the corporation were a domestic corporation, and satisfies:

• the 25 percent test described in reg. section 1.1297-4(c); or

• the requirements for an election by a U.S. person to apply the alternative facts and circumstances test described in reg. section 1.1297-4(d).

Reg. section 1.1297-4(c) provides that a foreign corporation satisfies the 25 percent test if its applicable insurance liabilities exceed 25 percent of its total assets. This determination is made by reference to the applicable insurance liabilities and total assets reported on the corporation’s applicable financial statement for the applicable reporting period.

Reg. section 1.1297-4(d)(1)-(6) clarifies the election to apply the alternative facts and circumstances test and will be the subject of a future article.

Reg. section 1.1297-4(e)(1)-(3) has rules limiting the amount of applicable insurance liabilities for determining whether a foreign corporation satisfies the 25 percent or 10 percent alternate test. Reg. section 1.1297-4(e) says that applicable insurance liabilities may not exceed any of the three amounts in reg. section 1.1297-4(e)(2)(i)-(iii). The limits in reg. section 1.1297-4(e)(2) apply after the discounting requirements in reg. section 1.1297-4(e)(3). The liability limits are:

(i) applicable insurance liabilities may not exceed the amount of liabilities shown on any financial statement that the foreign corporation filed or was required to file with its applicable insurance regulatory body;




HIGHLIGHTS


(ii) if the applicable financial statement is prepared under either GAAP or IFRS, applicable insurance liabilities may not exceed the amount of the applicable insurance liabilities in the applicable financial statement, whether or not the foreign corporation files the statement with its applicable insurance regulatory body; or

(iii) applicable insurance liabilities may not exceed the amount of liabilities required by the laws or regs of the insurance regulatory body’s jurisdiction at the end of the reporting period (or a lesser amount of liabilities if the foreign corporation is holding a lesser amount as a permitted practice of the regulatory body).

Reg. section 1.1297-4(e)(3) addresses discounting. If an applicable financial statement or a financial statement described in reg. section 1.1297-4(e)(2) is prepared on the basis of an accounting method other than GAAP or IFRS and does not discount insurance liabilities on an economically reasonable basis, the amount of applicable insurance liabilities may not exceed the amount on the financial statement reduced by applying the discounting methods in either GAAP or IFRS to the insurance or annuity contracts to which the applicable insurance liabilities relate. The foreign corporation may choose whether to apply either GAAP or IFRS discounting methods for this.

Reg. section 1.1297-4(e)(4) and (5) are reserved in the final regs, but the 2021 proposed regs include further provisions under these headings that require asset adjustments for the 25 percent and 10 percent tests and include an example.

Reg. section 1.1297-4(f)(1)-(11) contains definitions. Reg. section 1.1297-4(f)(1) defines applicable financial statement as the foreign corporation’s financial statement prepared for financial reporting, as listed below with the highest priority. The financial statements in order of descending priority are:

• a financial statement prepared in accordance with GAAP;

• a financial statement prepared in accordance with IFRS; or

• a regulatory annual financial statement required to be filed with the applicable insurance regulatory body.

Reg. section 1.1297-4(f)(2) defines applicable insurance liabilities, regarding any life insurance or property and casualty insurance business to include:

• Reported losses and incurred but not reported losses. Reported losses are expected payments to policyholders for losses related to insured events that have occurred and have been reported to, but not paid by, the insurer as of the financial statement end date. Incurred but not reported losses are expected payments to policyholders for losses relating to insured events that have occurred but have not been reported to the insurer as of the financial statement end date.

• Unpaid loss adjustment expenses (including reasonable estimates of loss adjustment expenses) associated with investigating, defending, settling, and adjusting paid losses, unpaid reported losses, and incurred but not reported losses as of the financial statement end date.

• The aggregate amount of reserves (excluding deficiency, contingency, or unearned premium reserves) held as of the financial statement end date to mature or liquidate future claims for death, annuity, or health benefits that may become payable, at the time the reserve is computed, under contracts providing coverage for mortality or morbidity risks.

The reg. section 1.1297-4(f)(2)(i)(D)(1) and (2) caveats that apply to the definition of applicable insurance liabilities include:

• no item or amount can be taken into account more than once in determining applicable insurance liabilities; and

• the applicable insurance liabilities eligible for consideration under reg. section 1.1297-4(f)(2) include only the applicable insurance liabilities of the foreign corporation whose QIC status is being determined.

Reg. section 1.1297-4(f)(2)(ii) provides that amounts not specified above in reg. section 1.1297-4(f)(2)(i) are not applicable insurance




HIGHLIGHTS


liabilities. For example, the term “applicable insurance liability” does not include any amount held as a deposit liability that is not an insurance liability, such as a funding agreement, a guaranteed investment contract, premium or other deposit funds, structured settlements, or any other substantially similar contracts issued by an insurance company. The term “applicable insurance liability” also does not include any reserve for a life insurance or annuity contract requiring payments that do not depend on the life or life expectancy of one or more individuals.

Reg. section 1.1297-4(f)(3) defines applicable insurance regulatory body to mean the entity that has been established by law to license or authorize a corporation to engage in an insurance business, to regulate insurance company solvency, and is the entity to which an applicable financial statement is provided.

Reg. section 1.1297-4(f)(4) defines applicable reporting period to mean the last annual reporting period for a financial statement ending with or within the tax year of a U.S. person owning stock in a foreign corporation (within the meaning of reg. section 1.1297-4(d)(6), which cross-references the indirect PFIC shareholder rules in reg. section 1.1291-1(b)(8) without regard to the 50 percent ownership limit in reg. section 1.1291-1(b)(8)(ii)(A)).

Reg. section 1.1297-4(f)(5) defines financial guaranty insurance company as any insurance company whose sole business is to insure or reinsure only the type of business written by a company licensed under a U.S. state law modeled after the Financial Guaranty Insurance Guideline (as established by National Association of Insurance Companies) that specifically governs the licensing and regulation of financial guaranty insurance companies.

Reg. section 1.1297-4(f)(6) defines financial statement generally as a statement prepared for a legal entity for a reporting period in accordance with the rules of a financial accounting or statutory accounting standard that includes a balance sheet, income statement, and cash flow statement (or equivalent statements under the applicable reporting standard).

Reg. section 1.1297-4(f)(8) defines insurance business for reg. section 1.1297-4, -5, and -6. Insurance business is the business of issuing

insurance and annuity contracts and reinsuring risks underwritten by insurance companies, together with the investment activities and administrative services that are required to support insurance, annuity, or reinsurance contracts issued or entered into by the foreign corporation.

Reg. section 1.1297-4(f)(10) defines mortgage insurance company to mean any insurance company whose sole business is to insure or reinsure against a lender’s loss of all or a portion of the principal amount of a mortgage loan upon default of the mortgagor.

Finally, reg. section 1.1297-4(f)(11) defines a foreign corporation’s total assets as the aggregate fair market value of the real property and personal property that the foreign corporation reports on its applicable financial statement as of the financial statement end date.

Preamble

The final regs’ preamble contains further insight on the definition of QICs, including guidance on the definitions of applicable insurance liabilities and applicable financial statements.

The final regs preamble recounts the rules in section 1297(f) defining a QIC as a foreign corporation that would be subject to tax under subchapter L if it were a domestic corporation and has either:

• applicable insurance liabilities constituting more than 25 percent of its total assets on its applicable financial statement; or

• meets an elective alternative facts and circumstances test that lowers the applicable insurance liability ratio to 10 percent.

Applicable Insurance Liabilities

The 25 percent test in section 1297(f)(1)(B) requires that the ratio of a foreign corporation’s applicable insurance liabilities to total assets exceed 25 percent. Section 1297(f)(3)(A) defines applicable insurance liabilities as loss, loss adjustment expenses, and reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance risks and claims under contracts providing coverage for mortality or morbidity risks (morbidity generally




HIGHLIGHTS


refers to states of disease, and mortality refers to death).

The 2019 proposed regs provided that for any life or property and casualty insurance business of a foreign corporation, applicable insurance liability is:

• occurred losses for which the foreign corporation has become liable but has not paid before the end of the last annual reporting period ending with or within the tax year, including unpaid claims for death benefits, annuity contracts, and health insurance benefits;

• unpaid expenses (including reasonable estimates) of investigating and adjusting unpaid losses described above; and

• the aggregate amount of reserves (excluding deficiency, contingency, or unearned premium reserves) held for future, unaccrued health insurance claims and claims under contracts providing coverage for mortality or morbidity risks, including annuity benefits dependent upon the life expectancy of one or more individuals.

Comments requested that the term “occurred losses” be changed because it is not an industry standard term. Some comments suggested that the word “occurred” be replaced with the word “incurred” or “unpaid” and be clarified to explicitly include incurred but not reported losses.

Other comments suggested that the term “occurred losses” be defined as it is used in the U.S. code, U.S. regulatory statements, or under GAAP or IFRS. Two comments also requested clarification that unpaid loss adjustment expenses related to both paid and unpaid losses be included in the definition of applicable insurance liability.

Treasury and the IRS agreed that further clarification of the 2019 proposed regs’ definition of applicable insurance liability was necessary. While still covering only losses that have occurred, the final regs clarify the definition of applicable insurance liability to include incurred losses (both reported and unreported) and unpaid loss adjustment expenses on all incurred losses (whether the losses are paid or unpaid).

Suggestions from commentators varied on items that should be included in the definition of

applicable insurance liability. For example, applicable insurance liabilities should include both insurance liabilities and loss reserves as reported on an applicable financial statement (without further modification). Alternatively, paid losses and paid loss adjustment expenses should be included as applicable insurance liabilities even though they have been paid and, as a result, do not appear as liabilities on the applicable financial statement.

Commentators also requested special rules for financial guaranty insurers and mortgage guaranty insurers. Financial guaranty insurers should be permitted to include in losses the greater of:

• the aggregate amount of reserves (excluding deficiency, contingency, or unearned premium reserves) held for future unaccrued insurance claims; or

• the average losses incurred for policies over the previous 10 years of the life of the policy, whichever is shorter.

Commentators suggested that the 25 percent test be waived for a foreign corporation engaged in the business of mortgage insurance and reinsurance if at least 80 percent of its net written premiums are derived from mortgage guaranty insurance (or reinsurance), and its gross investment income is less than 50 percent of its net written premiums as reported on its applicable financial statement.

The final regs do not adopt the suggestion that paid losses or paid loss adjustment expenses be treated as applicable insurance liability or the proposed rules for financial guaranty insurers and mortgage guaranty insurers. These suggestions are contrary to the statute and congressional intent.

Section 1297(f) is limited to amounts that constitute liabilities, while losses and loss adjustment expenses that have been paid are no longer liabilities and therefore do not qualify as applicable insurance liabilities. Further, when losses and loss adjustment expenses are paid, assets are reduced. It would not be appropriate to include loss and loss adjustment expense amounts in the numerator of the 25 percent test (or the alternative facts and circumstances test) when the corresponding assets are no longer




HIGHLIGHTS


reported on the applicable financial statement and included in the denominator.

The statute also requires that liabilities include only insurance liabilities but excludes some insurance liabilities that may be included in a financial statement, such as unearned premium reserves, contingency reserves, and deficiency reserves. For example, section 1297(f)(3)(A) provides that unearned premium reserves for any type of risk are not treated as applicable insurance liabilities. Therefore, reg. section 1.1297-4(f)(2)(ii) provides that liabilities not within the definition of applicable insurance liability are not included in the numerator of the 25 percent test (or the alternative facts and circumstances test).

Section 1297(f)(3) specifies that amounts that are not insurance liabilities are also not applicable insurance liabilities, like liabilities related to non-insurance products issued by insurance companies that may be treated as debt, such as deposit arrangements, structured settlements, and guaranteed investment contracts.

The statute also does not contemplate averaging liabilities over a multiyear period because section 1297(f)(1)(B) requires an annual calculation by looking to the foreign corporation’s applicable financial statement for the last year ending with or within the tax year. Therefore, the final regs do not include special rules for specialty insurers that would either require multiyear averaging or disregard the liability requirement.

Section 1297(f) contemplates that QIC status is determined on an entity-by-entity basis. Therefore, reg. section 1.1297-4(f)(2)(i)(D)(2) clarifies that the liabilities eligible to be considered in determining applicable insurance liabilities include only the liabilities of the foreign corporation whose QIC status is being determined.

For example, if a parent and subsidiary both issue insurance contracts to unrelated parties and the applicable financial statement is a combined financial statement, the applicable insurance liabilities of the parent and subsidiary must be separately determined. The liabilities of each include only the liabilities from the contracts that each has issued (without regard to contracts issued by the other party). This rule is consistent with reg. section 1.1297-4(f)(2)(i)(D)(1), which

provides that no item may be taken into account more than once.

Reporting Standard Conformity

Section 1297(f)(4) says that a foreign corporation can use GAAP, IFRS, or the accounting standard used for the annual statement filed with the local regulator as the starting point to determine applicable insurance liabilities (if a statement using GAAP or IFRS is not available). The annual statement filed with the local regulator may use local statutory accounting standards.

Treasury and the IRS are aware that GAAP, IFRS, and local statutory accounting sometimes have different categories, nomenclature, and methods of measuring losses and reserves for insurance companies. The final regs define applicable insurance liability more specifically so that only those liabilities that meet the regulatory definition are included in applicable insurance liability notwithstanding differences in nomenclature and methods among different financial reporting standards.

The starting point for determining the amount of applicable insurance liabilities should usually be the applicable financial statement balance sheet. However, it may be necessary to disaggregate components of balance sheet liabilities to determine the liabilities that meet the definition of applicable insurance liabilities.

For example, the International Accounting Standards Board issued new accounting standard IFRS 17 that applies to insurance contracts. Its effective date was originally January 1, but that has been deferred to January 1, 2023. Some companies may have already adopted IFRS 17 for financial reporting purposes on an optional basis.

IFRS 17 generally does not use the terms “unpaid losses,” “loss adjustment expenses,” or “unearned premium reserves” on its balance sheet. Instead, those amounts are included in the overall insurance liabilities on the balance sheet and are required to be separately identified in the notes as “liability for incurred claims” and “liability for remaining coverage.” While they bear different names, they are intended to be substantially the same in concept to claims reserves and unearned premium reserves.




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It is therefore expected that a foreign corporation using IFRS 17 will include only those amounts on the balance sheet that fall within the final reg’s definition of applicable insurance liability. Similarly, a foreign corporation using IFRS 17 (or any other financial reporting standard) is expected to exclude contingency reserves and deficiency reserves (in addition to unearned premium reserves) from applicable insurance liabilities, even when those categories do not separately appear on the balance sheet as a liability and are included within another line item.

Treasury and the IRS recognize that IFRS 17 is a new accounting standard that may raise questions on how to derive amounts relevant to the PFIC insurance exception from an applicable financial statement prepared in accordance with IFRS 17. Similar questions may also arise with respect to financial statements prepared using GAAP and local statutory accounting as standards evolve. Treasury and the IRS request comments on whether further guidance is necessary to clarify how applicable insurance liabilities are determined or how to make adjustments to ensure that similarly situated taxpayers are treated similarly without regard to the financial reporting standard adopted by the foreign corporation.

Insurance Liability Limitation Mechanics

The 2019 proposed regs provided rules limiting the amount of applicable insurance liabilities for the 25 percent test and the 10 percent alternative facts and circumstances test. It stated that applicable insurance liabilities may not exceed the lesser of:

• applicable insurance liabilities shown on the most recent applicable financial statement;

• the minimum applicable insurance liability required by the applicable law or regulation of the applicable insurance regulatory body jurisdiction; or

• applicable insurance liabilities reported on the most recent GAAP or IFRS financial statement if the financial statement was not prepared for financial reporting purposes.

Commentators requested changes to the second limitation (the minimum applicable insurance liability required by the jurisdiction).

The reference to a “minimum amount” is either redundant (because the amount required by law or regulation will always be a minimum amount) or ambiguous (because it could mean a hypothetical minimum amount required for any insurer without regard to its particular circumstances).

The 2019 proposed regs also did not take into account applicable insurance liabilities actually reported to the regulatory body if lower than the minimum required amount (which local regulators sometimes allow as a permitted practice). The minimum amount required under law or regulation should be determined by reference to GAAP or IFRS requirements.

Commentators also expressed concerns about the third limitation amount in the proposed regs (applicable insurance liabilities on the most recent GAAP or IFRS financial statement not prepared for financial reporting purposes). A statement not prepared for financial reporting is potentially unreliable and should not be used as a basis for determining applicable insurance liabilities. Also, further guidance on the meaning of “financial statement” and “financial reporting standard” is necessary.

In response to these concerns, the final regs provide that a foreign corporation’s applicable insurance liability may not exceed the lesser of:

• the amount shown on any financial statement filed with the insurance regulatory body for the same reporting period covered by the financial statement;

• the amount determined on the basis of the most recent GAAP- or IFRS-applicable financial statement regardless of whether the financial statement is filed with the regulatory body; or

• the amount required by the law or regulation of the regulatory body jurisdiction (or lower amounts allowed as permitted practice).

If one of the limitation amounts is not applicable (for example, if the applicable financial statement is not prepared using GAAP or IFRS), the limitation is equal to the lesser of the other two amounts.

Although the limitation in section 1297(f)(3) refers to the amount reported to the applicable insurance regulatory body in the applicable




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financial statement, the final regs clarify that an applicable financial statement prepared under GAAP or IFRS is taken into account in determining the limitation under reg. section 1.1297-4(e)(2)(ii) regardless of whether it is filed with the local regulator. This rule is intended to prevent foreign corporations that do not file GAAP or IFRS statements with the local regulator from relying on statutory accounting standards that define liabilities more broadly than GAAP or IFRS. The limitation in the 2019 proposed regs addressing financial statements prepared for a purpose other than financial reporting has been deleted.

The definition of the term “financial statement” has been revised to treat a statement as a financial statement only if it is prepared for a reporting period in accordance with a financial accounting or statutory accounting standard and includes a balance sheet, statement of income, and a statement of cash flows (or equivalent statements under the reporting standard). Consequently, a statutory accounting statement that is used to establish the limitation should provide all information necessary to apply the 25 percent test and the alternative facts and circumstances test.

Discounting

Under the 2019 proposed regs, if an applicable financial statement not prepared under GAAP or IFRS did not discount losses on an economically reasonable basis, applicable insurance liabilities were required to be reduced under the discounting rules that would apply if the financial statement had been prepared under either GAAP or IFRS. Commentators requested that the discounting requirement be removed because GAAP does not always require discounting of liabilities.

Treasury and the IRS agree that applicable insurance liabilities discounted as required by GAAP or IFRS have been discounted on an economically reasonable basis. Additional discounting of applicable insurance liabilities is not necessary when discounting is not required under either GAAP or IFRS. For example, IFRS 17 does not require discounting liabilities under nonlife insurance contracts with terms of one year or less.

However, Treasury and the IRS have determined that discounting is required when applicable insurance liabilities have not been discounted on a reasonable basis. Accordingly, the final regs clarify that, if a financial statement described in reg. section 1.1297-4(e)(2) does not discount applicable insurance liabilities on an economically reasonable basis, the foreign corporation may meet this requirement by choosing to apply the discounting methods required under either GAAP or IFRS.

Change of Financial Reporting Standard

Under the 2019 proposed regs, if a foreign corporation had prepared a financial statement under GAAP or IFRS, it could not cease to do so in subsequent years absent a (nontax) business purpose. If the foreign corporation failed to prepare a financial statement under GAAP or IFRS in a subsequent year without a business purpose, it was treated as having no applicable insurance liabilities in applying the 25 percent test (and the 10 percent test).

Commentators requested that this rule be removed because taxpayers should not be required to establish a business purpose for their choices of an accounting standard.

Also, financial reports are prepared to inform a corporation’s stakeholders and regulators of its financial condition. This function is so significant that a corporation is unlikely to change its accounting standard for tax purposes. Treasury and the IRS have concluded that other rules and limitations provided in the final regs are sufficient to protect the integrity of the amounts reported on the applicable financial statement. Therefore, the final regs delete the rule addressing a change of financial reporting standard.

Definition of Insurance Business

The 2019 proposed regs defined an insurance business to include the investment activities and administrative services required to support the QIC’s insurance, annuity, or reinsurance contracts (see prop. reg. section 1.1297-5(c)(2)). Commentators interpreted this definition as potentially excluding any investment activities in excess of the minimum amount required to meet the QIC’s insurance obligations from the scope of the insurance business exception.




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The definition should be broadened to include all QIC investment activities related to insurance, annuity, or reinsurance contracts. Although the definition of an insurance business (now contained in reg. section 1.1297-4(f)(8)) has not been changed, it is not intended to provide a maximum threshold for investment assets and income that may qualify for non-passive treatment under section 1297(b)(2)(B). This definition merely requires a sufficient factual relationship between a company’s insurance contracts and its investment activity.

NEWS ANALYSIS

The EU’s Cryptoasset Tax Strategy Needs Coordinationby Nana Ama Sarfo

As the cryptoasset industry awaits a much-discussed European Commission proposal that would extend EU tax reporting rules to cryptoassets and e-money, at least one tax-tech startup is courting investors in anticipation.

Austria-based Blockpit is one of a growing number of companies providing automated tax calculations for cryptocurrency trades, income generated from staking, and other crypto-related activities. The commission’s upcoming directive on administrative cooperation (DAC8) proposal is prompting Blockpit to think big. The company runs its tax platform in five European countries and the United States, but it is eyeing an EU-wide expansion, and hoping that a recent $10 million round of series A funding will help.

Blockpit’s funding dash may seem a bit premature considering that there is no DAC8 draft yet, but it’s pragmatic, based on several indicators. In late July the European Commission released a collection of DAC8 comments and feedback solicited over the past few months, and the prevailing sentiment is that the EU will, in fact, need some sort of standardized tax treatment. Reasonable minds differ on when that should happen. Some argue that policymakers should shelve the idea until the EU creates a legal definition of cryptoassets. But the important point is that no one argued against an EU-wide approach, although many urged the commission to tread with caution.

DAC8 Background

Europe is in the early stages of a digital renaissance: its Digital Europe project. Over the next several years, the bloc will be shelling out €7.5 billion to turn the EU into something more futuristic by 2030 — think a digital highway between Europe and Latin America, the world’s first artificial intelligence legal framework, and 5G connections all over the bloc. The regulatory web that will support this “digital decade” is just as ambitious. Up on the roster is a digital finance strategy to digitize the EU’s financial sector as




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well as a Regulation on Markets in Cryptoassets (MICA) that would allow passporting for cryptoasset providers and place strict regulations on things like capital requirements and investor rights. DAC8 will complement all of these by helping authorities automatically exchange data about cryptoassets and e-money so they can accurately tax income and revenue from investments and payments using cryptoassets, e-money, and other digital products.

Why does the EU need a DAC8 when some cryptoasset providers are already subject to reporting rules under the EU’s fifth anti-money-laundering directive? Two years ago, the European Banking Authority drafted an advice report for the European Commission and warned that cryptoassets typically fall outside the scope of the EU’s financial services regulations, except in limited cases, like those in which cryptoassets are considered to be e-money.

Compounding that, cryptoasset regulation is a patchwork across the EU. After years of drafting anti-money-laundering and tax transparency directives, the EU is concerned that decentralized, partially anonymous cryptoassets could provide a conduit to the shadow economy and undercut the market for traditional financial instruments, especially if cryptoasset-based income is underreported or not reported at all.

Defining Cryptoassets

DAC8 is wading into a world in which some of the terminology, like “cryptoasset,” is amorphous.

There’s no standard international definition for cryptoasset; it is a malleable term for a malleable industry. The European Commission has offered up its own proposed definition as part of MICA: “A digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology.”

DAC8 could rely on that definition; however, it may not cover all forms of cryptoassets, according to some commentators. In separate comments, KPMG LLP, the Malta Business Bureau, and Malta’s Institute of Financial Services Practitioners said it is “dubious” that MICA’s definition is specific enough for DAC8, particularly because the definition is broad

enough to include assets that lack cryptographic elements. They suggest the language should distinguish between “digital representations” and “cryptographic representations,” which would provide more specificity and distinguish DAC8 from other DAC directives.

MICA’s definition does not distinguish between centralized and decentralized cryptocurrency systems. That’s a problem for some stakeholders, who argue that this could undermine any future enforcement because the two are so different. There’s already a concern reflected in stakeholder comments that the DAC8 consultation largely focused on centralized approaches to the detriment of decentralized systems. After all, distributed ledger technologies were designed with decentralization and are likely to become more prevalent. That merits additional assessment on how the EU’s plans could affect decentralized systems.

Intermediaries

Decentralized ledgers like blockchain are intended to eliminate the need for intermediaries. In that context, it’s unclear how authorities should identify the best reporting intermediaries. It’s a question that will likely become more complex as more decentralized finance products and applications hit the market. PwC suggests that the commission think about identifying criteria. That’s not going to be a simple task, however. As the industry grows, the criteria could need frequent revisions. Already, intermediaries like cryptoasset exchanges, cryptoasset brokers and dealers, cryptoasset cash point ATMs, cryptoasset issuers or sponsors, cryptoasset trading platforms, and cryptoasset wallet providers all have very different functions.

Meanwhile, the French Banking Federation believes banks and other financial institutions are inappropriate intermediaries because it would be “impossible” for those institutions to determine whether account holders have those sorts of assets. Banks should bear these kinds of reporting obligations only if they offer cryptocurrency services, the federation said.

Relatedly, commentators like CFE Tax Advisers Europe are concerned about reporting obligations on intermediaries and advisers because they could be as “ignorant and blind” as the tax authorities seeking information.




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“Criminals will in all cases positively engineer non-compliance which means it is the ignorant or negligent ‘non-criminal’ and his/her advisers who could fall foul of the law,” the organization said. “Rather than . . . issue DAC8 with compliance requirements which, frankly, may be unenforceable, what makes sense is to prepare the way for ‘crypto compliance’ coupled with clear explanations of what it means.”

Individual traders should be responsible for handling their compliance requirements — that should be part of the cost of doing business, according to CFE.

Along those lines, should cryptocurrency wallets owned by private people be reportable? There are privacy and de minimis concerns at play. Swedish cryptocurrency accounting firm Monetax argues that reporting requirements for those kinds of wallets could make people vulnerable to information breaches. Custodian wallets — those offered by cryptocurrency service providers — are a different animal, however, and are already covered by the fifth anti-money-laundering directive.

Few threshold numbers have been suggested for cryptoasset reporting. Monetax suggested that profits below €10,000 could be tax free for private individuals. But a more pressing issue is determining where and how reportable transactions occur in the first place, according to PwC.

E-Money

It’s unclear whether the term “e-money” under DAC8 will refer to traditional e-money (regulated under several EU laws), new e-money tokens like stablecoin, or both. It matters because the two are not the same.

Broadly speaking, e-money tokens are treated as cryptoassets. MICA defines electronic money tokens as cryptoassets that are mainly used as a means of exchange and maintain a stable value by referring to the value of a fiat currency that is legal tender.

Electronic money, on the other hand, is defined under the EU’s electronic money directive as an electronically and magnetically stored monetary value that is represented by a claim on the issuer that is issued when funds are received for making payment transactions and are

accepted by a natural or legal person other than the electronic money issuer.

Considering that e-money tokens are folded into cryptoassets, the commission, when referring to e-money, may mean traditional e-money. On the other hand, e-money tokens need regulation more than traditional e-money. The distinction between the two will need to be teased out.

Both the Malta commentators and KPMG said they interpret “e-money” in the DAC8 consultation in line with the MICA “e-money tokens” definition. If that is correct, they suggest the commission use the term “e-money tokens” because it is not interchangeable with “e-money.”

The distinction is also important because the EU has been regulating e-money for over 10 years by an e-money directive (2009/110/EC) and under the second payment services directive (2015/2366/EU), as well as EU anti-money-laundering and know-your-customer reporting requirements. Given this regulatory landscape, some commentators, like the European Payment Institutions Federation (EPIF) and the French Banking Federation, are unconvinced that e-money and e-money institutions need additional regulation under DAC8. The federation thinks e-money issuers would be better served under DAC2 — the automatic exchange of financial account data — and not DAC8.

Existing regulations aside, the EPIF contends that e-money issuers should be exempted from DAC8 for de minimis uses. E-money products are often used in low-value ways — for example, digital payments or public transportation tickets — although they are being used more for luxury items.

EPIF would like an exemption for customer accounts with balances that do not exceed €15,000, as well as an exemption for accounts in which the average end-of-day balance over a 30-day calendar period does not exceed €15,000, reflecting that customers may occasionally hold more than €15,000 for specific transactional reasons.

€15,000 would be a logical threshold because it’s the threshold used for the EU’s anti-money-laundering/know-your-customer requirements that e-money issuers already follow, as well as the Financial Action Task Force’s customer due diligence recommendations. “In this case,




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e-money issuers would have to upgrade their compliance systems but not fundamentally re-design them.” Aligning DAC8 with the €15,000 threshold would also give e-money issuers more control over their business models — they could choose to avoid compliance costs by exclusively working with clients under that threshold, or they could choose to service higher net clients and corporate clients and take on the costs of DAC8 compliance.

Regardless of the approach, commentators say a carveout for low-risk transactions and low-value payments is necessary. If DAC2 were to apply, the federation would like to see a carveout based on a few possibilities such as:

• product value;• intended use of the e-money product; or• limitations on the types of users.

As e-money usage becomes more widespread, EPIF says any new regulations need to clearly distinguish between instances in which e-money holders are using the instruments to park capital for extended periods of time and those in which holders are using them for purchases.

Reporting Exemptions

Along those lines, commentators suggested a few other exemptions. EPIF wrote that the commission should distinguish products that are used as passthroughs, like money remittance platforms, platforms that enable merchants to acquire transactions, or platforms that are used to pay suppliers or employees.

These sorts of accounts seem to pose little transparency risk, according to EPIF. They’re not depository accounts or custodial accounts that could give rise to asset sheltering, nor do they qualify as financial accounts under the OECD’s common reporting standard, which, under Section VIII, paragraph C, are defined as accounts maintained by financial institutions that include both a depository and custodial account.

Also, trading activities are already being scrutinized by tax authorities and are being addressed through other avenues, suggesting they could be exempted from DAC8 as well, according to PwC.

Alignment With Other Standards

The European Commission is approaching a fork in the road with DAC8 and its digital regulatory plans. Parallel cryptocurrency regulation projects are underway at the OECD and the Financial Action Task Force, and some believe the commission should wait to align its standard with the others. Cryptocurrency is new enough that premature decisions on tax and reporting requirements could stifle the industry, according to CFE. “Regulation of crypto is far wider than the tax implications and the tax systems designed to accommodate it should be followers not leaders,” the organization said.

The European Commission has an unenviable job ahead in ensuring that DAC8 aligns with the Financial Action Task Force, the OECD, the EU’s suite of anti-money-laundering directives, and the MICA proposal. The stakes are high — discord could create opportunities for tax arbitrage or throw more uncertainty into an already uncoordinated space. In a similar vein, it’s important to think about how smaller companies, in an industry rife with startups, can reasonably comply with all these emerging regulations.

One interesting idea floated by CryptoValues, an Italy-based blockchain policy center, is a crypto-related one-stop shop for small and medium enterprises to consolidate anti-money-laundering and other regulatory compliance and truly ensure EU-wide cooperation as the bloc continues to grow its digital governance.




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NEWS ANALYSIS

Digital and Space Taxation: How Pillar 1 Endangers the Next Frontierby Mindy Herzfeld

A curious aspect of the global effort to more heavily tax mainly U.S. digital companies is that many of the countries that complain the most about the unfairness of the international tax rules seem the least concerned about their own lack of competitiveness in the digital sector. But improvements in competitiveness and innovation could do their economies more good than the smaller amounts expected to be collected — even under the most optimistic projections — from a global reallocation of U.S. tech companies’ profits. Underscoring that notion are huge quarterly corporate tech earnings and a report by the European Center for International Political Economy (ECIPE) highlighting the close connection between a lack of tech competitiveness and countries’ enactment of digital services taxes.

Meanwhile, the hype surrounding the recent space launches by Blue Origin and Virgin Galactic illustrates the problems with trying to rewrite tax rules to address today’s modes of doing business without considering the economy of the future. Innovators and entrepreneurs increasingly seek profits in worlds beyond, while lawmakers and taxwriters focus on writing rules for technology developed in the last century.

The investment being poured into the next area ripe for innovation — again, mostly by U.S. companies — also illustrates the extent to which the pillar 1 reallocation doubly penalizes the risk-takers who drive innovation and development. While the U.S. government partially absorbs the costs of high-risk ventures by granting tax benefits to losses incurred in the country to fund those investments, those ventures doubly benefit the rest of the world: once because other countries get to share in the improvements from the technology being developed and a second time when they’re asked to share the profits therefrom.

Digital Competitiveness and DSTs

In “Taxing Digital Services — Compensating for the Loss of Competitiveness,” ECIPE used its own metrics to highlight the close association

between a lack of digital trade competitiveness and DSTs. The report demonstrates how the five European countries that have imposed DSTs (Austria, France, Italy, Spain, and the United Kingdom) have suffered 15 years of “declining digital services competitiveness” relative to the United States and “a dismal decade of trade decline in digital services with the rest of the world.”

Declining digital competitiveness is not a pervasive problem in Europe; rather, as the report demonstrates, it is uniquely associated with those five countries — which also happen to be the loudest advocates of revamping international tax rules to ensure they receive a larger share of tech companies’ profits. The report notes that the growth of digital services production has been consistently negative in the five DST countries but positive for the rest of the EU, and that while the number of digital service workers has been growing in all European countries, it has grown more slowly in “the DST5.” The share of intangible business investments, including computer software and engineering designs, organizational capital, and research and development, also grew much more slowly in those five countries. The report points out that because trade is often driven by investments, that problem also needs to be addressed.

The report doesn’t explain why less-competitive countries latched on to DSTs as the solution to a much larger problem, but one takeaway from it is that the negotiations to rewrite international tax rules to better tax the digital economy need to be placed in a larger context and that concerns over fair taxation are likely only a small part of what’s really driving the effort. While few would deny that international tax rules should be revised to better reflect changing modes of business, those changes won’t do much to address the lack of investment in new technologies, a problem that won’t be eliminated simply by reallocating tech profits.

Sharing the Profits but Not the Losses

The quarterly profits reported the week of July 26 by tech companies (which one article called a “tech blowout”) show just how profitable the largest companies are: Apple’s quarterly profits were $21.7 billion on more than $81 billion




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of revenue, up 36 percent from last year; Alphabet (Google) reported quarterly net income of over $18 billion on revenue exceeding $60 billion; Microsoft reported quarterly revenue of $46.2 billion (an increase of 21 percent) and net income of $16.5 billion (a 47 percent increase from last year). Facebook reported net income of over $10 billion from revenues of $29 billion, up 56 percent. It’s no wonder that countries want to share in the profits— and not just the products — of those companies.

The week before those earnings were reported, former Amazon CEO Jeff Bezos traveled into space in the New Shepard rocket. His trip was widely criticized as an example of billionaires having too much money; some think the world would be better served if that wealth were more heavily taxed and reallocated among citizens (see Abby Maxman, “Billionaires in Space Are Costing Lives on Earth” (July 19, 2021)). But practically every modern convenience — electricity, air travel, and automobiles — resulted from years of capital and effort poured into attempts that were widely characterized as fools’ dreams. Billionaires putting their money into speculative investments that could benefit generations to come (rather than into nonproductive depreciating assets) could allow countries to recognize long-term gains.

Like big tech, the big three space companies SpaceX, Blue Origin, and Virgin Galactic are U.S.-based. Crunchbase has estimated that more than $5 billion in venture capital has already been invested in space tech in 2021. That amount includes $850 million invested in a private funding round for SpaceX, and another $650 million for California-based Relativity Space — and that’s on top of almost $6 billion invested in the sector last year. Although the big three space companies steal many of the headlines, there’s also strong investment in assets and opportunities with more immediate profitability prospects, such as satellite technology and businesses engaged in space-related activities, telecom, earth imaging, and data and mobility.

But someone has to absorb the immediate costs of nonprofitable ventures and losses from failed investments. And while that’s technically individual investors, the U.S. government also takes a share by allowing those individuals to

offset some of their losses against their income and to carry over losses incurred by corporate entities. In effect, the U.S. government shares in the risk associated with investing. So why, having borne the risk, should the U.S. government then hand those profits over to the rest of the world?

The amounts being invested in the big three space companies help illustrate the size of the losses and risks the U.S. government shares. Bezos has said he’s funding Blue Origin’s efforts by selling $1 billion of Amazon stock a year. Privately held SpaceX has raised close to $6 billion in venture capital funding over the last few years, based on expectations of profits from its satellite-based internet service. SpaceX has estimated that its investment in that project alone could be as much as $30 billion.

Virgin Galactic, the only publicly traded space company, reported almost $650 million in losses in 2020 and losses in the hundreds of millions in the two prior years. The risk factors in its most recent annual report include:

• that the company has incurred major losses since inception, expects to incur losses in the future, and might not achieve or maintain profitability;

• that success is highly dependent on the company’s ability to market and sell human spaceflights;

• that the market for commercial human spaceflight is still emerging and might not reach its expected growth potential;

• that any inability to operate the spaceflight system after commercial launch at the anticipated flight rate could harm the company’s business, financial condition, and results of operations; and

• that growing the business depends on the successful development of spaceflight systems and related technology, which is subject to many uncertainties, some beyond the company’s control.

As a U.S. C corporation, Virgin Galactic can’t use its U.S. losses to offset other income in the current tax year: Any tax benefit will arise only if the company becomes profitable (or merges with another profitable company, subject to a myriad of anti-loss-trafficking rules) and the income is otherwise taxable in the United States.




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In effect, the pillar 1 proposal asks the U.S. government to subsidize growth first by letting the world share in the products developed as a result of its shared investment in risky tech ventures and again when those investments become profitable.

Taxing Space Income

Legislation

All the activity in the space sector has led to congressional attempts both to encourage investment in the area and to extract revenue from it.

In February Rep. Bill Posey, R-Fla., introduced the American Space Commerce Act of 2021 (H.R. 1369) allowing for bonus depreciation for investments in space launches. The bill would amend IRC section 168(k)(2)(A) to allow accelerated depreciation for “qualified domestic space launch property.” Posey said a strong U.S. launch industry is crucial to the country’s continuing economic, scientific, and exploratory leadership and that commercial space launch vehicles manufactured and launched in the United States benefit national security and earth and space science.

At least one Democrat has opted for a different approach, preferring to tax space-related activities rather than grant them tax benefits. House Ways and Means Committee member Earl Blumenauer, D-Ore., has proposed the Securing Protections Against Carbon Emissions (SPACE) Tax Act, a two-tiered excise tax on commercial space travel for nonscientific purposes.

Regulations

Only a few U.S. tax rules address the taxation of income from space activities. Section 863(d) states that except as otherwise provided in regulations, income derived by a U.S. person from a space or ocean activity is U.S. source. Treasury has interpreted its regulatory authority to write broad exceptions to the general rule. The related regulations provide that space or ocean income derived by a U.S. person is non-U.S. source if the income is attributable to functions performed, resources employed, or risks assumed in a foreign country. Before section 863(d) was added to the code, all income derived by U.S. residents from

space activities was generally treated as foreign source. Space and ocean income derived by a foreign person other than a controlled foreign corporation is still considered foreign source, unless the foreign person is engaged in a U.S. trade or business.

Under the regulations, space or ocean activity includes activity characterized as communications activity, other than international communications activity. Section 863(e) provides that for U.S. persons, 50 percent of international communications income is U.S. source and 50 percent is foreign source. International communications income is defined as income from communications activity, which includes paying a taxpayer to transmit communications from a point in space to a point in the United States.

As with any other area of law, determining whether income from activities in space will be taxable by the United States depends first on its characterization. Depending on how the income is characterized, factors such as where the payer or recipient is located or where the transaction takes place become relevant in determining whether the United States will tax the income. There will be broad guidance gaps when those activities begin to generate meaningful profits, and the lack of clear guidance opens the door to tax planning opportunities.

Allocating Space Profits

Space travel might not be profitable for years, but questions regarding income from satellites already challenge taxwriters and administrators. Satellites generally provide communications signals from space to a customer on earth. In 2019 the International Fiscal Association Congress hosted a panel on the taxation of space, noting the analogies to questions of digital taxation, with one panelist saying that like the digital economy, “which is largely subject to tax rules designed for an industrial economy, taxation of space is by reference to rules applicable to an earlier terrestrial era” (Jonathan Schwarz, “Taxation of Space: The Final Frontier,” Kluwer International Tax Blog (Sept. 27, 2019)). Part of the uncertainty stems from the lack of clarity in international law on space generally, including not knowing where




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in space a state’s jurisdiction ends and outer space begins.

In the commentary to article 5 of its model treaty, the OECD said a satellite in geostationary orbit couldn’t create a permanent establishment for a satellite operator. It said that because there’s no international agreement over how far a state’s territory extends into space, and because a satellite in geostationary orbit could never be considered located in the territory of any given state, a PE couldn’t be created in any jurisdiction. The commentary also states that the area over which a satellite’s signals may be received can’t be considered at the disposal of the satellite operator so as to make that area its place of business (an Indian court applied that principle in Asia Satellite Telecommunications Co. Ltd. v. DIT, 332 ITR 340 (Del 2011)).

The OECD’s conclusion holds only if one assumes that a physical presence is required to create a PE. The tax world’s moving away from that concept — of which the agreement on pillar 1 is but the first step — might prompt a rethink of the principle in the commentary that a satellite in geostationary orbit can never create a PE in a jurisdiction because it’s not physically located there.

Source and allocation questions based on the consumer’s location may be relatively simple so long as consumers reside in states recognized as such by international organizations like the United Nations. But given the pace of technological development, it’s possible to imagine a time when individuals claim an absence of tax residence in any state because they’ve been living in space for a sufficient amount of time. And countries that rely on a managed and controlled test to determine residency could find themselves without resident companies if individuals can become nonresidents.

Space and satellite operations have also raised questions about the applicability of a VAT, some of which courts have tried to address. A Nigerian court has considered a case in which a satellite operated by a Dutch company supplied bandwidth capacity for use in Nigeria, transmitted by the Dutch company to its satellite

in geostationary orbit, which in turn transmitted it to the earth station of a Nigerian company. The court ruled that the supply of the broadband constituted a service rendered in Nigeria and was thus subject to VAT (Vodacom Business Nigeria Ltd. v. FIRS, CA/l/556/2018 (2019)). (See also Communications Satellite Corp. v. Franchise Tax Board, 156 Cal. App. 3d 726 (1984), holding that when satellite operators located outside California had an earth station there that received communication signals for transmission through independent carriers, the value of the satellites would be considered located in California for the property factor apportionment of the California income tax.)

Conclusion

As much of the world celebrates the G-20 digital tax agreement brokered by the OECD as an important step in updating the international tax rules for the 21st century, there are indications that the agreement still might do little to solve the underlying disparities that gave rise to the unequal distribution of profits from next-generation technologies, which in turn stems from unequal investment in new technologies. Reallocating profits is merely a Band-Aid. Capitalism encourages innovation by rewarding risk, but the rules being written seem to punish the risk-takers.

The gap between the digital problem and the tax solution is reflected in the differences among countries’ investments in commercial space. The rules that are proving so challenging to rewrite to address digital profits don’t even begin to contemplate profits from a place where most international law remains unsettled. Unless policymakers consider what tomorrow’s economy might look like, digital taxation will be overtaken by new technologies and frontiers, and the solution will likely be obsolete before an agreement is even implemented.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, counsel at Potomac Law Group, and a contributor to Tax Notes International.

Follow Mindy Herzfeld (@InternationlTax) on Twitter.




HIGHLIGHTS


Stay on top of developments and ahead of the curve.







Americans Abroad Should Also Pay For the Benefits of Citizenship

To the Editor:

The article “Should Overseas Americans Be Required to Buy Their Freedom?” by Laura Snyder, Karen Alpert, and John Richardson is a classic example of an argument by taxpayers who want all the rights and privileges of Americans but don’t want to pay for them (Tax Notes Int’l, July 12, 2021, p. 161).

The authors make all the classic arguments of why Americans living abroad shouldn’t have to pay U.S. taxes: It’s unfair. It discriminates (even though we provide a tax credit for taxes paid as residents of a foreign country). The article provides examples of “little people” being hurt, while ignoring the fact that most of the benefit of such an exemption would go to the wealthiest expatriates. It even throws in modern monetary theory, which is a new twist, but I’m not sure why it is relevant to a citizen’s obligation to pay for the

protection the U.S. government provides them. Perhaps they think it’s unfair for individuals living abroad to have to pay taxes on their foreign income while multinational corporations are able to avoid paying them. But that’s a losing argument because we have finally realized that encouraging the export of jobs and profits through the tax code is bad public policy.

In short, Americans living abroad who want the rights and privileges of citizenship should be willing to help pay for the government that provides them. Martin LobelLobel, Novins & Lamont LLPChairman Emeritus, Tax Analysts Board of DirectorsMember, Tax Analysts Board of Directors, 1970-2020 (Chairman, 1970-2018)July 28, 2021







U.S. Tax Review: International Tax Reform, Reverse Clawbacks, And GILTI

by James P. Fuller and Larissa Neumann

OECD Framework Agreement

On July 1 almost all countries and jurisdictions that are part of the OECD/G-20 inclusive framework on base erosion and profit shifting agreed to a statement on the implementation of a new two-pillar solution to reform international taxation. The pillar 1 and 2 proposals in the statement will be a significant change in the international tax rules. The statement describes the plan at a high level and states that the detailed implementation of the plan is expected to be finalized by October, to be brought into law in 2022 and be effective in 2023.

The United States joined the statement. Only nine of the 139 countries and jurisdictions in the

inclusive framework did not back the statement. All of the G-7 and G-20 governments joined the statement. The July 1 OECD announcement stated that the 130 countries and jurisdictions that backed the statement represent more than 90 percent of the global GDP.

A number of low-tax countries, such as Switzerland, that were expected to oppose the statement actually backed it. In fact, several jurisdictions with zero corporate tax rates — including Anguilla, the Bahamas, Bahrain, Bermuda, British Virgin Islands, the Cayman Islands, Guernsey, the Isle of Man, Jersey, Turks and Caicos Islands, and United Arab Emirates — signed the statement.

However, Ireland (which has a 12.5 percent corporate tax rate) and Hungary (which has a 9 percent corporate tax rate) have not backed the statement. Ireland has been engaged in the process and has been pushing for the minimum tax rate to be lower than 15 percent. The other countries that to date have not signed the statement include Barbados, Estonia, Kenya, Nigeria, and Sri Lanka.

The OECD announcement on the statement explains that pillar 1 would reallocate some taxing rights regarding multinational enterprises from their home countries to market countries, regardless of physical presence (this is called amount A). The statement provides that pillar 1 would only apply to in-scope companies that are MNEs with global turnover above €20 billion and profitability above 10 percent. However, the statement notes that the turnover threshold could be reduced in the future. Profits and losses are measured by reference to financial accounting income, with a small number of adjustments. The original scope of pillar 1 was to target digital companies, but the new scope is focused on large,

James P. Fuller and Larissa Neumann are with Fenwick & West LLP in Mountain View, California.

In this article, the authors discuss the OECD’s recent statement on the two-pillar approach to the international tax framework, an IRS memorandum on section 482 adjustments for cost-sharing agreements with reverse clawback provisions, and a new practice unit on global intangible low-taxed income.






profitable MNEs. However, there is an exclusion for extractive and regulated financial services companies.

The statement sets out a new special purpose nexus rule for amount A to a market jurisdiction when the in-scope MNE derives at least €1 million in revenue from that jurisdiction. For jurisdictions with GDP lower than €40 billion, the nexus will be set at €250,000. The multilateral instrument through which amount A is implemented will be developed and opened for signature in 2022, with amount A coming into effect in 2023.

There is a quantum amount for in-scope MNEs, according to which between 20 and 30 percent of residual profit (defined as profit in excess of 10 percent of revenues) will be allocated to market jurisdictions with nexus using a revenue-based allocation key. Revenue will be sourced to the end market jurisdiction where goods or services are used or consumed and detailed source rules will be developed.

The statement notes that double taxation will be relieved using either the exemption or credit method. This is key for U.S.-based multinationals, the majority of in-scope companies to which pillar 1 will apply. It is also important for the U.S. fisc. If the United States gives a full foreign tax credit for the pillar 1 amounts, then that will reduce U.S. tax revenues. Previously the OECD had stated that about $100 billion of profit could be reallocated under pillar 1. U.S. Treasury Secretary Janet Yellen has claimed that pillar 1 will be largely revenue neutral for the United States, but that does not seem possible if the taxes are fully creditable in the United States.

The statement notes that for amount B (which is the fixed return for some baseline activities), the application of the arm’s-length principle to in-country baseline marketing and distribution activities will be simplified and streamlined, with a particular focus on the needs of low-capacity countries.

The statement also provides that tax compliance will be streamlined and will allow reporting through one entity. It further provides that there will be coordination and the removal of all digital services taxes and other similar unilateral measures. This is a critical part of pillar 1 for U.S. MNEs. However, the statement does not provide any details about when countries will

need to remove their DSTs or how the removal will be enforced.

For pillar 2, the statement explains that it consists of two interlocking domestic rules that together are called the global anti-base-erosion rules (GLOBE). The first part of GLOBE is an income inclusion rule (IIR), which imposes a top-up tax on the parent entity of companies with low-taxed income. The second part of GLOBE is an undertaxed payment rule, which denies deductions or requires adjustment to the extent that low-tax income is not subject to tax under an IIR. There is also a treaty-based subject to tax rule (STTR) in pillar 2 that allows source jurisdictions to impose limited source taxation on some related-party payments subject to tax below a minimum rate, and the STTR is creditable as a covered tax under the GLOBE rules. The STTR is an integral part of achieving consensus on pillar 2 for developing countries. The minimum rate for the STTR will be from 7.5 to 9 percent.

Pillar 2 seeks to put a floor on tax competition, and the statement provides that the minimum rate used will be at least 15 percent. The GLOBE rules will apply to MNEs that meet the €750 million threshold, but countries are free to apply the IIR to MNEs headquartered in their jurisdiction even if they do not meet the threshold. The IIR allocates top-up tax based on a top-down approach subject to a split-ownership rule for shareholdings below 80 percent. The undertaxed payment rule allocates top-up tax from low-tax constituent entities including those located in the ultimate parent entity jurisdiction under a methodology to be agreed upon.

The GLOBE rules will operate to impose a top-up tax using an effective tax rate test that is calculated on a jurisdictional basis and that uses a common definition of covered taxes and a tax base determined by reference to financial accounting income.

Similar to the U.S. global intangible low-taxed income regime, the GLOBE rules will provide for a formulaic substance carveout that will exclude an amount of income that is at least 5 percent (in the transition period of five years, at least 7.5 percent) of the carrying value of tangible assets and payroll. The GLOBE rules will also provide for a de minimis exclusion.






The statement provides that it is agreed that pillar 2 will apply a minimum rate on a jurisdictional basis and that consideration will be given to the conditions under which the U.S. GILTI regime will coexist with the GLOBE rules to ensure a level playing field.

There is no timeline set for the pillar 2 implementation plan, but the statement contemplates that pillar 2 should be brought into law in 2022 and effective in 2023. The statement provides that the implementation plan will provide model rules and coordination mechanisms, including the possible development of an MLI. It will also include an STTR model provision and an MLI to facilitate its adoption.

The open U.S. issue, of course, is getting all this through Congress, especially if a multilateral treaty will be necessary. A two-thirds vote in the Senate is necessary to approve treaties. Even short of a treaty, revenue estimates presumably will become necessary. The implementation delay to 2023 also could present issues since the Biden administration is interested in increasing U.S. tax revenues much sooner than that. Also, other countries might lose interest if they see that the U.S. Congress isn’t going along with the proposals and that they are not going to get the extra tax revenue on which they’ve counted.

Stock-Based Compensation AM

On July 13 the IRS released AM 2021-004, dealing with section 482 adjustments for cost-sharing agreements with reverse clawback provisions. The guidance was written by the IRS associate chief counsel (international). Thus, even though it is non-precedential, it is clearly meant to set out the IRS’s current position on these issues.

The memorandum discusses stock-based compensation (SBC) adjustments post-Altera, addressing in particular reverse clawback clauses in intercompany agreements — clauses that call for a true-up payment if the law changes on whether SBC must be cost-shared. The memorandum addresses the following three issues:

• the appropriate year for the adjustment;• whether an IRS adjustment in an earlier year

reduces the outstanding amount of the contractual true-up obligation in the reverse clawback provision; and

• whether the IRS can make an adjustment in another year.

For the first issue the memorandum concludes that the IRS is entitled to adjust the cost-shared SBC amounts in the year they arose, even if the intercompany agreement calls for a reverse clawback in a later year. The IRS can make allocations to adjust any intangible development cost to equal the reasonably anticipated benefit share in the year in which the intangible development costs were incurred.

In terms of the second issue, if the IRS adjusts the cost-shared SBC amounts in the year they arose, the reverse clawback under the agreement may be reduced by the amount of the adjustment.

On the third issue, the memorandum states that if the IRS does not adjust the cost-shared SBC amounts in the year they arose (for example, because the statute of limitations is closed), it may instead adjust the amounts in the later year — based on the reverse clawback clause in the intercompany agreement, or “to ensure that the Non-SBC [cost-sharing] Agreement produces results that are consistent with an arm’s length result within the meaning of Treas. reg. section 1.482-1(b)(1).” Also, if a taxpayer disregards a reverse clawback clause or modifies it to defer or remove the obligation, the IRS may make appropriate allocations to “produce results consistent with the unmodified contract or otherwise to reflect an arm’s length result.”

GILTI Practice Unit

The IRS Large Business and International Division released a new practice unit on GILTI.

The practice unit provides a good general overview of how the GILTI rules work and compares the GILTI rules with the subpart F rules. For example, both GILTI and subpart F income are included in a U.S. shareholder’s gross income, and taxpayers may claim FTCs for both subpart F income and GILTI. Domestic corporations are deemed to have paid 80 percent of the foreign income taxes attributable to the GILTI inclusion. The FTC limitation is generally computed separately for GILTI, and unused credits in the GILTI category may not be carried back or forward (that is, credits not used in the current year are permanently lost).






The practice unit then outlines who is subject to GILTI — U.S. shareholders who directly or indirectly own 10 percent or more of the vote or value of the stock of a controlled foreign corporation — and then explains how the GILTI formula works and the computation. In computing GILTI, the practice unit explains how to calculate tested income/loss and qualified business asset investment.

In computing GILTI, the practice unit explains that specified interest expense is a U.S. shareholder-level item. It is the excess of the aggregate of the U.S. shareholder’s pro rata share of each CFC’s tested interest expense over the aggregate of the U.S. shareholder’s pro rata share of each CFC’s tested interest income. Tested interest expense is interest expense that is included in the deductions properly allocable to gross tested income. The practice unit notes that the final regulations reduce the tested interest expense of a tested loss CFC by an amount equal to the notional return on the QBAI that the tested loss CFC would have if the CFC were instead a tested income CFC.

The practice unit then describes the GILTI inclusion. A U.S. shareholder of a CFC that owns stock of the CFC within the meaning of section 958(a) must include in gross income its GILTI for the tax year. The GILTI inclusion is treated as an amount included under subpart F for some provisions of the code, including: previously taxed earnings and profits (section 959); basis adjustments (section 961); section 962 elections; section 1248(b)(1) and (d)(1); and the six-year statute of limitations rule under section 6501(e)(1)(C). There is also authority to extend to other code sections by regulation.

The allocation of GILTI among CFCs is then discussed. If a CFC has no tested income, the amount allocated is zero, and if a CFC has tested income, a proportionate amount is allocated based on the relative tested income. The amount

of GILTI allocated to a particular CFC is relevant in determining previously taxed earnings and profits and basis adjustments regarding the CFC.

The practice unit notes that the final regulations generally adopt a “single U.S. entity” approach for consolidated groups. The consolidated group aggregates the pro rata shares of QBAI, tested loss, and specified interest expense of each consolidated group member. A portion of each consolidated CFC tested item is allocated back to each member based on the member’s GILTI allocation ratio, which equals the ratio of the member’s aggregate pro rata share of tested income to consolidated tested income.

The GILTI antiabuse rules are discussed, including temporarily held specific tangible property and the disqualified basis rules for some asset transfers.

The practice unit then discusses the implications for corporate U.S. shareholders. The GILTI inclusion is generally taxed at an effective rate of 10.5 percent (13.125 percent beginning in 2026) because corporate U.S. shareholders are generally entitled to a deduction equal to 50 percent (37.5 percent beginning in 2026) of the GILTI inclusion. Corporate U.S. shareholders are deemed to have paid 80 percent of the foreign income taxes paid or accrued by the CFC regarding the CFC’s tested income that results in the U.S. shareholder’s GILTI inclusion. However, the related IRC section 78 gross-up includes 100 percent of the taxes deemed paid regarding GILTI.

There is also a comprehensive GILTI example in the practice unit with four CFCs with different amounts of gross taxable income, tangible property, deductions, and tested interest expense. The example describes how to calculate net CFC tested income, net deemed tangible income return, and GILTI inclusions, as well as how to allocate GILTI among the CFCs.







Addressing an Opaque Foreign Income Subsidy With Expense Disallowance

by Stephen E. Shay

Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . . 573II. Exemptive Deductions and Section

265 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575A. Objectives of an Income Tax . . . . . . . 575B. Scale of the Exemptive Deduction

Issue. . . . . . . . . . . . . . . . . . . . . . . . . . . . 577C. Statutory and Regulatory

Background . . . . . . . . . . . . . . . . . . . . . 579III. Section 265 and Exemptive

Deductions . . . . . . . . . . . . . . . . . . . . . . . . 582A. Section 265 Statutory Language . . . . 583B. Context: Section 265, Exemptive

Deductions . . . . . . . . . . . . . . . . . . . . . . 588C. Extrinsic Evidence: Legislative

History . . . . . . . . . . . . . . . . . . . . . . . . . 589D. Summary . . . . . . . . . . . . . . . . . . . . . . . 590

IV. A Regulatory Clarification . . . . . . . . . . . 590A. Reasons for an Amending

Regulation . . . . . . . . . . . . . . . . . . . . . . 590B. Prioritizing Regulatory Guidance. . . 591C. Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . 591D. Validity . . . . . . . . . . . . . . . . . . . . . . . . . 592

V. Legislation as an Alternative to a Regulation . . . . . . . . . . . . . . . . . . . . . . . . . 594

VI. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . 594VII. Appendix A: Marginal Tax Rate

Benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 595VIII. Appendix B: Regulatory Amendment. . 596IX. Appendix C: Legislative Amendments . 596

Amendment to Section 250(a)(1)(B) . . . . 596Amendment to Section 265(a)(1) . . . . . . 596

I. Introduction

This article considers whether income offset by deductions whose object is to exempt foreign income from U.S. tax is a class of income wholly exempt from taxes for purposes of the deduction

Stephen E. Shay is the Paulus Endowment Senior Tax Fellow at Boston College Law School. He thanks Reuven Avi-Yonah, Kimberly Clausing, Patrick Driessen, David Elkins, Cliff Fleming, Mike Kaercher, Peter Merrill, Isaac Moore, Susan Morse, Shu-Yi Oei, Paul Oosterhuis, Robert Peroni, James

Repetti, Diane Ring, Michael Schler, Martin Sullivan, Wade Sutton, Clint Wallace, and participants at the Boston College Law School Tax Policy workshop for comments on earlier versions of this article.

In this article, the author argues that the use of exemptive deductions — deductions whose object is to exempt foreign income from U.S. tax — should trigger the application of section 265 to expenses allocable to the exempted income, and he shows how the government could address the expense disallowance issue through various legal avenues, regardless of the outcome of the Biden administration’s fiscal 2022 revenue proposals.

The views expressed here are made in the author’s individual capacity and do not represent the views of any school with which he is associated, any organization for which he serves as an officer or trustee or is a member, or any client for which he acts or has acted on a compensated or pro bono basis.

Copyright 2021 Stephen E. Shay. All rights reserved.






disallowance rule of section 265(a)(1). From a normative perspective, the disallowance of deductions for expenditures to earn untaxed income is fundamental to achieving a tax on net income that measures ability to pay. Net income representing a change in taxpayer wealth will be mismeasured if expenses allocable to exempt income are allowed to offset other income instead of being disallowed. If deductions are to be allowed, the distortion of net income should be justified.

The issue arises under current law from the adoption of two deductions in the Tax Cuts and Jobs Act whose object is to exempt specific foreign income from the federal income tax.1 The deductions exempt 50 percent of a global intangible low-taxed income inclusion (subject to a taxable income limit) and 100 percent of the foreign-source portion of a dividend (the exemptive deductions).2 These deductions are not equivalent to rate reductions applied to a category of taxable income, because they apply before other deductions and do not thereby limit the benefit of those deductions to the lower tax rate.3 Unlike other business deductions, these deductions are fundamentally exemptive in nature and do not have a measurement-of-income objective.4 The better analysis of the section 265(a)(1) statutory language is that deductions (other than the exemptive deduction) allocable to income offset by an exemptive deduction are subject to disallowance under existing section 265(a)(1).

Allowing U.S. shareholder deductions allocable to exempt foreign income earned through a controlled foreign corporation would be an opaque subsidy for foreign investment. That subsidy would advantage multinational over domestic businesses, shareholders over workers, and high-income and foreign investors over other taxpayers. To disable the operation of section 265(a)(1), there should be evidence in the statute or legislative history that Congress intended that its disallowance rule not apply. That evidence is lacking, while there is clear evidence that Congress intended for the income to be untaxed.

Regulations under section 265 do not directly address the treatment of income offset by exemptive deductions. The relevant regulation adopts a meaning for “class of income wholly exempt from . . . taxes” that is narrower than the statute, presenting the interpretative question whether the meaning used in the regulation is exclusive.5 The regulation states that “a class of income wholly exempt from . . . taxes . . . includes any class of income which is (i) Wholly excluded from gross income . . . or (ii) Wholly exempt from taxes.” (Emphasis added.) While a contrary reading is possible, as explained below, the regulation’s use of the term “includes” indicates that it is intended to be nonexclusive.

The analysis in this article demonstrates that if reg. section 1.265-1(b) were interpreted by the IRS to be the exclusive meaning, and assuming the courts either agreed with or deferred to the agency interpretation, the IRS still could validly amend its regulation to adopt an interpretation that would cause section 265 to apply to income offset by an exemptive deduction.

Adopting a notice and comment regulation applying section 265 to income offset by an exemptive deduction would reasonably interpret the statute, offer stakeholders the opportunity for criticism, and mitigate the burdens of potential litigation on taxpayers and the government. Because exemptive deductions are a novel feature of the income tax law and the proper application of section 265 may be underappreciated by taxpayers, the IRS could exercise its discretion to make a regulatory amendment prospective. Such

1The TCJA is formally known as “An Act to provide for reconciliation

pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” P.L. 115-97 (Dec. 22, 2017).

2Sections 245A and 250(a)(1)(B). GILTI is defined in section 951A and

applies to include certain income of a controlled foreign corporation in income of a U.S. shareholder. A United States shareholder is a United States person that owns, directly or indirectly, 10 percent or more by vote or value of the stock in a foreign corporation. Section 951(b). In this article, U.S. shareholder refers to a shareholder described in section 951(b). A foreign corporation is a CFC if more than 50 percent of its shares are owned, directly or indirectly, by vote or value by U.S. shareholders on any day in the CFC’s year. Section 957(a).

3This situation arises in the cases of deductions of a domestic

corporation under sections 245A and 250(a)(1)(B) because they are determined in relation to net income of a foreign corporation before or without regard to the allocation of the domestic corporation’s expenses to the income.

4Deductions under section 250(a)(1)(B) are not taken into account in

determining a net operating loss carryover. Section 172(d)(9). The section 245A 100 percent dividends received deduction (DRD) is not limited by the section 246(b) limitation on the aggregate amount of section 243, 245, and 250 deductions.

5See reg. section 1.265-1(b).






an exercise of discretion would not be required, and the interpretation could apply from the effective dates of the exemptive deductions.

The alternative of seeking legislation clarifying the application of section 265 to income offset by exemptive deductions is available but not required. Legislation would be available, if, contrary to the analysis in this article, a court were to conclude that section 265(a)(1) cannot apply and find a confirming regulation invalid. Moreover, Congress can legislate if it disagrees with an interpretation adopted by regulation.6

Treasury’s fiscal 2022 revenue proposals include amending section 265 to disallow deductions allocable to a class of foreign gross income that is exempt from tax or taxed at a preferential rate through a deduction. The proposal states that no inference should be drawn regarding current law.7 Whether the legislative proposal would have a budgetary effect would depend on how the staff of the Joint Committee on Taxation interprets the statute and the existing regulation. If the JCT agrees with the analysis in this article, revenue from expense disallowance could be included in baseline revenue subject to adjustment for taxpayer practice and whether the IRS enforces the interpretation. If the JCT disagreed, a legislative clarification would increase revenue. Under the analysis in this article, Treasury has authority to adopt a regulation incorporating a reasonable interpretation of the statute, as proposed in this article, regardless of whether the proposed legislative clarification is adopted and whether or not the legislative proposal is considered to have a budgetary effect.

This article is intended to identify the expense disallowance issue and its structural importance in an income tax. The article illuminates the revenue significance of the expense disallowance

issue and shows how different legal avenues — including statutory interpretation, regulation, legislation, and their combinations — are available to address it.

II. Exemptive Deductions and Section 265

A. Objectives of an Income Tax

The primary objective of the U.S. federal income tax is to raise revenue to fund government expenditures for public goods and services appropriated by a democratically elected Congress.8 Federal expenditures include those for internal and external security, for a reasonable social safety net to achieve social welfare objectives, and for any other congressionally approved purpose. The United States relies more than its peer countries on the income tax as a principal source of federal revenue.9

The U.S. income tax is imposed on net income as an appropriate measure of a taxpayer’s ability to pay.10 Net income is determined by reducing gross income by the deductions related to that income.11 The resulting net income (or loss) reflects the taxpayer’s increased (or decreased)

6Recent experience shows that Congress is quite capable of

overriding administrative guidance when it disagrees with it. See, e.g., the Consolidated Appropriations Act, 2021. Section 276(a) of the act reversed guidance in Notice 2020-32, 2020-21 IRB 837, and Rev. Rul. 2020-27, 2020-50 IRB 1552 (obsoleted by Rev. Rul. 2021-2, 2021-4 IRB 495, that would have denied deductions paid for with later-forgiven Paycheck Protection Program loans). Similarly, section 265(a)(6)(B) reversed IRS guidance in Rev. Rul. 83-3, 1983-1 C.B. 72, ruling that mortgage interest paid by a minister receiving a housing allowance would be disallowed.

7Treasury, “General Explanations of the Administration’s Fiscal Year

2022 Revenue Proposals,” at 14 (May 28, 2021) (fiscal 2022 green book).

8Raising revenue is not the sole function of the federal income tax. Its

other functions include regulating behavior through providing tax incentives or disincentives and serving as a mechanism to make income transfers to the working poor and lower-middle-income taxpayers. The incentive for employer health insurance plans is the largest single tax expenditure, exceeding $1 trillion over a 10-year budget period. See Treasury Office of Tax Analysis, “Tax Expenditures,” at 4 (Feb. 26, 2020). The earned income tax credit is one of the largest components of the federal social safety net. Susannah Camic Tahk, “The Tax War on Poverty,” 56 Ariz. L. Rev. 791, 797 (2014).

9See OECD, “Revenue Statistics 2020,” Table 3.4. Taxes on income and

profits as a share of total revenues at all levels of government in the United States are 45 percent compared with an OECD average of 34.3 percent. Individual countries that have higher percentages of income taxes are Australia (60.2 percent), Canada (48.8 percent), Denmark (62.2 percent), Iceland (49.3 percent), Ireland (45.3 percent), New Zealand (56.3 percent), and Switzerland (47.7 percent). U.S. taxes on goods and services as a share of total revenues at all levels of government are lower than for any other OECD country. For a historical perspective on why the United States disfavors consumption taxes, see Ajay K. Mehrotra, Making the Modern American Fiscal State: Law, Politics and the Rise of Progressive Taxation 1877-1929 (2013); and Steven R. Weisman, The Great Tax Wars: How the Income Tax Transformed America (2004).

10Marvin A. Chirelstein and Lawrence Zelenak, Federal Income

Taxation 117 (2018); and J. Clifton Fleming Jr., Robert J. Peroni, and Stephen E. Shay, “Fairness in International Taxation: The Ability-to-Pay Case for Taxing Worldwide Income,” 5 Fla. Tax Rev. 299 (2001).

11Section 63(a).






capacity to consume or invest.12 If deductions in relation to gross income are understated, there is excessive income taxation. If deductions are overstated, taxable income is understated, resulting in undertaxation.13

When taxable income must be determined for an advantaged subset of gross income, such as foreign-source taxable income eligible for a foreign tax credit or income exempt from tax, the usual incentives are reversed. If deductions in relation to foreign-source income or exempted income are understated, U.S. tax will be understated if more foreign taxes are allowed as a credit or if deductions are allowed to offset nonexempt income. If deductions against foreign or exempt income are overstated, U.S. tax will be overstated if credits or deductions appropriately allowed are disallowed.

This article deals with the treatment of deductions allocable to income that is not taxed, in this case because of exemptive deductions. Section 265(a)(1) addresses the issue with a general rule that deductions “allocable” to a class of income “wholly exempt from . . . taxes” shall not be allowed. The reason for the general rule of section 265 is straightforward and may be seen in Example 1.

Example 1: If Corp. A has gross income of $100 and allocable business expenses of $25, its taxable income is $75, and its tax at 21 percent is $15.75. If the taxable income is exempt, the taxpayer saves the $15.75 tax otherwise due.

If the $25 of expense is allowed as a deduction and offsets other income, the taxpayer effectively is refunded the tax on income offset by the deduction, or $5.25 (21 percent * $25 = $5.25). Instead of benefiting from the exemption by $15.75, the taxpayer’s benefit is $21 ($15.75 + $5.25 = $21).

The principle underlying section 265 is that the benefit from exempting income should not exceed the tax on the income. The tax is imposed on the gross income after it is reduced by allocable deductions (in Example 1, the tax of $15.25 on net income of $75). Under this structure, exemption of income does not affect the distribution of tax burden according to level of net income.

If deductions allocable to exempt income are allowed such that exemption applies to gross income, the benefit of exemption ($15.25 in Example 1) will be increased to $21. In a business income context, exemption of gross instead of net income will be more beneficial for businesses with more deductions and lower margins than for businesses with fewer deductions and higher margins. It is difficult to reconcile this discrimination among taxpayers with rational policy.

Another way to describe the principle of section 265 is that a deduction should not give rise to a double benefit.14 A deduction for an expenditure to generate income that is exempted should not also be allowed to offset other income. That would be using the deduction twice. If this is allowed as a general matter, a taxpayer could increase its expenditures to earn the exempted income and thereby erode the nonexempt tax base. Accordingly, a limit is necessary to protect the income tax base.15

12The principles governing when it is appropriate to allow a

deduction arise in a variety of contexts. Underlying the deduction disallowance issue addressed in this article is the question of when an otherwise allowable deduction should be allocable to a class of income — a subject addressed at length under existing regulations but not discussed in this article. See reg. sections 1.265-1(c) and 1.861-8 et seq.

13When deductions are overstated (or understated) as a deliberate

legislative choice, the deviation from income tax principles may be designed to achieve a nontax regulatory objective. Treasury classifies as tax expenditures the “reduced rate of tax” on GILTI from the section 250 deduction and the exemption of foreign dividends from tax by reason of the section 245A 100 percent DRD. The Treasury tax expenditure estimate for “Reduced tax rate on active income of controlled foreign corporations (normal tax method)” for 2020-2029 is $480.08 billion. This includes an offset for the collection during this period of deferred payments of tax on mandatory deemed repatriations under section 965. See Treasury, “Tax Expenditures,” supra note 8. This article does not consider the propriety of that one-time offset, which is questionable. See Fleming, Peroni, and Shay, “Getting From Here to There: The Transition Tax Issue,” Tax Notes, Apr. 3, 2017, p. 69 (arguing for full-rate transition taxation of deferred earnings while acknowledging the arguments for a distribution timing discount).

14See United States v. Skelly Oil, 394 U.S. 678 (1969) (“The Code should

not be interpreted to allow respondent ‘the practical equivalent of double deduction,’ Charles Ilfeld Co. v. Hernandez, 292 U.S. 62, 68 (1934), absent a clear declaration of intent by Congress.”).

15See Charlotte Crane, “Matching and the Income Tax Base: The

Special Case of Tax Exempt Income,” 5 Am J. Tax Pol’y 161, 237-238 (1986) (“Without such a rule and in the presence of readily available sources of exempt income, any otherwise taxable income could be immediately transformed into a tax-exempt receipt. If one could deduct $10 from other income, and receive $10 tax-exempt receipt, taxable income could be avoided, without any diminution in wealth, merely by participating in the transaction. The only limit would be imposed by the availability of such transactions.” (Footnote omitted.)).






In the TCJA, Congress adopted a form of partial territorial taxation known as foreign dividend exemption. The section 245A deduction eliminates the U.S. tax on the foreign portion of a dividend from a foreign corporation. Similarly, a GILTI deduction offsets 50 percent (declining to 37.5 percent in 2026) of a GILTI inclusion.16 Both exemptive deductions apply without regard to whether the underlying earnings have been previously taxed by the United States or, indeed, taxed — or even subject to tax — by any foreign country. The deductions are not based on an expenditure by the taxpayer and serve no separate measurement-of-income purpose. To the extent of the exemptive deduction, the United States is declining to assert its taxing jurisdiction over the foreign earnings.17

There has been little discussion whether U.S. shareholder expenses (other than the exemptive deduction) allocable to a foreign dividend or the portion of a GILTI inclusion offset by an exemptive deduction should be allowed to the shareholder as a deduction. Allowing a U.S. shareholder’s deductions allocable to the income offset by an exemptive deduction would be inconsistent with the basic principle that deductions allocable to exempted income should not be allowed.18 It has been widely accepted that deductions allocable to exempt income in an exemption regime should be disallowed (or an equivalent adjustment should be made to limit the

exemption).19 While this normative conclusion is clear, this article focuses on the analysis of section 265 and the exemptive deductions under the code.

Before turning to the relevant statutory background and considering whether section 265 applies to gross income offset by exemptive deductions, to motivate analysis of the disallowance issue, the next section considers the revenue implications of not disallowing deductions allocable to a U.S. shareholder’s income offset by an exemptive deduction.

B. Scale of the Exemptive Deduction Issue

The effect of not disallowing under section 265 U.S. shareholder deductions allocable to a U.S. shareholder’s income offset by an exemptive deduction may be seen in Example 2.

Example 2: Assume that USP, a U.S. corporation, owns all the stock of CFC, its only foreign subsidiary. CFC has $500 of taxable income for the year that is not subpart F income and is not GILTI (for example, because USP’s net deemed tangible income return for the year exceeds $500, so there is no GILTI inclusion). CFC pays a dividend of $250 at the end of the year. USP has $750 of U.S.-source gross income; $250 of foreign-source dividend income eligible for a section 245A exemptive deduction; and $450 of expense, of which $50 would be stewardship expense allocable to a dividend on CFC stock.20

USP’s gross income is $1,000, and its deductions are a section 245A deduction of $250 and other deductions of $450, including $50 allocable to the foreign dividend. USP’s taxable income is $300 ($1,000 - $250 - $450 = $300), and USP pays U.S. tax of $63 (21 percent * $300 = $63).

16The section 250(a)(1)(B) deduction for GILTI is determined without

any allocation of expenses of the U.S. shareholder to the GILTI inclusion before the deduction is determined. Note that the section 250 deduction for foreign-derived intangible income is after all U.S. deductions have been taken. Accordingly, the FDII section 250 deduction is in relation to a base already reduced by allocable deductions, with the result that these deductions are not allocable to the income after it is exempted by the FDII section 250 deduction.

17See Hugh J. Ault and Brian J. Arnold, Comparative Income Taxation, A

Structural Analysis 467-471 (2010) (describing different countries’ approaches to exempting foreign income).

18Regulations under section 862(b) prescribe rules for determining

deductions allocable to foreign-source gross income to reach foreign-source taxable income. Reg. section 1.861-8 et seq. This article does not address the appropriate content for these rules, but for purposes of discussion accepts the current rules as given.

19See Martin A. Sullivan, “Should Biden Fix a Forgotten Flaw That

Mismeasures Foreign Profits?” Tax Notes Int’l, May 3, 2021, p. 589, at 591 (summarizing the history of exemption proposals since 2001 and recommending disallowing deductions or reducing the DRD to account for deductions); and Michael J. Graetz and Paul W. Oosterhuis, “Structuring an Exemption System for Foreign Income of U.S. Corporations,” 54 Nat. Tax J. 771, 781 (2001) (“On the other hand, expenses allocable to exempt foreign income are properly described as deductions incurred to earn exempt income, which the Code typically disallows. Such deductions should be disallowed or allowed only to the extent they exceed exempt income in any year and are subject to recapture out of exempt income in subsequent years.”). For the history and an insightful analysis of the application of section 265 generally, see Crane, “Matching and the Income Tax Base,” supra note 15, at 229-266.

20Reg. section 1.861-8(e)(4)(ii)(B).






The 245A deduction of $250 reduces U.S. tax by $52.50 ($250 * 21 percent = $52.50). But the foreign-source taxable income is $200 ($250 - $50 = $200). The U.S. tax saved by exempting the net income of $200 would be $42 ($200 * 21 percent = $42). The additional $10.50 of tax saved is attributable to allowing the deduction of $50 to reduce U.S. tax on other income, which is more than the tax that would be saved by exempting the gross income net of deductions. From a U.S. perspective, the effective marginal tax rate on the investment giving rise to the deemed tangible income return is negative.21

Some simple metrics suggest the scale of the issue from a revenue perspective. If 10 percent of CFC earnings is subpart F income22 and 25 percent of CFC earnings is equal to a 10 percent return on net deemed tangible investment return (NDTIR), the remaining 65 percent of CFC earnings and profits would be GILTI. The total earnings offset by exemptive deductions would be 57.5 percent of total earnings (half of GILTI or 32.5 percent of earnings plus 25 percent of earnings that are NDTIR). If it is assumed that expenses allocable to income from CFCs are equal to approximately 20 percent of total CFC earnings, disallowed expenses would be 10.4 percent of total CFC earnings.23 At 21 percent, the marginal tax rate benefit to taxpayers of not disallowing allocable deductions would be approximately 2.17 percent of total CFC earnings.

This table is reproduced at Appendix A with explanatory comments.24

Under this model’s assumptions, the U.S. pre-credit effective tax rate on CFC net tested earnings without applying section 265 would be 3.05 percent. (In other words, the effective U.S. tax on the CFC net tested earnings assuming the level of exemptive deductions in the facts would be 3.05 percent absent the application of section 265.)

21Whether a foreign tax is imposed on the exempted gross income is

irrelevant. Long-standing U.S. tax policy has been to allow double taxation relief only for U.S. tax on foreign-source taxable income. The effect of disallowing deductions allocable to income offset by a section 250(a)(1)(B) deduction would be similar to that in Example 2 at low rates of foreign tax. Because the disallowed expense would have the effect of increasing U.S. tax and the FTC limitation, at higher rates of foreign tax, the effect on increasing U.S. liability would vary and depend on the facts.

22The most recent published IRS data are for 2016. The total subpart F

income ($95 billion) was 7.8 percent of the E&P of positive income CFCs ($1.221 trillion) and 8.9 percent of E&P of CFCs less deficits ($1.071 trillion).

23There is a long history of business community lobbying success in

reducing allocations of expenses to lower-taxed income. See American Bar Association Section of Taxation, “Report of the Task Force on International Tax Reform,” 59 Tax Law. 649, 769-771 (2006). If the approach to section 265 argued for in this article were adopted, or the Biden green book proposal included in legislation, it may be expected that there will be redoubled business community efforts to lobby for allocations of expenses away from foreign income to domestic income.

Table 1

Inputs

Row Description

1 CFC total earnings less deficits 100%

2 Subpart F and other exceptions -10%

3 CFC net tested earnings 90%

4 NDTIR 10% return less CFC interest expense

-25%

5 GILTI 65%

6 U.S. shareholder expenses allocable to total CFC earnings

20%

Marginal Tax Rate Benefit of Allowing Expenses Allocable to Exempted Income

7 50% * GILTI 32.5%

8 NDTIR 10% return less CFC interest expense

-25%

9 Exempt income 57.5%

10 U.S. expenses allocable to exempt income

10.4%

11 U.S. pre-credit tax rate on CFC net tested earnings without section 265

3.05%

12 U.S. pre-credit tax rate of CFC net tested earnings applying section 265

5.22%

13 Marginal tax rate benefit of not applying section 265

2.17%

24I thank Patrick Driessen for help in thinking about the issue in this

way and Martin Sullivan for his comments and identifying an error in an earlier version. The assumptions described in the text and in the model at Appendix A (and any remaining errors) are mine. The assumptions can be readily adjusted when better data are available. Driessen has been the leading analyst of the effects of expense allocation on the effective tax rate incurred by U.S. multinationals on foreign income. See, e.g., Driessen, “Getting Foreign Deferral’s Epitaph Right,” Tax Notes Federal, June 15, 2020, p. 1883; and Driessen, “GILTI’s Effective Minimum Tax Rate Is Zero or Lower,” Tax Notes Federal, Aug. 5, 2019, p. 889. Sullivan has long recognized the issue as well. See Sullivan, supra note 19.






After applying section 265, the effective tax rate on CFC net tested earnings would be 5.22 percent. The tax rate effect of applying section 265 is 2.17 percent of net tested income. This rate would approximate an average for all CFCs and would, of course, vary for each company depending on its facts. Under a range of reasonable assumptions, however, the amounts at stake would be material, possibly in the range of $5 billion to $10 billion a year, or $50 billion to $100 billion over a 10-year budget period.

The application of section 265 to income offset by exemptive deductions would prevent the overstatement of allowable deductions that would result from failing to disallow expenses allocable to income that bears no U.S. tax because of the exemptive deductions. Allowing deductions allocable to untaxed income essentially refunds U.S. tax on other income, which subsidizes the investment made to earn the exempted income. There is no indication in the TCJA’s legislative history that this subsidy (from allowing deductions allocable to exempt income) is intended.25

The next section provides relevant statutory background on the exemptive deductions before analyzing in Section III whether section 265 applies to income offset by exemptive deductions.

C. Statutory and Regulatory Background

1. The GILTI Exemptive DeductionSection 951A requires a U.S. shareholder of a

CFC to currently include GILTI in income.26 A U.S. shareholder that is a domestic corporation is allowed a deduction for 50 percent of the sum of the GILTI amount and the section 78 dividend attributable to it.27 This article refers to this 50 percent deduction against GILTI as the GILTI

exemptive deduction. The section 250 GILTI deduction combined with the section 250 foreign-derived intangible income deduction is subject to a taxable income limit. If the GILTI and FDII exceed the U.S. shareholder’s taxable income, GILTI and FDII deductions are reduced pro rata.28 The section 250 deduction as so limited is subject to the limitation of section 246(b).29 The section 250 deduction is not allowed in determining the amount of a net operating loss.30

2. The Section 245A Exemptive DeductionSection 245A provides a 100 percent

deduction for the foreign-source portion of a dividend (that is not a hybrid dividend) received by a 10 percent corporate U.S. shareholder on stock in a foreign corporation satisfying a holding period condition (a section 245A dividend).31 The foreign-source portion of a dividend is based on the ratio of undistributed foreign earnings to total undistributed earnings of the foreign corporation, each determined at the end of the year without reducing earnings for the dividends distributed during the year. This article refers to the 100 percent deduction as the section 245A exemptive deduction.

It is possible that a dividend from a CFC is in whole or in part from earnings effectively connected with a U.S. business or from dividends from an 80 percent owned domestic corporation (that is not a regulated investment company or a real estate investment conduit). The portion of the dividend that is attributable to those earnings would be subject to 50 percent section 245 dividends received deduction (DRD).32 The apportionment of the dividend between the

25Indeed, the deduction for FDII at section 250(a)(1)(A) was designed

to offset any incentive to shift investment to take advantage of GILTI and/or the section 245A 100 percent DRD exemption mechanism. See Tim Dowd and Paul Landefeld, “The Business Cycle and the Deduction for Foreign Derived Intangible Income: A Historical Perspective,” 71 Nat. Tax J. 729, 730 (2018).

26GILTI is the sum of a U.S. shareholder’s share of the tested income

of each positive income CFC in which it is a U.S. shareholder, reduced by the sum of the tested loss of each tested loss CFC in which it is a U.S. shareholder. A U.S. shareholder’s net tested income exceeding a 10 percent return on qualified business asset investment of its tested income CFCs measures the GILTI inclusion. Section 951A(b).

27Section 250(a)(1)(B). A section 78 dividend equals the amount of

foreign tax deemed paid under section 960 on the included GILTI.

28Section 250(a)(2). This could occur as a result of losses from the U.S.

shareholder’s sales to domestic customers. For ease of discussion, except as otherwise noted, it is assumed that the taxable income limit is not binding.

29The section 246(b) limitation also applies to the DRDs under

sections 243 and 245.30

Section 172(d)(8).31

Sections 245A(a) and 246(c). This article’s discussion will focus on the case of a corporate U.S. shareholder in a CFC, although the section 245A deduction also is allowed to a corporate U.S. shareholder in a specified 10 percent foreign owned corporation, which is any foreign corporation that is not a passive foreign investment company and that has a U.S. shareholder that is a domestic corporation. Section 245A(b). The issue presented is the same in both cases.

32Sections 245(a) and 243(a). Section 245A is not subject to the

limitation under section 246(b) on the aggregate amount of the section 243 and section 245 DRDs.






foreign earnings and the rest of the earnings directs section 245A at foreign dividend income. No FTC or deduction is allowed for any foreign income taxes paid or accrued on a dividend for which the section 245A exemptive deduction is allowed.33

3. Section 265(a)(1)Section 265(a)(1) disallows deductions

allocable to “one or more classes of gross income” (other than interest to which section 265(a)(2) applies) “wholly exempt from the taxes imposed by this subtitle.” Under section 261, the disallowance of deductions under section 265 takes precedence over code provisions allowing deductions, including sections 245A and 250. Before turning to interpretation of section 265, the next subsection describes statutory provisions that intersect with the exemptive deductions to assess their potential import for the interpretation of section 265 in relation to gross income offset by the exemptive deductions.

4. Exemptive Deductions and the FTC

a. The FTC

It may reasonably be asked, what is the relevance of the FTC to the disallowance under section 265 of deductions attributable to gross income offset by exemptive deductions:

• First, some code provisions described in this subsection of the article prescribe rules for allocating and apportioning deductions attributable to exempt income for purposes of the FTC limitation. Consequently, they are a potentially relevant context for interpreting section 265’s disallowance rules.

• Second, the regulatory implementation of these rules shows that the IRS appears to consider gross income offset by exemptive deductions as exempt income for purposes of sections 864(e)(3) and 904(b)(4), described below.

• Third, the approach taken in regulations under sections 864(e)(3) and 904(b)(4), particularly in conjunction, is quite distortive if the section 265(a)(1) deduction disallowance does not apply.

Because of the technical nature of this part of the argument, a more generalist reader may prefer to skim this section and retain their focus on the section 265 discussion.

The FTC mitigates the effects of income being subjected to taxation by two countries. In this case, the two countries are the United States and the country where the CFC earns its income. The U.S. tax on the taxable portion of the CFC’s earnings may be reduced by a credit for corporate-level foreign income tax.34 As previously noted, a section 245A dividend is not allowed to be offset by an FTC.35

The FTC broadly involves two steps. The first is to determine whether the foreign tax is an income tax for purposes of the FTC, and how much tax is paid.36 In this discussion, it is assumed that the foreign taxes are income taxes and that the amount of the foreign tax is not in question. The second step is to determine the limit on the amount of the foreign tax allowed to offset the U.S. tax. The purpose of the FTC limitation is to prevent foreign taxes from being allowed as a credit against U.S. tax on U.S.-source taxable income.37

The FTC limitation is applied separately to categories of foreign-source income, including passive income,38 GILTI (that is not passive income),39 and general category income (including subpart F income that is not passive category income).40 The FTC limitation for a limitation category is determined by multiplying the U.S. taxpayer’s total U.S. taxes (before reduction by the FTC) by a fraction. The numerator is foreign-source taxable income in the relevant income category, and the denominator is the taxpayer’s worldwide taxable income.41 Accordingly, the allocation of deductions between U.S.-source and foreign-source income in a limitation category

33Section 245A(d).

34Section 960.

35Section 245A(d).

36Section 901.

37A corollary purpose for the limitation is to prevent foreign

governments from raising tax rates at the expense of the U.S. treasury.38

Section 904(d)(1)(C).39

Section 904(d)(1)(A).40

Section 904(d)(1)(D). There also is a separate limitation for income in a foreign branch limitation category. See section 904(d)(1)(B).

41Section 904(a) and (d).






determines the relative size of the numerator of the fraction. The more deductions allocated to a category in the numerator, the smaller the numerator and the limitation for that category. As this makes clear, the allocation of deductions to or away from foreign-source income in a category is an essential part of the FTC regime.42

b. GILTI, the Section 960 Indirect Credit, and Section 864(e)(3)

The portion of GILTI that is not offset by the GILTI exemptive deduction is foreign-source income taxed by the United States. If a domestic corporate U.S. shareholder elects the FTC for a year, the shareholder is treated as paying 80 percent of its share of the foreign taxes associated with a GILTI inclusion (before reduction by the GILTI exemptive deduction).43 The U.S. shareholder also must include in income a “section 78 dividend” for 100 percent of the CFC-level foreign income taxes associated with the net tested income that is included in GILTI.44 The U.S. corporate shareholder’s deemed paid foreign taxes assigned to the GILTI FTC limitation category may be used for cross-crediting against other GILTI but may not be used against income in other limitation categories.45

The final FTC limitation regulations make it clear that U.S. shareholder deductions must be allocable to GILTI in determining the numerator

of the FTC limitation.46 Section 864(e)(3), adopted in the Tax Reform Act of 1986,47 provides that a tax-exempt asset (and income from the asset) is not taken into account in the allocation and apportionment of deductions.48 This rule applies only to deductions that are allowed as expenses, and not to expenses disallowed under section 265.49

In applying section 864(e)(3), post-TCJA regulations treat GILTI offset by a GILTI exemptive deduction as exempt income, and they treat stock in the CFC as an exempt asset in proportion to the exempt income.50 Accordingly, GILTI (and stock from which it is derived) is excluded from the numerator and denominator of the FTC limitation fraction based on the ratio of the GILTI exemptive deduction to the amount of the GILTI inclusion.51 The effect of this rule is illustrated in Example 3, which is drawn from the example at reg. section 1.904(b)-3(e).

Example 3: USP, a domestic corporation, owns a domestic factory with a tax book value of $27,000x. USP owns three CFCs and has a tax book value of $10,000x in the shares of each CFC, $8,000x of which is assigned to the section 951A (GILTI) category and $2,000x of which is assigned to the general category in the section 245A subgroup. USP has U.S.-source gross income of

42See H. David Rosenbloom, “The U.S. Foreign Tax Credit Limitation:

How It Works, Why It Matters,” Tax Notes Int’l, Mar. 9, 2020, p. 1069.43

Section 960(d); see reg. section 1.960-1(d)(2)(ii)(C) and -2(c)(7), Example 1. Tested foreign income taxes include taxes on the portion of GILTI that is offset by the 50 percent section 250 deduction. The limit should have been based on 1 minus the GILTI deduction percentage, which would be 50 percent until 2026 and then would be 62.5 percent instead of 80 percent. Only the amount of taxes actually deemed paid should be included in income under section 78. The potentially material excess credits under the current regime may partially explain the denial of a carryover for foreign taxes in the GILTI limitation. Section 904(b).

44Section 78. More technically, the section 78 dividend is for a CFC’s

“tested income foreign taxes” deemed paid by the CFC on the GILTI included in the U.S. taxpayer’s income and attributed to the CFC. Tested income foreign taxes are the taxes associated with the tested income underlying the GILTI inclusion without reduction by the 20 percent haircut.

45Section 904(d)(1)(A) and reg. section 1.904-4(g). The regulations

appear to allow the deemed paid foreign taxes attributable to the GILTI inclusion offset by the GILTI exemptive deduction to be allowed as a credit available for cross-crediting. See reg. sections 1.960-2(c)(7), Example 1; and 1.903(b)-3(e), Example. If, as discussed below, GILTI offset by an exemptive deduction is exempt income for purposes of section 265, the foreign taxes attributable to the exempted gross income also should be disallowed. See, e.g., Heffelfinger v. Commissioner, 5 T.C. 985 (1945) (Canadian taxes on income exempt from U.S. tax under a predecessor to section 911 were not deductible).

46See T.D. 9882, 84 F.R. 69022, at 69023-69024 (citing JCT, “General

Explanation of Public Law 115-97,” JCS-1-18, at 381 n.1753 (Dec. 20, 2018)).

47Section 864(e)(3) provides:For purposes of allocating and apportioning any deductible expense, any tax-exempt asset (and any income from such an asset) shall not be taken into account. A similar rule shall apply in the case of the portion of any dividend (other than a qualifying dividend as defined in section 243(b)) equal to the deduction allowable under section 243 or 245(a) with respect to such dividend and in the case of a like portion of any stock the dividends on which would be so deductible and would not be qualifying dividends (as so defined).

48The second sentence of section 864(e)(3) subjects dividend income

offset by the section 243 and section 245 deductions to the same rule. The provision does not apply to deductions described in section 243(b) from a payer in the affiliated group. The deductions covered are partial DRDs mitigating double corporate taxation on specific dividends from a domestic corporation and dividends from a foreign corporation on earnings that have been subject to U.S. corporate taxation as effectively connected income. The general effect of these rules for domestic-source dividends from unaffiliated U.S. and foreign corporations is to prevent excessive allocation of deductions to domestic income that has already been subject to U.S. corporate tax.

49See JCT, “General Explanation of the Tax Reform Act of 1986,”

JCS-10-87, at 949 (May 15, 1987).50

Reg. section 1.861-8(d)(2)(ii)(C).51

Reg. section 1.861-8(d)(2)(ii)(C)(1) and (2)(ii).






$1,600x and a GILTI inclusion amount of $2,200x.52 USP has a GILTI exemptive deduction of $1,100x (50 percent * $2,200x) and interest expense of $1,500x.53 Half of each CFC’s stock assigned to the section 951A category, or $4,000x, is treated as exempt under section 864(e)(3), so $12,000x of stock basis is excluded from the apportionment fraction (and $12,000x stock basis remains).

The $1,500x of interest expense is apportioned based on assets after being adjusted for section 864(e)(3) as follows:

The effect of the regulation is to shift interest expense away from section 951A and to the other categories. If section 864(e)(3) did not apply, then absent any disallowance under section 265(a)(1), the allocation would be:

Specifically, the effect of the rule in Example 3 is to shift $232x of interest away from reducing the FTC limitation on foreign taxes imposed on GILTI to exempt foreign dividends and U.S. income instead. This will expand the GILTI FTC limitation and thereby allow more FTCs.54 This

does not reach the correct answer. The correct answer is to disallow the interest expense allocable to half the GILTI ($315x = 50 percent * $632 (rounded)) and allocate the remaining $1,185x according to the assets after the application of section 864(e)(3):

In other words, the operation of section 863(e)(3) is more coherent when section 265 applies to disallow deductions allocable to income offset by exemptive deductions.

c. Sections 245A and 904(b)(4)

Section 904(b)(4) provides that a 245A dividend and deductions allocable to a 245A dividend (and the portion of stock giving rise to a section 245A dividend) are not taken into account for purposes of the FTC limitation (numerator and denominator).55 This rule parallels the rule of section 864(e)(3), except that it applies only for purposes of subsection (a) of section 904.

With the preceding as background, we turn to statutory interpretation of section 265 in relation to income offset by an exemptive deduction.

III. Section 265 and Exemptive Deductions

This Section III considers the following: Does section 265(a)(1) disallow deductions allocable to gross income offset by the GILTI or the section 245 exemptive deduction? The discussion in this part of the article is broken into separate elements to allow the pieces to be assembled according to the reader’s interpretative proclivities.56 The order of questions addressed is:

52The example in the regulations provides that the CFCs make no

distributions, so we are not told directly whether the CFCs had any deemed tangible income return on their tangible assets (if any), but because $2,000x of the stock is assigned to the section 245A subgroup of the general category, it may be inferred that the CFC had deemed tangible income return. See reg. section 1.861-13(a).

53The example does not mention section 265.

Description Asset Basis Allocation

Section 951A assets $12,000x $400x

General section 245A assets $6,000x $200x

Residual U.S. grouping $27,000x $900x

Totals $45,000x $1,500x





Totals $57,000x $1,500x

54The rule also may permit foreign taxes attributable to the exempt

GILTI to be used to a greater extent than otherwise.





Totals $45,000x $1,185x

55Regarding whether section 904(b)(4) would be necessary if section

265 applied, the answer is yes, as indicated in the last sentence of reg. section 1.903(b)-3(b), applying the rule to the section 245A exemptive deduction itself.

56That is, as a textualist, a purposivist, or a pragmatic. The pragmatic

rejects ready classification. See, e.g., Richard A. Posner, How Judges Think, ch. 191-203 (2008).






• Does the statutory language support applying section 265(a)(1) to gross income offset by exemptive deductions?57

• Does the context support applying section 265(a)(1) to gross income offset by exemptive deductions?

• Does the legislative history support applying section 265(a)(1) to gross income offset by exemptive deductions?

A. Section 265 Statutory Language

The first clause of section 265(a)(1) identifies circumstances in which a deduction will be disallowed.58 The provision has three elements:

• it potentially applies to “any amount otherwise allowable as a deduction”;

• the amount must be “allocable to one or more classes of income other than interest”; and

• the “class of income” must be “wholly exempt from the taxes imposed by this subtitle.”

From the earliest days of the income tax, it was recognized that “expenses incurred in earning income which is not subject to tax under the income tax law do not constitute allowable deductions in computing net income from other sources which are taxable under the law.”59 This is the principle adopted in 1934 in the predecessor to section 265(a)(1) in relation to income other than interest.60

The question here is whether the language of the first clause of section 265(a)(1) admits of an interpretation that would apply the disallowance rule to expenses (otherwise allowable as deductions) allocable to income that is exempted by the mechanism of an exemptive deduction. Sections 250(a)(1)(B) and 245A each describe an amount that otherwise would be deductible. The gross income that is offset by these exemptive deductions is not exempt, so section 265 does not apply to the exemptive deductions themselves. Once an exemptive deduction is applied, however, the gross income that is offset by the exemptive deduction is readily described in the words “wholly exempt from the taxes imposed by this subtitle.” In other words, for purposes of section 265, exempting gross income is equivalent to including gross income and offsetting it with an exemptive deduction. In both cases, any deductions allocable to the resulting exempt income should be disallowed.

But wait. Would that reading cause section 265(a)(1) to potentially apply whenever any deduction was allocable to gross income? This clearly is not contemplated by section 265(a)(1).61 What is it about exemptive deductions that would justify marrying the exemptive deduction to gross income so as to treat the gross income as exempt and not similarly treating all other corporate deductions?

1. Attributes of Exemptive DeductionsExemptive deductions have the following

attributes that when combined, single out exemptive deductions from other deductions for corporations (found in parts VI and VIII of subchapter A):

• the exemptive deductions are not the result of any expenditure of amounts for property or services relating to the corporation’s business;62

57See Hughes Aircraft Co. v. Jacobson, 525 U.S. 432, 438 (1999) (“As in

any case of statutory construction, our analysis begins with ‘the language of the statute.’”). I forgo string cites of Supreme Court cases to the same effect.

58Section 265(a)(1) provides: “Any amount otherwise allowable as a

deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.” This article does not discuss the second clause, involving section 212 deductions allocable to interest. See Crane, “Matching and the Income Tax Base,” supra note 15, at 245-246.

59T.D. 2137, quoted in Crane, “Matching and the Income Tax Base,”

supra note 15, at 243. Crane goes on to note that the principle was not followed closely until the enactment in 1917 of the predecessor of section 265(a)(2) concerning tax-exempt interest. War Revenue Act of 1917, section 1201(1).

60See Revenue Act of 1934, adding section 24(a)(5).

61For example, if section 265 disallowed allocable deductions

whenever gross income was offset by a deduction, there would be no loss carryovers.

62Allowing a deduction without any underlying expenditure does

not achieve a measurement-of-income objective, but it is equivalent to excluding the same amount of gross income. Under an income tax, double taxation of the “same” income is avoided by allowing deductions for costs paid with after-tax dollars of producing that income. See Skelly Oil, 394 U.S. 678.






• the “amount” of each exemptive deduction is determined before the allocation of other deductions (here U.S. shareholder deductions that are not taken into account in determining tested income);63

• in contrast to other non-expenditure deductions, such as the section 243 and section 245 DRDs, the exemptive deductions do not serve a purpose to avoid double U.S. corporate taxation;64 and

• the exemptive deductions declare that the United States declines to assert its taxing jurisdiction over the foreign portion of a dividend from a foreign corporation and the requisite percentage of GILTI (50 percent until 2026).65

Deductions that share some of the features of the exemptive deductions are the percentage depletion deduction66 and the qualified business income (QBI) deduction.67 The percentage

depletion deduction, which is calculated as a percentage of gross income from the property (reduced by rents and royalties paid regarding the property and limited to 50 percent of taxable income from property), is the closest to the exemptive deductions.68 Percentage depletion, which substitutes for cost depletion when it is more generous, is best understood as a taxpayer-favorable instrument to measure income (much like accelerated depreciation) and as an incentive for resource extraction.69 The history of percentage depletion demonstrates that Congress thought it was enacting an administrable substitute for the discovery depletion deduction, which had proven incapable of being administered with any consistency or fairness but nonetheless was designed to allow recovery of costs of unsuccessful wells.70 Percentage depletion may be distinguished from the exemptive deductions, which are untethered from measurement-of-income objectives.

The QBI deduction is based on a percentage of taxable income from a business. There are no deductions allocable to pretax income offset by the QBI deduction, and consequently, application of section 265 would have no effect.71 A non-63

If the exemptive deduction is applied after all other deductions (i.e., to the gross income net of allocable deductions), section 265(a)(1) should not apply, because the other deductions all have been taken against nonexempt income. The section 250(a)(1)(A) FDII deduction is an example of such a case. The comparable legislative fix for GILTI is described in Section VI, and a possible text is in Appendix C. The fiscal 2022 green book, supra note 7, includes such a proposal, as well as other changes relevant to the exemptive deductions. The draft at Appendix C does not consider those other changes, but at their current level of specification, they would not appear to require a change to the draft.

64Note that in the TCJA, Congress did not add section 245A to the

second sentence of section 864(e)(3), showing that it did not consider section 245A to be the same as the intercorporate DRDs in sections 243 and 245. Section 246A also was not amended to add section 245A to the reduction in DRD for debt-financed stock. I thank Wade Sutton for pointing that out. See also Christopher P. Bowers, Oosterhuis, and Joshua G. Rabon, “Worldwide Interest Apportionment Has Arrived: What Do We Do Now?” Tax Notes Int’l, Jan. 25, 2021, p. 453, at 469 (in considering the policy underlying section 904(b)(4), they write: “Perhaps the most plausible explanation is that Congress viewed the section 245A deduction as fundamentally different from a DRD under section 243 or section 245(a), which are intended to relieve duplicative taxation on distributions of earnings that have already been subject to U.S. tax at least once.”).

65The exemptive deductions are the mechanism by which Congress

implemented partial territorial taxation in the form of a dividend exemption regime. See Bowers, Oosterhuis, and Rabon, supra note 64, at 469 (Section 245A “could be viewed as excluding a portion of a foreign corporation’s activities from the scope of the U.S. tax regime entirely, and therefore any shareholder-level expenses allocable to that income should be effectively disallowed for FTC purposes under principles similar to section 265.”).

66Sections 613 and 613A.

67Section 199A. See Crane, “Double or Nothing: Sorting Out the

Consequences of PPP Loans,” Tax Notes Federal, June 8, 2020, p. 1705, at 1710. The domestic production activity deduction (now repealed) preceded the QBI deduction. Former section 199 (in effect until 2018).

68Percentage depletion is taken before the QBI deduction. The

depletion allowance was recognized by the Supreme Court in Skelly Oil as having the same effect as an exclusion of income such that the Court upheld denial of a deduction of customer refunds to the extent they had originally been untaxed because of the depletion allowance. Skelly Oil, 394 U.S. 678. Crane, “Double or Nothing,” supra note 67, at 1710.

69For the history of the immediate predecessor of the percentage

deletion deduction, known as “discovery depletion,” and its evolution into the percentage depletion deduction, see Joseph J. Thorndike, “When Reforms Go Bad: The Origins of Percentage Depletion,” Tax Notes Federal, Aug. 12, 2019, p. 997; and George K. Yin, “A Maritime Lawyer, Percentage Depletion, and the JCT,” Tax Notes, Sept. 19, 2016, p. 1695. The 1918 adoption of the discovery deduction was based on the value of wells and resulted in a morass of valuation complexity. In 1926 it morphed into the percentage depletion deduction based on a percentage of the operating income from the well. Thorndike, supra, at 1,000.

70Thorndike, supra note 69; and Yin, supra note 69. The Revenue Act

of 1926 provided for a percentage depletion allowance equal to 27.5 percent of a well’s gross income. Adopted eight years before the predecessor to section 265(a)(1), there is no indication that Congress considered the percentage depletion deduction as a partial exemption of, or as a reduced effective tax rate on, income from oil and gas. It was a successor to the discovery depletion regime for recovering costs of unsuccessful wells. That the predecessor discovery depletion itself was flawed as a surrogate for costs of production is shown by Yin to be attributable to mistakes made in its formulation.

71In this respect, the effect is the same as the section 250(a)(1)(A) FDII

deduction. See supra note 16.






expenditure deduction calculated in relation to taxable income is a proxy for a modification of the tax rate. A non-expenditure deduction calculated in relation to gross income has an effect equivalent to a reduced tax rate only if other expenses allocable to the gross income reduce the gross income before the deduction is taken or, if not, are disallowed. Those who would argue that Congress intended for the exemptive deductions to serve as an effective rate reduction implicitly are arguing for section 265(a)(1) to apply.

There is no evidence in the statute enacting the exemptive deductions that Congress did not intend for section 265 to apply.72 As demonstrated in Section III.B below, the affected provisions operate as intended when section 265 is applied. As discussed in Section III.C below, the legislative history supports the conclusion that section 265 should apply.

2. Scope of ‘Class of Income’What is meant by the statute’s use of the term

“class of income”? For example, is it limited to the items of gross income listed in section 61? Clearly, the answer is no. First, the list of income items in section 61 is by its own terms nonexclusive, because gross income is defined to be “all income from whatever source derived, including (but not limited to) the following items.”73 (Emphasis added.)

Can the term “class of income” refer to gross income that is offset by an exemptive deduction? The infamous (to tax lawyers) Gitlitz decision is instructive in interpreting “item of income” to include cancellation of debt income excluded from gross income of a corporation to the extent it

remained insolvent after the forgiveness.74 If Gitlitz remains good law, despite the evident failure of its interpretative method to discern what Congress appears to have intended,75 the same interpretative approach applied here (hopefully more appropriately) supports allowing “class of income” to include income identified by its being offset by an exemptive deduction. Importantly, this reading of the term “class of income” comports with the use of the term elsewhere in the code.

Sections 652(b) and 662(b), which provide for flow-through to a trust beneficiary of character of amounts distributed by a trust, use “class of income” to refer to the possibility that the trust instrument specifically allocates income to different beneficiaries. A class of income for this purpose can be income under trust accounting rules that differ from tax accounting and can include net income amounts. Thus, the code’s use of the term “class of income” is consistent with an understanding that it refers to an inherently flexible concept and is not limited to categories of gross income. Accordingly, a class of income can include gross income identified by its being offset by an exemptive deduction.

3. Income Wholly Exempt From TaxDoes the class of income described in section

265(a)(1) have to be excluded “gross income,” for example, of the kind found among exclusions from gross income in Part III of subchapter B?76 The regulations under section 265(a) consider a class of income wholly exempt from taxes to include income “wholly excluded from gross

72See the discussion of the legislative history of exemptive

deductions, infra at Section III.C.2.73

Does the use of the parenthetical words “but not limited to” in section 61 imply that use of “includes” in the regulation under section 265 without modifying language should be deemed exclusive? That goes too far. As then-Judge Brett M. Kavanaugh observed regarding the consistent usage canon, “Of course, that rigidity is inappropriate — in documents as complex and sprawling as statutes, oftentimes authors will use the same term to mean different things in different places.” Kavanaugh, “Fixing Statutory Interpretation,” 129 Harv. L. Rev. 2118, 2162 (2016). This may be going out on a limb, but regulations under the IRC arguably come within the scope of “complex and sprawling.”

74Gitlitz v. Commissioner, 531 U.S. 206 (2001). For a cogent criticism of

stupid literalism in the interpretation of tax statutes as exemplified by Gitlitz, see Jasper L. Cummings, Jr., “The Meaning of ‘Tax-Exempt Income,’” Tax Notes Federal, June 21, 2021, p. 1957. See also Calvin H. Johnson, “The Supreme Court’s Statutory Interpretation in Gitlitz: A Failed Approach to Interpretation and a Bad Decision,” 40 ABA Tax Times 1 (2020).

75The result in Gitlitz (decided Jan. 9, 2001) was legislatively

overruled by an amendment to then-section 108(d)(7) to prevent excluded cancellation of indebtedness income of an S corporation from increasing shareholder basis. Job Creation and Worker Assistance Act of 2002, section 402.

76Part III of subchapter B encompasses sections 101-140. Relatively

few of these exclusions for income other than interest have relevance to a corporation.






income under any provision of Subtitle A.”77 (Emphasis added.) This interpretation would restrict the scope of what is considered income wholly exempt from taxes to an extent not required by the text of the statute.

Gross income offset by an exemptive deduction is in fact “wholly exempt from the taxes imposed by this subtitle.”78 As stated in Curtis, the earliest reported case applying the predecessor to section 265(a)(1), in 1944: “The language of section 24(a)(5), including therein the phrase [‘income wholly exempt from . . . taxes’], is susceptible of only one sensible interpretation, namely, that a taxpayer is allowed no deduction for expenditures which are allocable to income that is nontaxable for whatever reason.”79 (Emphasis added.)

Importantly, the section 265 regulation’s meaning for income wholly exempt from taxes is prefaced by the term “includes,” which can either be used to indicate an exclusive list or a nonexclusive list of items. The term “includes” in legal usage is more commonly used to leave open

the possibility of additional items,80 although it is possible for it to describe a closed group of items. The interpretation of the regulation as providing a nonexclusive definition of exempt income encompasses a statutory interpretation that includes gross income offset by an exemptive deduction within the scope of section 265(a)(1).

The term “income” is used throughout the code and is preceded by numerous modifiers (“gross,” “adjusted gross,” “taxable,” and so forth). Section 265(a)(1) uses the term “class of income” and not, as used for example in section 862(b), “class of gross income.” There is no presumption that when the word “income” is preceded by “class of,” it means “gross income,” particularly where “wholly exempt from the taxes imposed by this subtitle” can refer to taxable income and exemption can be achieved by deduction as well as exclusion. As observed in Curtis, the target of section 265 is income “that is nontaxable for any reason.”

4. Section 265 Case LawThere are relatively few cases that address

section 265 (or its predecessor) generally and even fewer that raise interpretative questions. There is no Supreme Court case interpreting section 265(a)(1).81

Cases interpreting section 265(a) generally involve excluded gross income, as expected in light of the regulation’s approach to defining income wholly exempt from taxes. With one arguable exception, the cases do not consider exemption situations paralleling those involving exemptive deductions. This may be because there are few precedents for deductions having the configuration of attributes of exemptive deductions. The cases do not foreclose the

77Reg. section 1.265-1 provides in part:(b) Exempt income and nonexempt income.

(1). . . . For purposes of this section, a class of income which is considered as wholly exempt from the taxes imposed by subtitle A includes any class of income which is:

(i) Wholly excluded from gross income under any provision of Subtitle A, or(ii) Wholly exempt from the taxes imposed by Subtitle A under the provisions of any other law.

(2) As used in this section the term nonexempt income means any income which is required to be included in gross income.

The regulation is substantially unchanged from when first adopted soon after the enactment of the predecessor to section 265(a)(1). See Heffelfinger, 5 T.C. at 991.

78Indeed, final regulations issued in 2019 interpreting a different

code provision, section 864(e)(3), treat gross income offset by the GILTI exemptive deduction as “exempt income.” Reg. section 1.861-8(d)(2)(ii)(C) (GILTI income offset by a GILTI exemptive deduction treated as exempt income for purposes of applying section 864(e)(3)). As a result, GILTI income (and stock from which it is derived) is excluded from the numerator and denominator of the FTC limitation apportionment fraction based on the ratio of the GILTI exemptive deduction to the amount of the GILTI inclusion. Reg. section 1.861-8(d)(2)(ii)(C)(1) and 2(ii). The operation of section 864(e)(3) is discussed supra, at Section II.B.4.

79Curtis v. Commissioner, 3 T.C. 648, 651 (1944). Section 59(i) provides

in part that “any amount shall not fail to be treated as wholly exempt from tax imposed by this subtitle solely by reason of being included in alternative minimum taxable income.” The reference to an “amount” without reference to “income” or “gross income” lends support to the argument in the text.

80This corresponds to the semantic canon of interpretation to

presume a nonexclusive meaning of the word “include.” See Antonin Scalia and Bryan Garner, Reading Law: The Interpretation of Legal Texts 132-133 (2012) (“That is the rule both in good English usage and in textualist decision-making.” (Footnotes omitted.)). See also Cummings, supra note 74, at 1962-1964 (listing cases supporting predominant usage of “including” to expand, not limit, the meaning of a term). The use of the term “or” in relation to the two categories listed is best understood to include the sense of “and.” Garner, The Elements of Legal Style 103 (2002).

81Under the Supreme Court’s decision in Brand X, a notice and

comment regulation would not have to follow a prior court’s interpretation unless it is a Supreme Court interpretation of the text that leaves no ambiguity. National Cable & Telecommunications Association v. Brand X Internet Services, 545 U.S. 967 (2005); and United States v. Home Concrete & Supply LLC, 566 U.S. 478 (2012). There is no such Supreme Court decision here.






application of section 265(a)(1) to income offset by exemptive deductions.

Perhaps the most significant interpretative issue addressed in the section 265 case law is whether specific nonrecognition provisions should be considered to give rise to gross income “wholly exempt from the taxes imposed by this subtitle.” This line of cases has concluded that income subject to nonrecognition under sections 332 and 337 is not considered wholly exempt.82 The decisions’ rationales are largely based on the view that the carryover of tax attributes preserves future taxation so that exemption may be considered temporary. In contrast, the exemptive deductions result in permanent, not temporary, exemption from tax.83

In Petschek, the Second Circuit overruled a district court decision and held that the exclusion of a war loss recovery to the extent a prior deduction for the loss had not been used would not be treated as wholly exempt gross income, and deductions incurred to win the recovery were allowed.84 The class of income tested by the court under section 265 was the war loss recovery and not solely the excluded portion, and therefore the gross income should not be considered wholly exempt. This conclusion may raise the question whether the exempt income analysis can be based on a portion of underlying gross income. The Second Circuit placed weight on the fact that had the taxpayer not been required by the code’s war loss provision to claim a deduction for the year of the loss, the recovery likely would have

constituted recovery of basis and not gross income in the first place (in which case section 265 would not apply, and deductions to win the recovery would be allowed).85

The facts and context of Petschek are distinguishable from treating as exempt gross income offset by an exemptive deduction. Petschek seeks to measure net income correctly over the affected periods. In contrast, the amount of the GILTI exemptive deduction is determined based on a fixed percentage of a category of income — GILTI as defined in section 951A — and the 245A exemptive deduction is 100 percent of the foreign-source portion of a dividend from a foreign corporation. The income offset by the exemptive deductions will be “untaxed” without regard to tax attributes of the taxpayer.

It might be argued that the taxable income limitation on the section 250 deductions in section 250(a)(2) is a taxpayer attribute. This limitation effectively restricts the income exclusion to the GILTI and FDII that would be taxed, if, for example, there were a domestic loss. It is unclear why this limit should be given significance. Gross income exclusions are subject to comparable limitations. For example, the section 104 exclusion from gross income of a recovery for damages physical injuries or sickness is not applicable to the extent of prior section 213 medical deductions (which in turn must exceed a percentage, currently 7.5 percent, of adjusted gross income). The taxable income limit is a similar mechanic to prevent the effective reduction in tax rate from applying to income not intended to be within its scope. The limit is consistent with treating the deduction as equivalent to an exclusion and does not align with a tax base measurement rationale.

Nonetheless, an argument against an interpretation applying section 265 to exemptive deductions could be that under section 265, the “class of income” should be all dividends from a foreign corporation or all GILTI, not just the portion eligible to be offset by the GILTI exemptive deduction, and that the income therefore should not be considered “wholly

82See Commissioner v. McDonald, 320 F.2d 109 (5th Cir. 1963); and

Commissioner v. Universal Leaf Tobacco Co., 318 F.2d 658 (4th Cir. 1963). The IRS has acquiesced to decisions in these cases. Rev. Rul. 63-233, 1963-2 C.B. 113. See also Hawaiian Trust Co. Ltd. v. United States, 291 F.2d 761 (1961).

83If the income offset by the exemptive deduction is later used to

acquire an asset, the asset will have a full cost basis. This is the same result as for excluded gross income. This article does not address whether or when a “backward disallowance rule” should apply under section 265. See Joseph M. Dodge, “Disallowing Deductions Paid With Excluded Income,” 32 Fla. Tax Rev. 749 (2013). See also Cummings, supra note 74, at 1967; and Crane, “Matching and the Income Tax Base,” supra note 15, at 250-254.

84Petschek v. United States, 335 F.2d 734 (2d Cir. 1964). Viktor Petschek

claimed a deduction for war losses in relation to the assets for which he later received war loss awards. The relevant income exclusion provided that war loss recoveries would be excluded to the extent attributed to prior deductions that did not give rise to a tax benefit. War loss recoveries attributed to prior deductions that had yielded a tax benefit were includable in income, and any recoveries exceeding prior deductions were treated as gain from an involuntary conversion eligible for a section 1033 rollover.

85Petschek, 335 F.2d at 738 (“If Congress had not required him to take

the deduction in 1941, his later recoveries up to his basis would not have been income exempt from taxes, to which the prohibition of section 265 alone applies they would not have been income at all.”). See Crane, “Matching and the Income Tax Base,” supra note 15, at 242 n.105.






exempt from . . . taxes.” This would be at odds with the position recently taken by the IRS in Notice 2020-32, 2020-21 IRB 837, and Rev. Rul. 2020-27, 2020-50 IRB 1552, which would have disallowed certain expenses to the extent they give rise to forgiveness of a covered PPP loan (when forgiveness of the loan is based on the amount of those expenses).86 Although the notice was overridden by legislation, the reason was not that the analysis in the notice was incorrect, but that Congress intended to provide the double benefit.87 The interpretation in the notice also is consistent with the approach to interpreting section 265(a)(1) manifest in Curtis that section 265(a)(1) should apply to income “that is nontaxable for whatever reason.”88

What may be concluded so far is that the text of section 265(a)(1) permits an interpretation that would apply it to gross income offset by an exemptive deduction.

B. Context: Section 265, Exemptive Deductions

Section 265 prevents a double benefit from the exemption of gross income.89 Section 261 provides that deduction disallowances in Part IX of subchapter B take precedence over income tax deductions. As commonly stated, deductions are a matter of legislative grace, and the burden is on the taxpayer to establish eligibility for a deduction.90 There should be a basis in the statute or in the legislative record (discussed in the next

section) to show that Congress intended that deductions be allowed against gross income offset by the exemptive deductions despite section 265.

There is nothing in the statute to indicate that section 265 does not apply to gross income offset by a section 245A exemptive deduction. As previously observed, those dividends are readily encompassed by the words class of “income other than interest . . . wholly exempt from the taxes imposed by this subtitle.” The statute is silent on the treatment of expenses allocated under section 862(b) to the untaxed foreign dividend income.91 Section 904(b)(4) operates appropriately regarding the section 245A dividend, the section 245A exemptive deduction, and any other deduction not disallowed because of section 265(a)(1).92

Section 265(a)(1) also operates coherently to disallow deductions allocable to an inclusion in gross income under section 951A that is offset by the GILTI exemptive deduction. The disallowance does not change the amount of the taxable and untaxed amount of the GILTI inclusion. The CFC earnings attributable to the taxable amount are assigned to CFCs in the same way as previously to become previously taxed E&P.

There is further statutory evidence that Congress intended for section 265(a)(1) to apply to income exempted by the GILTI exemptive deduction. The second sentence of section 864(e)(3), which addresses the treatment of income exempted by intercorporate dividend deductions under section 243 and section 245, was not amended to include section 245A, leaving it to be addressed under the first sentence as the regulations do. The regulations have applied section 864(e)(3) to treat GILTI offset by the GILTI exemptive deduction as exempt gross income for

86Rev. Rul. 2020-27 was obsoleted by Rev. Rul. 2021-2, 2021-4 IRB 495.

Notice 2020-32 explains that under section 1106(b) of the Coronavirus Aid, Relief, and Economic Security Act, a recipient of a covered loan can receive forgiveness of indebtedness on the loan without income inclusion (covered loan forgiveness) in an amount equal to specified expenses under a series of conditions and limits.

87See Crane, “Double or Nothing,” supra note 67, at 1711; letter from

Thomas Barthold to Senate Finance Committee member John Cornyn, R-Texas (July 27, 2020) (on this basis and the manner in which the Congressional Budget Office scored the CARES Act, the congressional override did not change the revenue baseline, and the JCT accordingly found no revenue effect). For criticisms of the application of section 265 to the PPP loans, see Stanley I. Langbein, “The Deductibility of PPP-Reimbursed Expenses,” Tax Notes Federal, Dec. 14, 2020, p. 1747; Matthew A. Morris, “Does the Deductibility of Qualifying PPP Loan Expenses Violate ‘Tax 101’?” Tax Notes Federal, Jan. 25, 2021, p. 577 (deduction in connection with general welfare payments typically allowed); see also Cummings, supra note 74, at 1967.

88Curtis, 3 T.C. at 651.

89Id.; see also Skelly Oil, 394 U.S. 678.

90New Colonial Ice v. Helvering, 292 U.S. 435, 440 (1934); INDOPCO Inc.

v. Commissioner, 503 U.S. 79, 84 (1992); and Northern California Small Business Assistants Inc. v. Commissioner, 153 T.C. 65, 69 (2019).

91Section 862(b) provides in relevant part:From the items of gross income specified in subsection (a) there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto, and a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income. The remainder, if any, shall be treated in full as taxable income from sources without the United States.

92This article does not address whether any deductions allocated and

apportioned to the dividend income would not be described in reg. section 1.265-1(c) and disallowed.






allocation purposes. Section 864(e)(3) should apply after the application of section 265.93

In summary, the statutory context of section 265 in relation to the exemptive deductions supports the application of section 265 to gross income exempted because of the exemptive deductions. Indeed, applying section 265 to this exempt income maintains the coherence of the U.S. international tax rules.

C. Extrinsic Evidence: Legislative History

1. Section 265The predecessor of section 265(a)(1) was

section 24(a)(5) of the 1939 code, adopted in 1934.94 The legislative history refers to income “wholly exempt” from the taxes imposed by then Title I and does not otherwise refer to gross income except in relation to affected deductions from gross income.95 The discussion of the amendment by Samuel Hill in the House referred to disallowing expenses incurred in earning “nontaxable” income.96

Fifty years ago, an IRS general counsel memorandum reviewing the legislative history of section 265 found:

Although expenses incurred for the purpose of producing exempt income (interest on state securities, salaries received by state employees, and income

from leases of state school lands) comprised the specific situations that Congress had before it when considering the predecessor of section 265(1), we conclude that they enacted a broader statute.97

The legislative history as understood close to the adoption of the statute and by the IRS in 1971 supports an interpretation of section 265 that restricts double tax benefits.98

2. Sections 250 and 245AThe legislative history to section 250 makes

explicit the congressional intent that the section 250 deduction be treated as exempting the offset income from tax.99 The legislative history to section 245A also makes explicit that its purpose is to exempt the foreign portion of a dividend.100

In the legislative history, Congress did not consider allocable U.S. shareholder deductions.101 Taxpayers have argued as a result that Congress did not intend to allocate any U.S. shareholder deductions to GILTI. The IRS has rejected the argument for purposes of determining the FTC, observing: “The TCJA did not provide for any changes to how the generally applicable rules for computing taxable income within each separate

93I was critical of the regulations’ approach at the time of the

proposed regulations because of the distortion that resulted if the expenses allocable to the exempted gross income are not disallowed. Shay, “A GILTI High-Tax Exclusion Election Would Erode the U.S. Tax Base,” Tax Notes Federal, Nov. 18, 2019, p. 1129, at 1133-1134. I had asserted that applying section 864(e)(3) to disregard the exempted GILTI income (and portion of stock) lacked a foundation in the statute, a position I reconsider based on the analysis in this article and the application of section 265 to the GILTI exemptive deduction. If the facts of Example 2 in that article, which pointed out the distortions of applying section 864(e)(3) (if expenses allocable to the exempt GILTI are not disallowed), instead provide for disallowance of the U.S. shareholder expense allocable to the exempted GILTI, the application section 864(e)(3) rules reach a coherent result.

94Bernard D. Reams Jr., Internal Revenue Acts of the United States: The

Revenue Act of 1954 With Legislative Histories and Congressional Documents a65 (1982).

95Jacob S. Seidman, Seidman’s Legislative History of Federal Income Tax

Laws — 1938-1861, 314-315 (1938).96

Id. at 315 (“This particular amendment has reference to the question of deductions from gross income. It makes very certain the text of the bill disallowing deduction of expenses incurred in the production of non-taxable income.”). This is the same language relied on in Curtis, 3 T.C. 648. As a historical aside, Samuel Hill resigned from Congress in 1936 after being confirmed as a member of the Board of Tax Appeals, serving as a judge until 1953. See Biographical Directory of the United States Congress, “Hill, Samuel Billingsley 1875-1958.”

97GCM 34506 (May 26,1971). Cummings correctly observes that the

originally stated objects of the predecessor to section 265(a)(1) (first clause) were limited to situations involving intergovernmental tax immunity. Cummings, supra note 74, at 1966. There is no suggestion, however, that the provision’s application was intended to be limited to those cases. The memorandum’s conclusion on this point appears to be correct.

98See Skelly Oil, 394 U.S. 678. It is unnecessary to resolve the academic

question whether the rule against double tax benefits is a “substantive tax canon” or a “presumption.” Jonathan H. Choi, “The Substantive Canons of Tax Law,” 72 Stan. L. Rev. 195, 249-251 (2020). Either characterization supports the interpretation of section 265(a)(1) set forth in this article.

99See Finance Committee explanation of the TCJA (Nov. 22, 2017),

which is contained in the Senate Budget Committee explanation of the Finance Committee’s fiscal 2018 reconciliation legislation., S. Prt. No. 115-20, “Reconciliation Recommendations Pursuant to H. Con. Res. 71,” at 376 n.1210 (Dec. 2017) (“The Committee intends that the deduction allowed by new Code section 250 be treated as exempting the deducted income from tax.”); and H.R. Rep. No. 115-466, at 623 n.1517 (Dec. 15, 2017) (same) (conference report on H.R. 1).

100Conference report on H.R. 1, supra note 99, at 598-599 (“The

provision in the conference agreement . . . allows an exemption for certain foreign income by means of a 100-percent deduction for the foreign-source portion of dividends received from specified 10-percent owned foreign corporations by domestic corporations that are United States shareholders of those foreign corporations.” (Footnotes omitted.)).

101See id. at 627 n.1527 (description of effective tax rate disregards

possibility of deductions allocable to GILTI inclusions).






category should apply with respect to the new section 951A category.”102

An electronic scan of the conference report finds that there is no reference to section 265 other than those pertaining to interest, which is covered by section 265(a)(2), not section 265(a)(1). There is no discussion of section 265 in relation to section 245A or 250.

In summary, nothing in the TCJA legislative history suggests that Congress did not intend that section 265(a)(1) apply by its terms. Moreover, there is strong support for the view that Congress did understand and intended that the exemptive deductions be treated as exempting the gross income offset by the deductions.

D. Summary

The preceding analysis shows that the statute, its context, and the legislative history allow and indeed support interpreting section 265(a)(1) to apply to gross income offset by an exemptive deduction under current law. Under the U.S. self-assessment system, this interpretation of the statute would require that taxpayers forgo deductions allocable to gross income offset by an exemptive deduction.

Based on the analysis in this article, if the government asserted this position on audit before expiration of relevant statutes of limitation, it would have a material chance of success on the merits.103 This raises important practical issues regarding whether a corporation should book a reserve in financial statements for years for which the TCJA has been effective for claiming deductions allocable to income offset by an exemptive deduction on a tax return.104 As

described in Section II.B, billions of dollars likely are at stake.

The next part discusses possible use of a regulation amendment to confirm and publicize the interpretation.

IV. A Regulatory Clarification

A. Reasons for an Amending Regulation

Reasons to favor adopting an amendment to reg. section 1.265-1(b) include to announce the scope of application of section 265(a)(1), to allow stakeholders an opportunity to comment on the interpretation, to mitigate the burdens of potential litigation on taxpayers and the government, and, in the discretion of the IRS, to make the interpretation prospective.105 One approach to amending the existing section 265 regulation is set out in Appendix B.106

This article has argued that the current regulation left open the interpretation of the scope of application of section 265(a)(1). Under this analysis, an amendment to the regulation is an exercise of regulatory authority under section 7805 and not a change of agency position.107 Even if construed as a change in position, an appropriately executed notice and comment

102Preamble to T.D. 9882, 84 F.R. 69022, 69023-69024 (Dec. 17, 2019).

103I leave for lawyers, tax advisers, and their clients to decide

whether the taxpayer’s likelihood of success is “substantial” or “more likely than not” in opinion terms.

104See Financial Accounting Standards Board Accounting Standards

Codification 740-10. The financial disclosure question in turn raises issues regarding whether amounts should be disclosed on Schedule UTP of Form 1120, “Uncertain Tax Position Statement.” Reg. section 1.6012-2(a)(4). Disclosure can be required even if the corporation did not record a reserve for that tax position because the corporation expects to litigate it. Recent reporting on the effects of IRS underfunding suggests that there are insufficient IRS resources to pursue companies even if they do report a position on Schedule UTP. Douglas MacMillan and Kevin Schaul, “As IRS Audits Waned, Big Businesses Racked Up Unapproved Tax Breaks,” The Washington Post, July 14, 2021.

105Despite the likely significant revenue loss from providing relief for

past years (explicitly or implicitly), the U.S. tax system is asymmetric in that the IRS has broad scope to decline to enforce the tax law without serious risk of challenge by taxpayers that do not benefit from the nonenforcement. Article III standing limits effectively preclude review of IRS decisions initiated by persons who do not pay tax or are not the taxpayers, no matter how significant their interests may be in enforcement of the law. Allan v. Wright, 468 U.S. 737 (1984) (Supreme Court denies standing to NAACP plaintiffs seeking review of tax exemption for segregated private schools formed to avoid reach of public school desegregation after Brown v. Board of Education, 347 U.S. 483 (1954)).

106The amendment at Appendix B does not attempt to identify

collateral amendments to regulations affected by a change to the section 265 regulation and does not propose making the change prospective.

107A nonexclusive reading of the existing regulation supports a

conclusion that applying section 265(a)(1) as proposed in this article does not constitute a change in agency position. See Note, “Judicial Review of Agency Change,” 127 Harv. L. Rev. 2070 (2014). An agency should be permitted to change its own long-standing interpretation for good reason, including circumstances presented by novel statutory provisions and application of provisions in circumstances not anticipated in earlier regulations. See Anita S. Krishnakumar, “Longstanding Agency Interpretations,” 83 Fordham L. Rev. 1823, 1863 (2015). In any event, the interpretation proposed in this article should be subject to the same deferential review as a first-instance agency decision. Id. at 1878.






regulation should support Chevron deference.108 Whichever deference results, the use of a regulation should reduce the practical scope of controversy and litigation.

In light of the novel nature and context of the exemptive deductions, a tax administration argument could be made for using a notice and comment regulation to implement the application of section 265(a)(1) to the exemptive deductions. There will be specific situations identified by taxpayers in written comments that might not be anticipated by statute and regulation writers and warrant consideration as to whether and how section 265 should apply. Ideally, this would reduce the burden on tax and generalist courts.

To the extent the application of section 265 to gross income offset by an exemptive deduction has been underappreciated as a tax exposure, there likely would be taxpayer pressure for prospective application of such a regulation. While the IRS would not be required to apply that regulatory interpretation prospectively, it would be within its discretion to do so.109

B. Prioritizing Regulatory Guidance

The Treasury tax regulatory agenda in recent years has been dominated by the demands for guidance on how to apply provisions adopted in the TCJA.110 Tax regulatory priorities and resources now should be redirected. First,

resources should be used to ensure that regulatory interpretations take account of all Americans, including those of underrepresented communities, to further previously underweighted or disregarded social and racial justice objectives.111 Second, Treasury and the IRS should favor interpretations that determine taxable income in accordance with measurement-of-income and ability-to-pay principles, and reconsider interpretations that are not required by the statute and in many cases give rise to unfair and inefficient distortions. Third, resources should be devoted to improving administration of the tax law. The regulation suggested here satisfies these criteria and should be given priority for guidance.

There should be a corresponding adjustment to executive branch legislative priorities. In general, Treasury should propose a regulatory change in preference to a legislative proposal in cases in which statutory authority already exists and the goals of a proposal can be accomplished by regulation. Whether a delegation of authority is general or specific, exercising rather than disregarding existing congressional delegations under the code respects separation of powers. A preference for a notice and comment regulation also serves transparency and democratic objectives when the alternative is to pass complex legislation hurriedly, without hearings and without public input (other than from interested lobbyists).

C. Policy

Whether in the form of a dividend exclusion or a 100 percent dividends deduction, the effect is the same: The dividend income is wholly exempted from U.S. tax. It has long been understood that as a normative matter, a territorial or dividend exemption should not allow deductions allocable to the exempt income

108Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., 467

U.S. 837 (1984); Skidmore v. Swift & Co., 323 U.S. 134 (1944); and Krishnakumar, supra note 107, at 1863.

109Section 265(a)(1) was enacted before July 30, 1996, so regulations

related to it are subject to the version of section 7805(b) that preceded the 1996 amendment. Taxpayer Bill of Rights 2, Title XI, section 1101(b). Before amendment, the text read: “The Secretary may prescribe the extent, if any, to which any ruling or regulation, relating to the internal revenue laws, shall be applied without retroactive effect.” See UnionBanCal Corp. v. Commissioner, 113 T.C. 309, 327 (1999), aff’d, 305 F.3d 976 (9th Cir. 2002); and Islame Hosny, “Interpretations by Treasury and the IRS: Authoritative Weight, Judicial Deference, and the Separation of Powers,” 72 Rutgers U. L. Rev. 281, 305 (2020); but see John Bunge, “Statutory Protection From IRS Reinterpretation of Old Tax Laws,” Tax Notes, Sept. 8, 2014, p. 1177.

110Before enactment of the TCJA, the regulatory agenda tended to be

weighted toward projects that responded to requests from interested parties represented by Washington lobbyists, large law firms, and Big Four accounting firms, as well as from bar association tax sections composed principally of business-taxpayer representatives, for explicitly favorable, or as next-best clear and certain interpretations of statutory provisions.

111See Dorothy A. Brown, The Whiteness of Wealth — How the Tax

System Impoverishes Black Americans — And How We Can Fix It (2021); and Shu-Yi Oei and Leigh Osofsky, “Legislation and Comment: The Making of the Section 199A Regulations,” 69 Emory L.J. 209 (2019). The usual default to requests on behalf of interested taxpayers generally will not address social justice concerns. See Clinton G. Wallace, “Congressional Control of Tax Rulemaking,” 71 Tax L. Rev. 179, 216-224 (2017) (describing the uneven involvement of different interests in tax regulations).






to be deducted.112 This is consistent with the apparent objective of section 265, which should be applied to reach this result for income offset by the section 245A and section 250(a)(1)(B) exemptive deductions.

The failure to disallow deductions allocable to exempt income goes beyond exempting the net income tax on the income. It provides an additional subsidy that is, irrationally, based on the ratio of allocated expenses to the exempted income. Income with a lower operating margin receives a greater subsidy than income with a higher operating margin. This can be seen in Example 4.

Example 4: Assume a U.S. corporation (USCorp) has a section 245A dividend of $100 and allocable deductions of $25. USCorp will have taxable income of $75 before section 245A, and U.S. tax at 21 percent of $15.75. The benefit of exemption should be the tax saved of $15.75. If the $25 of deductions are nonetheless allowed, the benefit will be increased by 21 percent * 25 = $5.25.

If, instead, USCorp had allocable deductions of $60, it will have taxable income of $40 before section 245A, and U.S. tax at 21 percent of $8.40. Again, the benefit of exemption should be the tax saved of $8.40. If the $60 of deductions are nonetheless allowed, the benefit will be increased by 21 percent * 60 = $12.60.

It makes no sense as a matter of tax or economic policy to design a general subsidy for foreign investment that varies according to the level of the U.S. shareholder’s allocable deductions. Section 265 is designed to limit the benefit of exemption to the income tax saved. Failure to apply section 265, particularly in the international context, results in an excessive incentive to engage in foreign rather than domestic economic activity.

As described above, the amount of deductions involved and the potential subsidy for foreign investment are material. It is reasonable to expect that the revenue impact of allowing deductions allocable to gross income offset by exemptive deductions would be billions of dollars annually. This hidden subsidy favors multinational over

domestic businesses and shareholders over workers.113 The distribution of burden of the corporate tax among individuals is heavily skewed toward those within the highest income categories.114 Moreover, an increasing share of owners of U.S. corporations are foreign investors.115

There is no coherent policy reason to favor allowing deductions allocable to exempt foreign income. If it is urged that the tax burden on foreign income is too high, alternative policy instruments would be far superior.

D. Validity

The proposed amendment to reg. section 1.265-1(b) at Appendix B is a permissible interpretation of the statute.116 The preceding analysis in this article demonstrates that it is a reasonable interpretation of section 265(a)(1) to cover income that is not taxed because of an exemptive deduction. If an alternative interpretation of the statute is preferred, at a minimum the preceding analysis demonstrates that the language of the statute is susceptible to more than one interpretation, thereby satisfying an essential element of Chevron analysis.117

There is no meaningful distinction for the language or objective of section 265 between excluding the gross income and offsetting it by exemptive deductions. When, as here, the

112Sullivan, supra note 19; Shay, “Ownership Neutrality and Practical

Complications,” 62 Tax L. Rev. 317, 325-326 (2009); and Graetz and Oosterhuis, supra note 19, at 781.

113Note that foreign multinationals only are allowed U.S. deductions

allocable to a U.S. trade or business. Section 882(c). The incidence of corporate taxes is contested among economists. The most recent published review of the issue by the JCT staff concluded that owners of capital bear 100 percent of the corporate income tax burden in the short run and 75 percent of it in the long run, with the remainder not distributed to domestic and foreign owners of capital being borne by labor. The JCT does not use the long-run distribution for a provision until the 10th year after its adoption. See JCT, “Modeling the Distribution of Taxes on Business Income,” JCX-14-13, at 30 (Oct. 16, 2013).

114See Urban-Brookings Tax Policy Center, “Share of Change to

Corporate Income Tax Burden by Expanded Cash Income Percentile, Preliminary Results,” Table T17-0180 (June 6, 2017).

115Steve Rosenthal and Theo Burke, “Who’s Left to Tax? U.S. Taxation

of Corporations and Their Shareholders,” TPC Working Paper (2020) (estimating that 40 percent of stock in all U.S. corporations, public and private, is held by foreign investors).

116See Chevron, 468 U.S. 1227.

117There is extensive academic commentary on Chevron, including

analyses that suggest varying numbers of Chevron analytical steps (including step zero and step one and a half, as well as step one and step two). This analysis focuses on the traditional two steps: (1) is there ambiguity in interpretation of the statute for the agency to fill, or has Congress “directly spoken to the precise question at issue”; and (2) is “the agency’s answer based on a permissible construction of the statute?” Chevron, 467 U.S. at 842-843.






exemptive deductions eliminate tax on the income, involve no expenditure of taxpayer assets, and serve no measurement-of-income purpose — or indeed any purpose other than to exempt the income — it is reasonable to apply section 265(a)(1) to this untaxed income.

An argument might be made that section 911(d)(6), which disallows deductions (and FTCs) allocable to the portion of wages and housing allowance that is exempt under section 911, shows that Congress understood that income only partially exempt would not be subject to section 265 and knew how to disallow deductions for that income. Congress made no such disallowance for the exemptive deductions.118 However, the predecessor to section 911 including the expense disallowance was adopted in 1926, before adoption of the predecessor to section 265(a)(1) in 1934.119 The application of section 265 does not interfere with section 911(d)(6) if the usual canon applies that the more specific provision takes precedence. The presence of section 911(d)(6) is unpersuasive as a basis for arguing that the proposed regulation is an impermissible interpretation of section 265.

What about a reenactment concern that Congress has had many opportunities to modify section 265? The reenactment doctrine is inapposite in a context in which the interpretation complements and does not supplant the prior interpretation and can be readily reconciled with the prior interpretation. For some, the acknowledgment in the TCJA legislative history that the exemptive deductions are intended to exempt the income further supports application of section 265(a)(1).

It is impossible to discern from silence that Congress viewed section 265 as inapplicable. Congressional silence regarding the application of section 265 is the arena within which section 265 operates. Nothing prohibits Treasury from exercising its authority under section 7805(a) to

address exemptive deductions. As the Supreme Court said, “‘It is a fundamental principle of statutory interpretation that absent provision[s] cannot be supplied by the courts.’ This principle applies not only to adding terms not found in the statute, but also to imposing limits on an agency’s discretion that are not supported by the text.”120

Another question that could be raised is why disallow deductions allocable to income exempted by section 245A and not by sections 243 and 245? The corporate income targeted by the exemptive deductions has not previously been subject to U.S. corporate tax, which distinguishes section 245A’s exemption from intercorporate tax relief under sections 243 and 245.121 There is no U.S. double corporate taxation justification for section 245A or 250.

The long-standing view is that the U.S. tax base is determined independently of the foreign base on which foreign taxes are applied.122 Under sections 245A and 960, the foreign tax base is disregarded.123 Insofar as foreign income taxes are taken into account, an FTC subject to the section 904 limitation is allowed. If U.S. income is not taxed, the fact that it may have been subject to foreign tax is not a justification for allowing a U.S. deduction allocable to the exempt income. The effect would be for the United States to make a refund to the U.S. taxpayer (with allocable deductions) to pay the foreign tax on the exempted income.

If a notice and comment regulation is executed properly, a regulation applying section 265 to the exemptive deductions would be a valid exercise of regulatory authority. If, contrary to the analysis in this article, a court concluded that existing section 265 cannot apply even by regulation, or if Congress disagrees with a regulatory interpretation, legislation would remain an available tool.

118Moreover, Congress denied any credit under section 901 or

deduction under chapter A (of title 26) for foreign taxes in relation to section 245A exempt dividend income. Section 245A(d). These provisions, however, merely complete the articulation of how international double taxation will be addressed and ignore the separate and distinct issue of whether allocable deductions should be allowed under section 265.

119See “history” in Heffelfinger, 5 T.C. 985.

120Little Sisters of the Poor v. Pennsylvania, 140 S. Ct. 2367, 2381 (2020)

(citation omitted); see also Scalia and Garner, supra note 80, at 94.121

See Hawaiian Trust, 291 F.2d 761.122

See section 904(a); and Biddle v. Commissioner, 302 U.S. 573 (1938) (payment of foreign tax determined under U.S. tax laws).

123Sections 245A(d), 904(a), and 960(d)(1). The foreign tax base is

taken into account in attributing foreign taxes to tested units. See reg. section 1.904-6.






V. Legislation as an Alternative to a Regulation

Treasury’s fiscal 2022 revenue proposals would amend section 265 to disallow deductions allocable to a class of foreign gross income that is exempt from tax or taxed at a preferential rate through a deduction.124 (A possible draft is set out in Appendix C.) President Biden also has proposed significant modifications to GILTI, including eliminating the exclusion from GILTI of a deemed return on certain tangible business investment, which would reduce the scope for the section 245A exemptive deduction; and decreasing the percentage of the GILTI exemptive deduction. Under the draft revision to section 250 at Appendix C, there would be no need to apply section 265 to the GILTI exemptive deduction because, just as for the FDII section 250 deduction, there would be no deductions allocable to the exempt income.125 Because the Biden proposals do not repeal section 245A, the revision to section 265(a)(1) would remain relevant.

There are trade-offs between the use of a regulation and seeking legislation to achieve the same objective.126 When the regulation is interpreting the law and not exercising a specific grant of authority, the rationale for seeking legislation would appear to be quite weak. The objective of using legislation may be based on a concern that a different administration may change a regulatory interpretation, although even that step would be subject to reversal by Congress. Factors favoring a regulation include the ability to use the expertise of the agency outside the constraints of the legislative process;

the opportunity for notice and comment; the availability of the preamble for reasoned responses to comments; and the greater flexibility to adjust regulations in the future. In a highly technical area like the one discussed in this article, the regulatory process affords greater opportunity to avoid or mitigate errors.

A reported rationale to prefer a legislative proposal is to benefit from a budgetary “score” counting the revenue to be raised from a proposal.127 This would seem to be a weak argument other than as a matter of assigning political credit for the revenue. If revenue is indeed increased materially enough to warrant a budget score (that is, it exceeds $50 million in the relevant period), it should also show up in collections if a regulation is implemented. Those revenues should be included in the budget baseline for future legislation. In a political environment hostile to tax increases, using a regulation could allow easier passage of associated or other tax legislation. Of course, in a political environment in which pay-fors are needed to meet political or procedural budgetary objectives, a positive budget score for legislation often is motivation for a legislative change in lieu of a regulatory change.

VI. Conclusion

This article considers whether gross income offset by exemptive deductions is covered by the deduction disallowance rule of section 265(a)(1). The better analysis is that section 265 should apply to income offset by exemptive deductions such that deductions (other than the exemptive deduction) allocable to that income should be disallowed.

Adopting a notice and comment regulation amendment confirming the application of section 265 to income offset by an exemptive deduction would reasonably interpret the statute, offer stakeholders the opportunity for criticism, and mitigate the burdens of potential litigation on taxpayers and the government. Support for such a regulatory amendment would advance good tax policy while not implying agreement with the

124The green book proposal states that no inference should be drawn

regarding current law. Fiscal 2022 green book, supra note 7, at 14.125

The Biden proposal would repeal the provision excluding the 10 percent return to QBAI, which would effectively limit the scope for section 245A, but the proposal does not appear to repeal section 245A.

126See generally Daniel Jacob Hemel, “The President’s Power to Tax,”

102 Cornell L. Rev. 633 (2017). I do not discuss in detail here the concerns that notice and comment tax regulations are less democratic than fully specified legislation. That concern seems formalistic for taxation when congressional provision for regulatory guidance is ubiquitous and necessary, the statute already is detailed, and remaining issues for guidance are technical (as evidenced by this article), and there is extensive public demand for regulatory guidance. The notice and comment regulatory process allows for public input on an ex ante basis. In addition to executive branch ex ante oversight, there is ex post congressional oversight and regular tax legislation providing opportunity for congressional changes to regulatory decisions that historically has been exercised. Finally, there is judicial review. The clear democratic legitimacy of fulsome administrative guidance is a topic for another day.

127The flip side of this consideration is that a regulation can be a

stealth revenue raiser or revenue loser.






TCJA’s reduced taxation of foreign dividend income or GILTI. If, contrary to the analysis in this article, a court concluded that existing section 265 cannot apply, or if Congress disagrees with the regulatory interpretation, legislation would remain an available tool.

The Biden green book proposes a legislative clarification of section 265. Whether the legislative proposal would have a budgetary effect would depend on how the JCT staff interprets the statute and existing regulation and whether the income should be considered as already in the budget

baseline. Under the analysis in this article, Treasury has authority to adopt a regulation incorporating a reasonable interpretation of the statute, as proposed in this article, regardless of whether a legislative clarification were enacted and regardless of whether the legislative proposal were considered to have a budgetary effect.

Irrespective of the outcome of the immediate legislative proposals, the use of exemptive deductions should trigger the application of section 265.

VII. Appendix A: Marginal Tax Rate Benefit

Table 1

Inputs

Row Description Source

1 CFC total earnings less deficits 100% See IRS Statistics of Income, “U.S. Corporations and Their CFCs: Tax Year 2016” Table 1, Col. 10, Row All Industries

2 Subpart F and other exceptions -10% Rough estimate based on 2016 data

3 CFC net tested earnings 90% Row 1 - Row 2

4 NDTIR 10% return less CFC interest expense -25% Rough estimate

5 GILTI 65% Row 3 - Row 4

6 U.S. shareholder expenses allocable to total CFC earnings

20% Rough estimate based on 2016 data

Marginal Tax Rate Benefit of Allowing Expenses Allocable to Exempted Income

7 50% * GILTI 32.5% 50% * Row 5

8 NDTIR 10% return less CFC interest expense -25% Row 4

9 Exempt income 57.5% Row 7 + Row 8

10 U.S. expenses allocable to exempt income 10.4% Row 3 * Row 6 * Row 9

11 U.S. pre-credit tax rate on CFC net tested earnings without section 265

3.05% 21% * (Row 3 - Row 9 - (Row 3 * Row 6))

12 U.S. pre-credit tax rate of CFC net tested earnings applying section 265

5.22% 21% * (Row 3 - Row 9 - (Row 3 * Row 6 - Row 10))

13 Marginal tax rate benefit of not applying section 265 2.17% Row 12 - Row 11 [alternatively, 21% * Row 10]






VIII. Appendix B: Regulatory Amendment

The proposal is to amend reg. section 1.265-1(b) and (c):

“(b) Exempt income and nonexempt income.

(1) As used in this section, the term class of exempt income means any class of income (whether or not any amount of such income of such class is received or accrued) wholly exempt from the taxes imposed by Subtitle A of the Code. For purposes of this section, a class of income which is considered as wholly exempt from the taxes imposed by subtitle A includes any class of gross income which is:

(i) Wholly excluded from gross income under any provision of Subtitle A, or

(ii) exempted from tax by reason of a deduction under section 245A or section 250(a)(1)(B), or

(iii) Wholly exempt from the taxes imposed by Subtitle A under the provisions of any other law.

(2) As used in this section the term nonexempt income means any income not described in paragraph 1 which is required to be included in gross income.

(3) The deductions to be disallowed under this section shall not include a deduction described in subparagraph (ii) of paragraph 1 of this subsection.

(c) Allocation of expenses to a class or classes of exempt income.

. . . For purposes of income described in subsection (b)(1)(ii), expenses shall be allocated under section 862(b).”

IX. Appendix C: Legislative Amendments

Amendment to Section 250(a)(1)(B)

Section 250

(a) Allowance of deduction

(1) In general. In the case of a domestic corporation for any taxable year, there shall be allowed as a deduction an amount equal to the sum of —

(A) 37.5 percent of the foreign-derived intangible income of such domestic corporation for such taxable year, plus

(B) 50 percent of the excess of —

(i) the sum of

(I) the global intangible low-taxed income amount (if any) which is included in the gross income of such domestic corporation under section 951A for such taxable year, and

(II) the amount treated as a dividend received by such corporation under section 78 which is attributable to the amount described in clause (i), over

(ii) the deductions properly allocable to such gross income.

Amendment to Section 265(a)(1)

Section 265

(a) General rule — No deduction shall be allowed for —

(1) Expenses

Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle (including by reason of a deduction), or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.







Amount A: The G-20 Is Calling the Tune, And U.S. Multinationals Will Pay the Piper

by Kartikeya Singh

The OECD inclusive framework’s July 1 statement on the two-pillar project to address the tax challenges arising from the digitalization of the global economy had the backing of 130 of its 139 members.1 The statement provides new details on the criteria and thresholds that will determine which companies will be within the scope of amount A of pillar 1.

This article analyzes how the statement’s amount A scoping criteria under pillar 1 would affect U.S. and non-U.S. multinationals. The analysis relies on publicly available company-level data to estimate how many U.S. companies would be within the scope of amount A relative to companies from other countries, as well as those U.S. companies’ share of the total worldwide tax base under amount A.2

I. Background

The inclusive framework statement details the criteria and specifies the thresholds that will determine which companies will be subject to amount A under pillar 1: those with global revenues over €20 billion and pretax profit margins over 10 percent. Companies in the extractives and regulated financial services industries are carved out.

The scoping criteria for amount A in the July statement differ significantly from those in the October 2020 blueprint, more closely resembling (albeit with a few important differences) the comprehensive scoping proposal presented

Kartikeya Singh is a principal in the transfer pricing practice of PwC’s Washington National Tax Services group. He thanks Peter Merrill and Pam Olson for their comments and suggestions on this article.

In this article, the author uses publicly available data to quantify the number

and profits of U.S. companies that would be affected by the OECD’s pillar 1 as a share of all affected companies.

The views expressed herein are solely the author’s and do not necessarily reflect those of PwC. All views and any errors are those of the author and should not be ascribed to PwC, its partners and principals, or any other person. This content is for general information purposes only and should not be used as a substitute for consultation with professional advisers.

Copyright 2021 PwC. All rights reserved.

1At the time of this writing, two more countries had agreed to the

inclusive framework statement.

2The allocable tax base is insufficient to quantify how much tax

revenue each country would gain or lose under the proposal. See, e.g., Kartikeya Singh, “What’s It to (the) U.S.? An Impact Analysis of Pillar 1 for U.S. Multinationals,” Tax Notes Int’l, Apr. 12, 2021, p. 151, which explains that the magnitude of interjurisdiction income reallocation will depend on which jurisdictions will have to cede income from their tax base, as well as the extent to which the amount they have to cede in their capacity as relieving jurisdictions exceeds the amount A tax base they stand to receive as market jurisdictions. Said differently, the net amount of income reallocation may be lower than the allocable tax base under amount A because some of the amount A base is allocable to the same jurisdictions that will have to cede some of the income allocated to them under existing rules.

Similarly, this analysis is insufficient to quantify the incremental tax cost multinational enterprises will incur as a result of amount A. That would require analyzing the jurisdictions that would receive amount A taxing rights and those that would stand to cede taxing rights and taxable income, as well as the method for relieving double taxation in the ceding jurisdictions.






April 8 by the U.S. Treasury Department to the inclusive framework steering group.

The blueprint laid out two sets of criteria to determine which multinational groups would be subject to the amount A nexus and income allocation rules. The first was intended to identify specific types of businesses based on an activity test. A company might be in scope if it provided automated digital services or was consumer-facing.3 The second set of criteria was based on quantitative thresholds related to global and local revenues.

But for a few important differences, the scoping criteria in the inclusive framework statement draw from Treasury’s comprehensive scoping proposal, which involved a $20 billion global revenue threshold and an unspecified profit margin threshold.4 Importantly, the Treasury proposal rejected segmentation of a company’s financials for amount A purposes, while the inclusive framework statement requires segmentation in limited cases.

II. Data

The analysis in this article relies on publicly available data sourced from the Orbis database, which includes both publicly listed and private companies.5 The database was used to construct a sample of companies with worldwide operations. The sample covers the most recent fiscal year for each company for which financial data was available, as well as the two preceding fiscal years. A three-year weighted average was used to avoid an atypical year skewing the conclusions.

In constructing the Orbis sample, a company was included if its average consolidated third-party revenue over the most recent three-year

period was no lower than $850 million, chosen so that the sample would — as a starting point — have broad coverage of multinational enterprises by industry and headquarters jurisdiction. The same revenue threshold is used for country-by-country reporting, which for U.S. purposes is treated as $850 million. Table 1 shows the breakdown of the Orbis sample between U.S. and non-U.S. multinational groups: four non-U.S. multinationals for every U.S. multinational.

For companies in the sample, Table 2 shows the most recent fiscal year for which financial data were available.

The global revenue threshold in the inclusive framework statement is in euros, while the data extracted from the Orbis database are in U.S. dollars. Solely for applying the €20 billion global revenue threshold, the annual revenue for each company in a given year was converted from U.S. dollars to euros using the average exchange rate for that year.6

Public statements from government and OECD officials have made clear their intent to provide for segmentation to ensure that large prominent companies viewed as part of the digital economy are not excluded from amount A on account of companywide pretax profit margins

3Also, the OECD blueprint excluded some industrial sectors from the

scope of amount A.4Notably, the $20 billion threshold figure is in U.S. dollars in the

Treasury proposal and is in euros in the OECD statement. The Treasury proposal also limited sector-based carveouts to the extractives industry.

5The database’s coverage of private companies might be limited, so

this analysis and its results might not accurately reflect the impact of the scope criteria in the inclusive framework statement in a way that accounts for all relevant private companies. Other details, such as the criteria for determining which companies would need to estimate amount A and the allocable tax base using segmented (rather than consolidated) financial data, could also affect the analysis and its conclusions. As noted in Section III, infra, this analysis relies on segmented financial data for one company. There might be other companies for which the numbers could be determined on a segmented, rather than consolidated, basis, as is assumed in this analysis.

Table 1. U.S. MNEs vs. Non-U.S. MNEs

U.S. Multinational Groups 1,459

Non-U.S. Multinational Groups 5,952

Total Multinational Groups 7,411

Table 2. Most Recent Fiscal Year With Financial Data

Most Recent Year With Financial Data

Number of Multinational Groups

2017 83

2018 339

2019 4,008

2020 2,981

Total 7,411

6Data on the average annual U.S. dollar-euro exchange rate for each

relevant year were sourced from www.ofx.com.






falling below the profitability scope threshold.7 Consequently, for one U.S. company, the analysis relied on segmented financial data instead of consolidated financial data as used for all other companies in the Orbis sample. The segmented data for that one U.S. company covered fiscal 2018 through 2020 as reported in the company’s annual report for 2020. This article does not attempt to identify other companies that might meet any criteria for inclusion on a segmented basis.

Companies likely to be in the carved-out extractive industries were excluded by identifying those mapped to the following two-digit Standard Industrial Classification codes: 10 (metal mining), 12 (coal mining), 13 (oil and gas extraction), and 14 (nonmetallic minerals, except fuels). Companies likely to be in the carved-out regulated financial services industries were excluded by identifying those mapped to the following two-digit SIC codes: 60 (depository institutions), 61 (nondepository institutions), 62 (security and commodity brokers), 63 (insurance carriers), 64 (insurance agents, brokers, and service), and 67 (holding and other investment offices).

The amount A tax base for a given company was calculated assuming that 20 percent of pretax profit in excess of the 10 percent margin will be allocable to market jurisdictions (the inclusive framework statement specified a range of 20 percent to 30 percent). The 20 percent assumption affects the size of the estimated amount A tax base but not its distribution between U.S. and non-U.S. MNEs.

III. Analysis

A. Scope

Table 3 summarizes by headquarters jurisdiction the number of multinationals estimated to be in scope of amount A based on the scoping criteria in the inclusive framework statement and using three-year average financial data for companies in the Orbis sample.

U.S. MNEs account for more than 48 percent of the companies estimated to be affected by amount A — almost six times the number of Chinese MNEs, and more than twice the figure from all other G-7 countries combined. That is the case even though Chinese MNEs outnumber U.S. MNEs 124 to 121 in the global Fortune 500.8

B. Allocable Tax Base

For each in-scope company in the Orbis sample, an estimate of the company’s average amount A tax base was calculated based on its three-year average pretax profits and third-party revenues. As noted, the analysis is premised on a

reallocation percentage equal to 20 percent (together with a pretax profit margin threshold of 10 percent as specified in the inclusive framework statement).

7For instance, U.S. Treasury Secretary Janet Yellen stated that U.S.

companies like Amazon and Facebook will qualify for pillar 1 “by almost any definition.” See Stephanie Soong Johnston, “G-7 Global Tax Reform Accord a ‘Big Step Forward,’ OECD Chief Says,” Tax Notes Int’l, June 14, 2021, p. 1539.

8By way of context, the United States accounts for less than 25

percent of global GDP (in nominal terms), but U.S. MNEs would account for more than 48 percent of MNEs that would be within the scope of amount A. In contrast, China accounts for more than 15 percent of global (nominal) GDP, but Chinese MNEs would account for less than 10 percent of all in-scope MNEs.

Table 3. In-Scope Multinational Groups by Headquarters Jurisdiction

Number of MNE Groups

U.S. Multinational Groups 41

Chinese Multinational Groupsa 7

Non-U.S. G-7 Multinational Groups 19

Multinational Groups From Other Countries

18

Total Multinational Groups 85aFor three Chinese multinationals, the Orbis database reported financial information at the level of the respective group’s holding company registered in the Cayman Islands. The data reported for the holding company represent the group’s consolidated financials.

China restricts foreign investment in some industries, and many companies in those industries rely on a structure in which foreign investors invest in a variable interest entity (VIE) that is owned, together with the company’s operating entities, by a holding company registered in a foreign jurisdiction. Non-Chinese investors own shares in the VIE (also registered in a foreign jurisdiction) where the VIE has a contractual claim on the income of the operating companies in the consolidated group. See Matt Levine, “Owning Chinese Companies Is Complicated,” Bloomberg.com, July 7, 2021.






The allocable tax base for each in-scope company was calculated as shown in the equation, with “Pretax Profit Margin” referring to the company’s pretax profits divided by third-party revenue9:

Amount A Tax Base = [(Pretax Profit Margin - 0.1) * 0.2] * Revenue

C. Results

Table 4 shows the allocable amount A tax base by country of in-scope MNEs. Approximately $84 billion of income is estimated to be subject to reallocation as amount A.10 The income subject to reallocation is 9.7 percent of the total three-year average pretax profits of the 85 in-scope multinationals.

Table 4. Pillar 1 Amount A: Allocable Tax Base by Headquarter Jurisdiction

Amount (USD millions)

Share of Total Amount A

Share of Global Nominal GDP

U.S. Multinational Groups 51,728 61.9% 24.2%

Chinese Multinational Groupsa 7,693 9.2% 17.7%

Non-U.S. G-7 Multinational Groups 8,212 9.8% 21%

Multinational Groups From Other Countries 15,912 19% 37.1%

Total Multinational Groups 83,546 100% 100%

aNumbers include three Chinese multinationals for which the Orbis database reported financial information at the level of the respective group’s holding company registered in the Cayman Islands.

Table 5. In-Scope MNEs and Allocable Tax Base by Headquarters Jurisdiction — Top 10 Countries by Nominal GDP

Country Number of MNEsAmount A Tax Base

(USD millions)Total Share of

Amount AShare of Global Nominal GDPa

United States 41 77,592 61.9% 24.2%

China 7 11,540 9.2% 17.7%

Japan 5 3,145 2.5% 5.7%

Germany 4 1,729 1.4% 4.6%

United Kingdom 4 4,891 3.9% 3.3%

India 1 39 0% 3.2%

France 5 2,416 1.9% 3.1%

Italy — — 0% 2.2%

Canada 1 137 0.1% 2%

South Korea 2 6,896 5.5% 1.9%

Total 70 108,386 86.5% 68.1%

aBased on the IMF’s projected nominal GDP for 2021.

9For each company, three-year averages for pretax profits and

revenues were used.

10The total amount A tax base would equal approximately $125

billion if the reallocation percentage were 30 percent instead of 20 percent, as assumed in this analysis.






Of that total amount A tax base of $84 billion, approximately 62 percent is estimated to come from U.S. MNEs — more than six times the share of MNEs from China and from all other G-7 countries combined. Said differently, the tax base from MNEs from China and the other non-U.S. G-7 countries collectively account for less than one-third of the tax base estimated to come from U.S. MNEs. Table 4 also shows the share of each country’s (or group of countries’) share of global nominal GDP.11 Whereas the United States accounts for less than 25 percent of global GDP, China and the G-7 countries other than the United States account for more than 35 percent of global GDP.

Table 5 shows information for MNEs headquartered in the 10 largest countries (based on nominal GDP).

IV. Other Research

A recent study analyzed issues similar to those covered in this article, with qualitatively

similar results.12 It estimates that 78 of the world’s 500 largest companies will be subject to amount A under pillar 1, with a total amount A tax base of $87 billion — 64 percent of which is estimated to come from U.S. companies.

The study relies on different data and uses single-year figures rather than the three-year average data from the Orbis database used in this report. The analysis primarily is based on 2020 financial information for the Fortune Global 500 supplemented by data on public companies from Datastream International and Orbis Europe (which contains a subset of companies covered by the Orbis database used in this article). The study appears to assume a $20 billion revenue threshold instead of the €20 billion threshold specified in the inclusive framework statement and used in this analysis. Finally, and given the primary data source used, that analysis estimates pretax profits by grossing up after-tax profits at an assumed effective tax rate of 20 percent.

11Based on the IMF’s projected nominal GDP for 2021.

12Michael Devereux and Martin Simmler, “Who Will Pay Amount

A?” 5(36) EconPol Policy Brief (July 2021).






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Curtail U.S. PTEP Reporting Complexity: Know Your P’s and Q’s

by Lewis J. Greenwald, Brainard L. Patton, and Brendan Sinnott

There is much for U.S. international tax practitioners to grapple with these days, especially with the changes wrought by the Tax Cuts and Jobs Act. This article focuses on just one element of those changes: those that relate to previously taxed earnings and profits (PTEP)1 and the extraordinary complexity of PTEP-related information now required by Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” We review those changes and suggest options for greatly simplifying that compliance burden.

Background

Before the TCJA, Form 5471 could be viewed as a reasonable balance of the government’s need for, and taxpayers’ effort to provide, information on earnings and profits and related foreign income taxes of controlled foreign corporations. All the required information for E&P and related foreign tax credits was included on three Form

5471 schedules: Schedule E (“Income, War Profits, and Excess Taxes Paid or Accrued”), Schedule H (“Current Earnings and Profits”), and Schedule J (“Accumulated Earnings & Profits (E&P) of Controlled Foreign Corporation”). Taxpayers were able to provide all the required information for each CFC on less than two full pages!

Those days are gone. Because of the complexity and incompleteness of the TCJA’s international provisions, along with congressional failure to pass a technical corrections act to remedy the well-known errors of those provisions, Treasury and the IRS were left to bridge the gap and forced to promulgate new regulations (which can safely be called extremely complex) and a grossly expanded Form 5471 that could not have been imagined four years ago. Besides adding pages and complexity to the above-mentioned schedules, Schedule G (“Other Information”) was expanded from eight questions to 22 (including a new line 19 that leads to 22 additional questions). Further, four new schedules have been added to Form 5471: Schedule I-1 (“Information for Global Intangible Low-Taxed Income”), Schedule P (“Previously Taxed Earnings and Profits of U.S. Shareholders of Certain Foreign Corporations”), Schedule Q (“CFC Income by CFC Income Groups”), and Schedule R (“Distributions From a Foreign Corporation”).

Before addressing the TCJA’s changes to international provisions, it is worthwhile to note that the provisions on PTEP that taxpayers and their advisers were familiar with had changed very little since the Tax Reform Act of 1986. For example, PTEP distributions by CFCs to U.S. shareholders were exempt from U.S. income tax,2

Lewis J. Greenwald is a managing director in the international tax practice of Alvarez & Marsal Taxand LLC in Miami and New York, Brainard L. Patton is an adjunct professor in the graduate tax program at Boston University School of Law, and Brendan Sinnott is a senior director in the international tax practice of Alvarez & Marsal Taxand in New York.

In this article, the authors consider changes to the U.S. compliance requirements for previously taxed earnings and profits and suggest how to simplify the burden.

Copyright 2021 Lewis J. Greenwald, Brainard L. Patton, and Brendan Sinnott. All rights reserved.

1Referred to as previously taxed income, or PTI, before the TCJA.

2IRC section 959(a).




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corporate U.S. shareholders were entitled to a credit for foreign taxes related to PTEP distributions (to the extent not previously claimed as a credit),3 and U.S. corporate shareholders that reported additional foreign taxes for PTEP distributions were entitled to an additional FTC limitation under IRC section 904 (to facilitate absorption of those additional foreign taxes on the distributions).4 Also, before the TCJA, most CFCs had very little PTEP — all of which arose by virtue of subpart F and section 956 inclusions.

The TCJA and PTEP

The TCJA made several changes to the rules for FTCs on CFC income that have created significant complexity and have indirectly led to unnecessary U.S. tax reporting when PTEP is repatriated. The first and most significant of those changes was the creation of a 100 percent dividends received deduction under new section 245A and the related repeal of section 902.5 Besides the obvious impact of disallowing FTCs on what are now nontaxable dividends, that action also terminated the rule that had been in effect for over 30 years by which deemed-paid credits for income inclusions related to E&P of CFCs were calculated by pooling the E&P and related taxes of each CFC (for all years from 1986 through the date of distribution).6 The TCJA simultaneously modified section 960(a) to require calculating indirect credits on subpart F inclusions (including inclusions under new section 951A for GILTI) on a current-year basis.7

A second set of changes involves the GILTI provisions of new section 951A. The TCJA created a special 10.5 percent tax rate on GILTI (13.125 percent after 2025), a new section 904 basket for GILTI, a 20 percent haircut for the foreign taxes for a GILTI inclusion, and, most significantly, a disallowance of a carryover for excess FTCs on a GILTI inclusion. The combination of limiting FTCs to current-year taxes and disallowing excess FTCs on only one of the four post-TCJA FTC categories or baskets is at the root of the complexity concerns discussed herein.

Rather than provide specific guidance, section 960(a) provides that deemed-paid credits shall be those foreign income taxes properly attributable to the included income,8 thus obligating Treasury to provide regulations for determining creditable taxes and allocating those taxes to specific baskets. As will be discussed, Treasury and the IRS interpreted those changes as requiring taxpayers to keep track of E&P and related creditable taxes by year, by basket, and by PTEP group based on the principles of Treas. reg. section 1.904-6 — calculations that are exponentially more complicated than the rules in effect before the TCJA.

Unfortunately, at the same time that PTEP reporting became more complex, the TCJA led to an exponential increase in the amount of PTEP generated by CFCs. Our post-TCJA experience is that, as a result of GILTI and subpart F, virtually all CFC E&P is now PTEP, with very little untaxed section 959(c)(3) E&P, or E&P that has not been previously taxed.9 Despite that, other than the potential additional creditable foreign income taxes that may come with a distribution of PTEP, there is little in the post-TCJA environment that should make the U.S. international tax aspects of PTEP distributions more complicated than before the TCJA.

With a view to assisting taxpayers in efficiently meeting their U.S. international tax

3Section 960(b)(1), formerly section 960(a)(3). Individual

shareholders electing to report income from CFCs under section 962 are also entitled to the indirect credit under section 962(a)(2). A discussion of that is beyond the scope of this article.

4Section 960(c), formerly section 960(b).

5Section 902 is deemed no longer necessary because post-TCJA

dividends from CFCs are entitled to the 100 percent deduction under section 245A and foreign income taxes related to those dividends are no longer creditable.

6Those of us who were U.S. international tax practitioners before

1986 will recall the difficult calculations and lost FTCs that resulted from the year-by-year deemed-paid FTC rule in effect before TRA 1986.

7In what was either a veiled attempt to cover a complex wolf in

simple sheep’s clothing or evidence of a profound misunderstanding of what was being enacted, the accompanying committee report said that “offering deemed paid FTCs on a current year basis under section 960 reflects what the Committee believes to be a simpler and more appropriate application of the foreign tax credit regime in a 100 percent participation exemption system.” H. Rep. 115-409, at 312 (2017).

8The indirect credit under pre-TCJA section 960(a) (for inclusions

under section 951(a)) was calculated as if the section 951(a) inclusion were a dividend, governed by section 902.

9Post-TCJA untaxed E&P generally consists of the return on qualified

business asset investment under section 250(b)(2)(B) and income excluded from GILTI by virtue of the high-tax exclusion of section 954(b)(4).




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compliance obligations and encouraging Treasury and the IRS to take action to reduce the extremely inefficient filing requirements spawned by the TCJA, the remainder of this article looks at the PTEP-related law and expanded reporting requirements.

Discussion

As evidence of the difficulty in interpreting the impact of the law’s changes on PTEP calculations and related reporting obligations, nearly four years after enactment of the TCJA, Treasury and the IRS have been unable to issue formal PTEP guidance. We attempt to fill in the gaps by reviewing the applicable code sections and related guidance provided to date.

New Section 960(b)

Whereas section 960(a) allows for an FTC for income inclusions under section 951(a)(1), new section 960(b)10 provides updated post-TCJA rules for foreign taxes attributable to PTEP distributions that are excluded from gross income under section 959(a), including distributions made through tiered CFCs.

New section 960(b)(1) generally provides that if any portion of a distribution from a CFC to a domestic corporation (that is also a U.S. shareholder of that CFC) is excluded from gross income under section 959(a), the domestic corporation will be deemed to have paid the foreign corporation’s foreign taxes that are properly attributable to that portion and have not been deemed previously paid by the domestic corporation under section 960 for that tax year or any prior tax year.11 For this discussion, section 960(b)(2) is key: A CFC’s deemed-paid foreign income taxes must include income taxes attributable to a PTEP distribution from another CFC as described in section 959(b). In those cases, additional FTCs on a PTEP distribution (described in section 960(b)(1)) include any additional taxes attributable to the section 959(b) PTEP distribution.

For example, if a U.S. shareholder excludes under section 959(a) any part of a distribution received from a lower-tier CFC through a chain of CFCs as PTEP, that shareholder will be deemed to have paid any withholding or other taxes paid by an upper-tier CFC that are properly attributable to distributions of the PTEP by the lower-tier CFC.12

Unfortunately for Treasury, section 960(f) directs the secretary to prescribe regulations and other guidance “as may be appropriate to carry out the purposes of section 960.”

Section 959

Before reviewing the section 960 regulations and guidance, it is helpful to revisit how section 959 operates. Section 959(c) specifies that E&P distributions from a foreign corporation are first attributable to PTEP described in section 959(c)(1),13 then to PTEP described in section 959(c)(2),14 and then to other E&P described in section 959(c)(3).15

Treasury and the IRS determined that adherence to reg. section 1.904-6 principles created the need to track and account for several new groups of PTEP because section 959(c)(2) PTEP (and related deemed-paid FTCs) may arise by reason of income inclusions under sections 951(a)(1)(A), 245A(e)(2), 951A(f)(1), 959(e), 964(e)(4), and 965(a), or by reason of the application of section 965(b)(4)(A).

Also, because section 959(c)(2) PTEP may be reclassified as section 959(c)(1) PTEP as a result of sections 956 and 959(a)(2), Treasury and the IRS

10Successor code section to former section 960(a)(3).

11Post-TCJA section 960(b)(2) provides a similar rule for tiered

foreign corporations.

12Joint Committee on Taxation, “General Explanation of Public Law

115-97,” JCS-1-18 (Dec. 2018).13

Section 959(c)(1) PTEP is E&P attributable to amounts previously included in income under section 951(a)(1)(B) — that is, amounts determined under section 956 — and E&P attributable to amounts previously included in income under section 951(a)(1)(C) — that is, amounts determined under now-repealed section 956A.

14Section 959(c)(2) PTEP is E&P attributable to amounts previously

included in income under section 951(a)(1)(A) — that is, subpart F income.

15Changes made by the TCJA slightly modified the section 959

ordering rules. Now, starting with section 959(c)(1) PTEP, as an exception to the last-in, first-out approach, distributions are sourced first from reclassified section 965(a) PTEP and then from reclassified section 965(b) PTEP. Once those PTEP groups have been exhausted, under LIFO, distributions are sourced pro rata from the remaining section 959(c)(1) PTEP groups in each annual PTEP account, starting with the most recent. Once the PTEP groups relating to section 959(c)(1) PTEP are exhausted, distributions are sourced from section 959(c)(2) PTEP. Finally, once all the PTEP groups have been exhausted, the remaining amount of any distributions are sourced from section 959(c)(3) “live” E&P.




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determined that mirror PTEP groups for section 959(c)(1) PTEP must be maintained. Finally, PTEP subaccounts must be maintained for each section 904 FTC category.

The Proposed Section 960(b) Regulations

On December 7, 2018, Treasury and the IRS issued proposed regulations under section 960(b) (REG-105600-18).

Annual PTEP Accounts and Associated TaxesThe proposed regs require a CFC to establish

a separate, annual account for its E&P for each current tax year to which subpart F or GILTI inclusions of U.S. shareholders of the CFC are attributable. Each account must correspond to the inclusion year of the PTEP and to the section 904 category of the inclusions at the U.S. shareholder level.

The PTEP in each annual account is assigned to one of 10 possible PTEP groups.16 The PTEP groups serve a similar function to the subpart F income groups and tested income groups — they are a mechanism for associating foreign taxes paid or accrued, or deemed paid, by a CFC with section 959 PTEP distributions.

A CFC accounts for a section 959(b) distribution that it receives by adding the distribution amount to an annual PTEP account and PTEP group that corresponds to the account and group from which the distributing CFC made the distribution. A CFC that makes a section 959 distribution must similarly reduce the annual PTEP account and related PTEP group from which the distribution is made by the distribution amount. A CFC must also reduce PTEP groups that relate to section 959(c)(2) PTEP to account for reclassifications of amounts into those groups as section 959(c)(1) PTEP (reclassified PTEP) and increase the PTEP group that corresponds to the reclassified amount.17

Associating Foreign Taxes With PTEP GroupsUnder the proposed regs, PTEP group taxes

consist of: (1) foreign income taxes deemed paid by the CFC under section 960(a) for a current-year

income inclusion in a PTEP group; (2) the foreign income taxes paid or accrued by the CFC as a result of its receipt of a section 959(b) distribution that are allocated and apportioned to the PTEP group; and (3) for a reclassified PTEP group, foreign income taxes that were paid, accrued, or deemed paid for an amount that was initially included in a section 959(c)(2) PTEP group and later added to a corresponding reclassified section 959(c)(1) PTEP group.

PTEP group taxes are reduced by the amount of foreign income taxes in the group that are deemed paid by a U.S. shareholder under section 960(b)(1) or by another CFC under section 960(b)(2), as well as foreign income taxes relating to amounts in a PTEP group that have been reclassified to a section 959(c)(1) PTEP group.

Under the proposed regulations, a CFC’s current-year taxes are associated with a PTEP group for section 960(b) purposes only if the receipt of a section 959(b) distribution causes an increase in a PTEP group. The increased PTEP group is treated as an income group to which current-year taxes are imposed solely by reason of that section 959(b) distribution. Taxes that are allocated and apportioned to a PTEP group by reason of a CFC’s receipt of a section 959 distribution are allocated and apportioned to the PTEP group under reg. section 1.904-6 principles.18 For example, a withholding tax imposed on a section 959(b) distribution received by an upper-tier CFC is allocated and apportioned to the PTEP group and relevant tax year, as well as to the section 904 category that was increased by the section 959(b) distribution. The withholding tax also reduces (as a distribution) the amount in the same PTEP group, year, and section 904 category.

Computational RulesA domestic corporation that receives a section

959(a) distribution is deemed to have paid the foreign income taxes properly attributable to the distribution from the distributing CFC’s PTEP group if the PTEP group taxes have not already been deemed paid in the current tax year or any prior tax year. The amount of foreign income taxes properly attributable to a domestic corporation’s

16Technically, one of only five PTEP groups, as will be discussed

below.17

Prop. reg. section 1.960-3(c)(4).18

Prop. reg. section 1.960-1(d)(3)(ii)(B).




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receipt of a section 959(a) distribution from a PTEP group in a section 904 category is its proportionate share of PTEP taxes associated with the PTEP group. The domestic corporation’s proportionate share of foreign income taxes associated with a section 959(a) distribution from a PTEP group is determined by a fraction equal to the amount of the section 959(a) distribution attributable to the PTEP group over the total amount of PTEP in the PTEP group.19

Notice 2019-1

Immediately after issuing the proposed regulations, Treasury and the IRS released Notice 2019-1, 2019-3 IRB 275, announcing their intention to issue regulations on foreign corporations with PTEP. Notice 2019-1 affirmed the requirement to maintain annual PTEP accounts but expanded the number of PTEP groups from 10 to 16 and provided that the rules would be coordinated with prop. reg. section 1.960-1 and -3.

The Final Section 960(b) RegulationsBoth the preamble to the proposed

regulations and Notice 2019-1 requested comments on possible ways to simplify the PTEP groups. While no comments suggested how to combine or consolidate PTEP groups, one noted that the rules were complex and questioned whether tracking all the PTEP groups was necessary.

On December 17, 2019, Treasury and the IRS issued final regulations under section 960(b) (T.D. 9882) that finalized the proposed regulations with some modifications.

After evaluating the various limitations on the creditability of some foreign income taxes and the application of the section 986(c) foreign currency rules to PTEP groups, the final regulations still permit the application of the relevant FTC and

foreign currency provisions but consolidate the PTEP groups into five under section 959(c)(2)20: PTEP arising under sections 965(a), 965(b)(4)(A), 951A(f)(2), 245A(d),21 and 951(a)(1)(A).

Although section 956 has virtually no significance following the availability of the 100 percent dividends received deduction of section 245A, the final regulations implicitly acknowledge that the distribution-ordering rule of section 959(c) requires that U.S. taxpayers reclassify section 959(c)(2) PTEP as section 959(c)(1) PTEP whenever the CFC has a section 956 investment in U.S. property that was included in the U.S. shareholder’s gross income under section 951(a)(1)(A), or would have been included except for section 959(a)(2).

In that case, the section 959(c)(2) PTEP group is reduced by the functional currency amount of the reclassified PTEP, which is added to the corresponding section 959(c)(1) PTEP group described in the same section 904 category and same annual PTEP account as the reduced section 959(c)(2) PTEP group. That tracking requirement adds extreme complexity without any corresponding FTC value.

New Form 5471 Reporting Requirements

Reg. section 1.960-3 detailed what CFCs must do to calculate the taxes properly attributable to items of income under the principles of reg. section 1.904-6. As a result, the IRS has determined that U.S. shareholders must complete and include as part of the annual Form 5471 for each CFC several schedules (essentially workpapers) to disclose how they calculated the current-year FTC on income inclusions, as well as the various PTEP categories and related foreign taxes, even though that information is largely irrelevant for the calculation of the current-year tax liability.

The new and expanded Form 5471 schedules that implement those rules are briefly described below.

19A single section 959(a) distribution could be attributable to

multiple PTEP groups of the distributing CFC for multiple inclusion years. The proposed regulations, including their order of PTEP groups, do not provide rules for allocating distributions among different kinds of PTEP under section 959(c). Treasury and the IRS anticipate that future regulations under section 959 will provide ordering rules for determining the annual PTEP account and PTEP group to which a section 959 distribution is attributable.

20The regulations list 10 PTEP groups, but five are duplicated under

section 959(c)(1)-(2).21

Reg. section 1.960-3(c)(2)(ix)(A) is E&P described in section 959(c)(2) by reason of section 254A(e)(2), reg. section 1.960-3(c)(2)(ix)(B) is E&P described in section 959(c)(2) by reason of section 959(e), and reg. section 1.960-3(c)(2)(ix)(C) is E&P described in section 959(c)(2) by reason of section 964(e)(4).




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Schedule J

Before the TCJA, Schedule J merely rolled beginning-of-year E&P to end-of-year E&P, reflecting the impact of current earnings, current reclassifications of E&P under section 959(c)(3) and the two PTEP categories under section 959(c)(2) and (1), and distributions of E&P. For taxpayers taking advantage of the pre-TCJA deferral regime, Schedule J might take only a few minutes to complete.

Simplicity, however, is a foreign concept for the new Schedule J. At the highest level, the post-TCJA version of Schedule J serves the same purpose as before: rolling E&P from the beginning of the year to the end. However, it expanded the amount of detail on how E&P rolls and the number of section 959(c)(2) PTEP categories to be reported from one to five. It also expanded section 959(c)(1) into the same five PTEP categories.

Beyond merely reflecting current E&P, section 959(c) reclassifications, and distributions, the new Schedule J requires that several other drivers of untaxed E&P be tracked, including E&P subject to the section 909 anti-splitter rules, E&P carried over in nonrecognition transactions, and hovering E&P deficits — and that relates just to untaxed E&P under section 959(c)(3).22

While those details can prove problematic, the real trouble begins with the expanded categories of PTEP resulting from the section 1.960-3 regulations discussed above. The new Schedule J requires taxpayers to show PTEP attributable to section 965(a) inclusions, section 965(b) deficit offsets, section 956 investments in U.S. property, GILTI inclusions, subpart F inclusions, section 245A hybrid dividends, and section 1248 amounts. Within those categories, taxpayers must report whether the PTEP is section 959(c)(2) or (c)(1) PTEP. Taxpayers must also separately track each PTEP according to its FTC category, as well as track movements of PTEP between section 959(c)(2) and (c)(1) groupings for the five new PTEP groups.

As a result, a taxpayer can easily have many different PTEP categories reported on a single Form 5471, with no practical benefit to that level of detail outside the application of sections 960(b) and 986(c).

Schedule P

Form 5471 was expanded to require additional detail on PTEP at the U.S. shareholder level. While similar to Schedule J in organization and purpose, new Schedule P requires several additional levels of detail to be tracked.

Most notably, Schedule P must be prepared for each U.S. shareholder of a CFC, tracking the shareholder’s portion of the CFC’s PTEP balances in each group and FTC basket. For 100 percent owned CFCs, that information may be readily available after completing Schedule J. However, complexities inevitably arise when CFCs have multiple U.S. shareholders. For example, a taxpayer filing for a 90 percent owned CFC with an unrelated 10 percent minority U.S. shareholder cannot reasonably be expected to know the minority shareholder’s section 951A PTEP balance, which is a function of the tested income and losses of any other CFCs owned by that shareholder. Despite that impracticality, taxpayers are expected to track and report not only their tax attributes but also those of unrelated taxpayers — an obligation with no known comparable in U.S. federal tax compliance.

Schedule P also diverges from Schedule J in requiring that the PTEP balances be reported in both functional currency and U.S. dollars. The clear implication here is that Schedule P serves as a roadmap for the IRS to audit section 986(c) calculations with no effect on the current-year U.S. tax liability of the reporting U.S. shareholder.

As similarly observed with Schedule J, Schedule P creates a degree of impracticality to accommodate a narrow range of transactions. Absent actual distributions of PTEP, Schedule P provides no meaningful information to justify the effort it requires.

Schedule E-1

For any taxpayers uncertain why the expanded reporting on schedules J and P was necessary, Schedule E-1 serves to clarify the matter. As discussed above, the relevance of

22As indicated above, despite the additional reporting complexity,

most CFCs report small amounts of untaxed section 959(c)(3) E&P.




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expanded PTEP reporting is largely a function of accommodating section 960(b) and (c), in which distributions of PTEP may carry the opportunity for claiming FTCs.

Schedule E-1 supports that function. Mirroring schedules J and P in organization, Schedule E-1 traces foreign taxes paid that are associated with PTEP (for example, when a CFC-to-CFC section 959(b) distribution of PTEP is subject to non-U.S. income or withholding tax). When that PTEP is ultimately distributed to a U.S. shareholder, those foreign taxes may be available as an FTC, subject to the rules of sections 960 and 904. However, that should apply only when the reporting CFC receives from a lower-level CFC a PTEP distribution subject to local withholding tax in the country of payment or income tax in the country of the receiving entity.

Schedule E-1 therefore stands somewhat in contrast to schedules J and P: Its complexity is borne out of actual, rather than potential, necessity. A taxpayer must disclose a level of detail on Schedule E-1 only if its PTEP balances are subjected to foreign tax (for example, by reason of a taxable distribution). A taxpayer without that fact pattern leaves the vast majority of Schedule E-1 blank. By contrast, schedules J and P must be fully reported, regardless of the relevancy of much of the detail.

Schedule Q

Schedule Q amounts to a worksheet by which the preparer of the other schedules must show the underlying calculations.

Taxpayers who have already disclosed their subpart F amounts on Schedule I and shown their calculations of tested income on Schedule I-1 must go into even greater detail. Schedule Q requires that a taxpayer report the gross income and deductions allocable and apportionable to that gross income for the various subpart F income groups, tested income, and residual income. Again, the net income in those income groups is already reflected elsewhere on Form 5471; nothing reported on Schedule Q alters a taxpayer’s taxable income. Therefore, Schedule Q merely follows a similar pattern of the IRS requiring that taxpayers put their workpapers directly into their U.S. tax returns.

Conclusion and Recommendation

Based on the foregoing, we can safely say that the section 960 regulations and the related reporting requirements scrupulously adhere to the “principles of section 1.904-6” as directed by the House Ways and Means Committee. Those principles in turn are driven solely by U.S. FTC considerations and are designed to ensure that U.S. corporate taxpayers that include income under section 951(a)(1) — whether under the subpart F, GILTI, or section 956 provisions — will claim credit only for deemed-paid foreign income taxes that are properly attributable to the section 904(d)(1) FTC category of income being reported.

Only after that income has been included and taxed on a U.S. return does it become PTEP under section 959(c)(2). Under section 959(a), PTEP distributions by a CFC to its U.S. shareholders are not again included in gross income. In that case, under section 960(b)(1), the foreign income taxes claimed as a credit on the original income inclusion are not allowable as a deemed-paid credit at the time of the PTEP distribution. In fact, the only time a U.S. corporate shareholder might be entitled under section 960(b) to a deemed-paid FTC for taxes related to PTEP distributions is when the CFC is redistributing PTEP that it received via a section 959(b) distribution of PTEP from a lower-level CFC and the distribution was subject to foreign income taxes that were not claimed as a deemed-paid credit under section 960(a) at the time of the original inclusion.

In our view, the availability of an additional FTC on PTEP distributions and the related requirements to track and report the PTEP and related FTC have no relevance or benefit if the CFC making a PTEP distribution to its U.S. shareholders has no CFC subsidiaries making section 959(b) distributions or the U.S. shareholder is an individual (because individuals are not entitled to deemed-paid taxes under section 960).

Section 960(b) Election

To address the vastly disproportionate effort-to-value problem and reduce the burden on U.S. shareholders of reporting unnecessary information, we propose that reg. section 1.960-3 be revised to allow the U.S. shareholders of a CFC to make an annual election to forgo the benefit of any deemed-paid credit under section 960(b) for




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distributions by that CFC of PTEP arising in that year. If later section 959(b) distributions of that PTEP to an upper-level CFC are subject to withholding taxes in the paying country or to additional income taxes in the recipient country, those taxes would not be allowable as a credit under section 960(b) on eventual distribution to a U.S. shareholder and would also not reduce E&P of the recipient CFC.

CFCs for which all U.S. shareholders have made that election would file a simplified Schedule J for each section 904(d)(1) category, with four columns to report E&P in that category under section 959(c)(1)-(3) and total E&P (similar to the format for Schedule J) as of December 2012. In that case, the Form 5471 for the CFC would not be required to include the post-TCJA schedule J, P, or Q.

Although we find them unnecessarily burdensome, schedules E and E-1 would still be required for U.S. shareholders claiming a current-year FTC under section 960(a).

PTEP Purge

Even if Treasury and the IRS view as untenable the proposed election to forgo section 960(b) FTCs, U.S. shareholders of a CFC can still engage in self-help. They can significantly reduce the burden of tracking the annual amounts of E&P and related foreign income taxes in each PTEP group by causing the CFC to purge its PTEP by repatriating all PTEP, reducing the end-of-year E&P balances in each PTEP group to as close to

zero as possible. However, U.S. taxpayers with minimum tax basis in the shares of the CFCs should be mindful of a potential exposure to capital gain under section 961(b)(2).23 The conundrum is that the distribution of PTEP in excess of basis can generate capital gain while the distribution of less than all PTEP leaves the U.S. shareholders with the burden of completing and filing Form 5471 attachments that have no relevance.

Unless Treasury and the IRS relax the requirement that U.S. shareholders of CFCs fastidiously track PTEP and related foreign taxes by PTEP group, FTC basket, and year, U.S. taxpayers are in for a frustratingly difficult and costly exercise to timely complete Form 5471 and related schedules J, P, and Q — while knowing that their efforts will likely have little or no impact on their current or future FTC calculations.

23Under reg. section 1.961-2(a)(1), PTEP distributions that are

excluded from gross income under section 959(a) reduce the adjusted tax basis in the stock of the distributing CFC at the time of distribution, whereas an inclusion of income under section 951(a) increases the U.S. shareholder’s basis in the stock of that CFC only at the end of the CFC’s tax year. The IRS is well aware of this problem and has promised guidance over the last several years to address it.






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The Future of Transfer Pricing

by Elizabeth J. Stevens and Niraja Srinivasan

The forecast for the future of transfer pricing as a technical discipline is partly cloudy. The arm’s-length principle is in retreat. An agreement on a global minimum tax that would substantially diminish opportunities for tax rate arbitrage is close at hand.

The forecast for the future of the transfer pricing profession, however, is increasingly bright. Law and economics graduates continue to flock to the field, bringing an intuitive understanding of digital business models as well as keen analytical skills. They have increasingly elected to take additional courses to specialize in

transfer pricing or international tax. The next generation of transfer pricing professionals is more diverse in terms of education, experience, and perspective as well as ethnicity, race, religion, and sex — and more technically savvy than any that preceded it. The only gap that some new graduates have is a meaningful understanding of how the large multinationals (that will become their clients) operate their internal tax and transfer pricing functions.

Until now.In fall 2020 the American Bar Association

Section of Taxation’s Transfer Pricing Committee launched an educational outreach program called “Transfer Pricing: From Classroom to Boardroom” (TP C2B), a first-of-its-kind curated mentorship program that pairs motivated law and graduate taxation and economics students interested in pursuing transfer pricing careers with in-house corporate tax and transfer pricing leaders. The program’s broad goal is to educate and nurture a diverse and well-rounded next generation of transfer pricing professionals by providing opportunities for real-world grounding alongside classroom studies. For students, a structured look into how transfer pricing policies are designed and administered provides a balanced and informed view of a multinational corporation’s priorities and operations. For corporate mentors, the program offers an opportunity to share wisdom and experience and thereby enhance the transfer pricing profession.

The transfer pricing committee recruited six mentor-mentee pairs for the first-year pilot program, roughly running from October 2020 through May 2021. The program was designed to culminate in a capstone exercise with presentations made by mentees on a cutting-edge transfer pricing topic. The committee invited the mentors, screened the mentees, matched them up, and waited to see what would happen.

Elizabeth J. Stevens is a member of Caplin & Drysdale Chtd.’s international tax practice in Washington. Niraja Srinivasan is a director at NERA Economic Consulting and an adjunct professor at Texas A&M University School of Law. Before joining NERA, she was a vice president in Dell Technologies’ global tax group.

In this article, the authors review a new educational outreach program for students interested in pursuing transfer pricing careers, with in-house corporate tax and transfer pricing leaders serving as the students’ mentors.

Copyright 2021 Elizabeth J. Stevens and Niraja Srinivasan. All rights reserved.




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The experiment succeeded. The mentees had enriching and unique opportunities to learn about transfer pricing practices in major multinationals. The mentors enjoyed sharing their “inside” perspective and teaching students the art of applied transfer pricing. Despite their demanding in-house roles, the mentors gave generously of their time and knowledge, meeting regularly with their mentees every two to four weeks throughout the academic year to discuss topics ranging from operational transfer pricing to court decisions and their application to practice, to how a tax department operates and interfaces with other corporate stakeholders, to the students’ career paths and interests. The mentors went above and beyond — they deserve not only our gratitude but also public recognition for their contributions.

The TP C2B mentors for fiscal 2020-2021 include Liz Chien of Protocol Labs Inc., formerly Ripple Labs Inc.; Sahar Gaya of KPMG, formerly with Glencore; David Paul of American Honda Motor Co. Inc.; Joel Wilpitz of Sazerac Company Inc., formerly with The Kraft Heinz Company; and Terri Ziacik of Microsoft.

Kudos are also in order for our TP C2B mentees: Marin Dell of University of Florida Fredric G. Levin College of Law (LLM), Hannah Karraker of University of San Diego School of Law (JD/LLM), Cory Prewit of Texas A&M University School of Law (JD), Lukens Rivil of University of Florida Fredric G. Levin College of Law (LLM), Franklin Shen of New York University School of Law (JD), and Suzanne Suttles of Texas A&M University School of Law (JD).

The 2021 TP C2B program culminated in a capstone exercise held in conjunction with the ABA Section of Taxation’s May meeting. Initially an interactive role-play was planned — a mock IRS Appeals hearing — during which the mentees would leverage both their knowledge of transfer pricing concepts acquired in the classroom and their understanding of corporate transfer pricing practice gained through the mentoring relationships, followed by a networking reception. When the May meeting went virtual, it was rebooted with Plan B: a case study of the Tax Court’s 2017 decision in Amazon.1

The mentees worked in teams of two, and through dialogue with their mentors and the study of publicly available materials, they developed analyses of three questions provided by the committee.

On May 13 the mentee pairs presented their analyses and responded on the fly to questions from an expert panel and the audience of tax section members assembled via Zoom. And, wow, were the mentees ever impressive!2

Below we present the three mentee teams’ original, copy-edited summaries of their capstone presentations, followed by a look ahead to the next year of TP C2B.

Amazon and the TCJA — Cory Prewit and Marin Dell

Amazon is undoubtedly an interesting case involving the transfer of intangibles from a parent company to a subsidiary. The IRS determined that Amazon.com Inc. had a federal income tax deficiency for the 2005 and 2006 tax years arising from unreported income stemming from a transfer of intellectual property to its European subsidiary (AEHT). The Tax Court held that Amazon’s calculated buy-in payments for this transfer were appropriate, and that the IRS was incorrect in its calculations for the deficiency notice. This holding was ultimately upheld by the Ninth Circuit.3

Because the tax years in question are pre-2017, and perhaps more importantly pre-TCJA, the case almost certainly would have turned out differently had the TCJA applied to the years at issue. In particular, the IRS would have had firmer legal ground to stand on if it had been able to rely

1Amazon.com v. Commissioner, 934 F.3d 976 (2019).

2Many, many thanks to our designated experts — Peter Barnes, lately

of the Duke University Law and Business schools, and David Bowen, of the University of San Diego School of Law — for shepherding the mentees through the thicket of cost sharing and sharing their wisdom on the case.

Amazon involved pre-Tax Cuts and Jobs Act years. Do you believe the case would have been decided differently if post-2017 law — in particular, new section 367(d)(4) — had applied, and if so, how and why?

3Amazon, 934 F.3d 976.




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on section 367(d)(4). However, section 367(d)(4) would likely still not have captured all the applicable IP that was transferred from Amazon to AEHT. Further, the issue of valuing some of these intangibles will likely need to be resolved by the courts or further legislation.

The enumerated list of intangibles likely would have captured many of the intangibles at issue in Amazon. Section 367(d)(4)(f), which covers “goodwill, going concern value, or workforce in place (including its composition and terms and conditions (contractual or otherwise) of its employment),” would have likely allowed the IRS to properly bring in goodwill and going concern value, which were at issue in Amazon. However, several other areas of IP at issue would still likely be left out despite the catchall provision in section 367(d)(4)(g).

As stated in Amazon, the “culture of innovation” at Amazon was invaluable to the company. From Amazon’s inception through today, the company has constantly innovated. Its rapidly changing software was developed quickly and built up a lot of “technical debt,” which reduced the useful life of its software. It isn’t entirely clear that the IRS would be able to rely on the catchall provision in section 367(d)(4)(g) to bring this “culture of innovation” into a buy-in agreement for a transfer. It is also unclear how much of Amazon’s culture of innovation was transferred to AEHT and how much was independently created by the European subsidiary. As stated in the Ninth Circuit’s opinion, Amazon’s European subsidiary had to constantly innovate to meet the cultural expectations of the various countries in which it operated.4

Valuation of intangibles — such as a “culture of innovation” — isn’t neatly addressed by the new sections created by the TCJA. As stated in Amazon, the culture of innovation would likely fall under the enterprise valuation of a business. Enterprise valuation items aren’t IP and don’t have “substantial value independent of the services of any individual.”5 In Amazon, the court held that these items wouldn’t be included in the

buy-in payments. It isn’t entirely clear that these items have been brought under the umbrella of IP as defined in section 367. This area will need to be further defined by the courts as well as new legislation and regulations.

If Amazon were decided today for post-TCJA tax years, the court likely would have decided differently. Several IP transfer items that were excluded from the buy-in payment almost certainly aren’t captured by the addition of section 367(d)(4). However, other potential IP items — like Amazon’s culture of innovation — aren’t covered by the code, and the proper method for valuing them is unclear.

Realistic Alternatives — Lukens Rivil and Suzanne Suttles

The Tax Court’s Interpretation

In Amazon,6 the IRS defended its principal valuation expert’s approach under the realistic alternatives principle (RAP) and argued that Amazon had an available realistic alternative: the continued ownership of all its intangibles in the United States. The IRS urged that if dealing with an unrelated party, Amazon would have preferred that alternative to a cost-sharing arrangement that would give a competitor access to its “crown jewels.”

The Tax Court was unpersuaded by the IRS’s argument for many reasons, but it focused on two. First, the court determined that the IRS’s realistic alternatives approach “would make the cost-sharing election, which the regulations explicitly make available to taxpayers, altogether meaningless.” Second, the court, as it noted in

4Id. at 118.

5Id. at 157.

Consider the Tax Court’s discussion of “realistic alternatives” in Amazon in light of reg. section 1.482-1(f)(2)(ii), the sentence added to section 482 by the TCJA, and economic principles. What is the Tax Court’s interpretation of “realistic alternatives” and how the IRS should consider them, and is that interpretation consistent with sound economic principles?

6Amazon v. Commissioner, 148 T.C. No. 108 (2017).




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Veritas,7 decided that the IRS’s realistic alternatives argument conflicted with the requirement of the regulations that the IRS respect the transactions as actually structured by the parties as long as the transaction has economic substance.8

On appeal to the Ninth Circuit, the IRS brief argued that the Tax Court’s “restructure” critique conflicts with reg. section 1.482-1(f)(2)(ii)(A) and that the principle doesn’t restructure a transition; rather, it re-prices the transaction.9 The Ninth Circuit affirmed the Tax Court’s decision without discussing the realistic alternatives approach.

The IRS’s Interpretation

The Tax Court decisions in Amazon and Veritas provide the most recent judicial declarations regarding the merits of the IRS’s realistic alternatives approach.10

It is important that the scope of the Amazon and Veritas decisions concerns pre-2009 cost-sharing regulations, which were substantially overhauled through cost-sharing regulations issued in temporary form in 200911 and finalized in 2011.12 The current cost-sharing regulations reflect many of the theories and arguments that the IRS advanced in Veritas and Amazon, and the TCJA amendments to section 482 have essentially codified the RAP as argued by the IRS in Veritas and Amazon.

Sound Economic Principles

The issue presented asks whether the IRS’s interpretation/U.S. transfer pricing regulations are consistent with the OECD guidance on sound economic principles.

According to the OECD, sound economic principles must be compatible with the arm’s-length principle and reflect the realities of the controlled taxpayer’s particular facts and

circumstances while adopting the normal operation of the market as a benchmark.13 In the United States, the RAP is not a replacement for the arm’s-length standard and must meet the requirements of the best method approach to achieve a reliable outcome. The RAP must be considered as part of the comparability analysis under reg. section 1.482-1(d), and the comparability is a determinant of the best method under reg. section 1.482-1(c). Therefore, the RAP endorsed by OECD guidelines closely resembles the concept as described in the section 482 regulations, and both are largely interpreted as a valuation concept.14

Since the 2015 base erosion and profit-shifting final report on actions 8-10 was formally adopted, the OECD has issued 2017 transfer pricing guidelines on control over risk and intangible development, enhancement, maintenance, protection, and exploitation (DEMPE) functions. Although the United States has not directly adopted the OECD guidelines, Treasury has maintained that the OECD guidelines are consistent with general Treasury regulations — that is, that the section 482 regulations already contain similar concepts in line with the principles in BEPS actions 8-10.

But even if the U.S. regulations are conceptually similar, are they consistent in application? Transfer pricing litigation and the divergent approaches to risk between the OECD and U.S. regulations may suggest otherwise.15

Challenges posed by the COVID-19 pandemic will no doubt contribute to the need to address the section 482 regulations in light of the TCJA, ensure alignment with OECD guidelines, and take into account potential changes brought by any international tax reform. Clarification about the role of economic substance and respect for the

7Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), nonacq.,

No. 12075-06 (2010).8Referring to reg. section 1.482-1(f)(2)(ii)(A).

9Molly Moses, “Tax Court’s Amazon Ruling Thwarts Reg’s Purpose,

IRS Says,” Law360, Mar. 30, 2018.10

Because Treasury and the IRS issued the section 482 regulations in 1994. PwC, “Tax Court in Amazon Rejects IRS’s Proposed Application of Income Method for Pricing Cost-Sharing Buy-In Payments,” at 4 (May 2, 2017).

11T.D. 9441.

12T.D. 9568.

13OECD, “Revision of the Recommendation of the Council on the

Determination of Transfer Pricing Between Associated Enterprises,” at 1.14 (June 29, 2010).

14For a deeper discussion, see Ryan Finley, “The U.S. Transfer Pricing

Regulations’ Risky Approach to Risk,” Tax Notes Int’l, May 10, 2021, p. 723.

15See Finley, “Disputes Over Recharacterization Spread in Transfer

Pricing,” Tax Notes Int’l, Nov. 16, 2020, p. 980. See also Finley, supra note 14; but see Finley, “After Coca-Cola, Practitioners See DEMPE as Part of U.S. Law,” Tax Notes Int’l, May 24, 2021, p. 1133 (“The Coca-Cola opinion suggests that the Tax Court may now interpret U.S. law in a way that incorporates OECD guidance on control over risk and intangible DEMPE functions.”).




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taxpayer’s actual transaction after the TCJA will help address any abuse of discretion exercised by the IRS and indicate whether the U.S. regulations truly align with OECD guidelines.

Useful Life and Decay Rates — Hannah Karraker and Franklin Shen

We considered the Tax Court’s discussion in Amazon of the useful life and decay rates of transferred intangibles from Amazon U.S. to its European subsidiary.

Perpetual vs. Limited Useful Life

Amazon’s argument relied on the regulations, stating that the buy-in payment should represent compensation solely for the use of preexisting intangibles, and that new products or services would add to the existing IP, reflected in the cost-sharing agreement. While the commissioner attempted to argue that the existing technology could be valued in perpetuity, equating the transfer of preexisting intangibles to the sale of the entire business, the court agreed with Amazon that compensation for subsequently developed IP shouldn’t be covered in the buy-in, but rather would be dealt with in the cost-sharing agreement.

Royalty Rate

The royalty rate analysis for the intangibles was split into two parts: first, the determination of a base rate; and second, whether a volume adjustment should be applied. The commissioner chose a base rate of 4 percent from a single comparable agreement that Amazon had with Target, contending that it was the single most comparable agreement to the underlying transaction. On the other hand, Amazon analyzed deal decks to back out a range of rates from 1.4 to 4.4 percent, which the court was more inclined to agree with. The court agreed that a middling rate of 3.3 percent was appropriate because Amazon’s process was more proper.

Application of the volume adjustment was based on the observation that the industry accepts the notion that there is a negative correlation between sales volume and royalty rates across transactions. However, of the four largest comparable agreements, only two had adjustments, both of which were by 50 basis points. The court ended up splitting the baby by using a 25-basis-point adjustment. While the court’s decision is understandable, it brings into question just how persuasive industry standards really are. It seems that industry practice established the appropriateness of the adjustment here, but the court applied its own discretion to determine the extent of the adjustment.

The court also applied a royalty rate for the separate marketing intangibles, finding the structural norm in other multiple agreements to be more persuasive and applying a flat rate of 1 percent. It remains unclear why the court was less willing to engage in a more detailed analysis of the underlying marketing intangibles while it spent numerous pages discussing the merits and aspects of the underlying technology.

Decay Rates

Amazon contended a “ramp down” decay curve was necessary to correlate the buy-in to the value of the preexisting intangibles, originally developed in 2005, which gradually declined in value as major components were modified or replaced. Without such a decay rate, the cost-sharing regulations would be violated, and as the court found in Veritas, “an adjustment must be made to the stated royalty rate to account for the static nature of original technology.”16 Without ramping down, Amazon’s European subsidiary would be required to pay for subsequently developed intangibles twice — in the cost-sharing agreement and inflated buy-in price. The court agreed, finding the commissioner’s method failed to eliminate from the buy-in payment the value of subsequently developed intangibles by ignoring the relative contribution of both parties.

Consider the Tax Court’s discussion in Amazon of the useful life and decay rates of the transferred intangibles. Do the Court’s conclusions make sense in light of its finding of fact or economic principles?

16Veritas, 133 T.C. 297.




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Discount Rate

Amazon used the Capital Asset Pricing Model (CAPM) and a beta of 2 and monthly data to calculate the weighted average cost of capital (WACC) to be 18 percent. Notably, this is the same WACC that the commissioner used under the discounted cash flow model that the court threw out early in its opinion. However, using CAPM, a beta of 1.55, and weekly data, the commissioner came up with a WACC of 14 percent. Another of the commissioner’s experts used a beta of 1.45 calculated not from Amazon’s own data but from that of comparable companies. The court, agreeing with Amazon’s entire method, found that monthly data more accurately measured volatility compared with the market and that when data on the underlying taxpayer is available, it should be used instead of consulting data from other companies.

Conclusion

Overall, we agree with the court’s decision regarding the IP because it incorporated understood industry practices and sound principles of economics and valuation. We are less sure if the assumptions the court made regarding the underlying IP also applied to the marketing intangibles. A deeper analysis of how Amazon marketed its web technology would have allowed for greater precision in determining the applicable useful life and royalty rate.

2021-2022 TP C2B Launch

Planning is underway for the second year of TP C2B. The committee believes — and our pilot-year mentors and mentees heartily agree — that the program is valuable. It serves the legal educational and diversity objectives of the ABA, the tax section, and the transfer pricing committee. It builds connections between people and invests in the future of our profession. Our mentors are already leaders in this field; our mentees are the next generation. With the continued sponsorship of the ABA tax section and growing engagement from the corporate sector, the committee hopes to transform TP C2B from a start-up project into an institution, with larger cohorts of mentors and mentees each year.

Watch this space.






TAX HUMOR

Tax Accounting Challenge

by Peter Mason

The story below is the second part of my hypothetical climb up a mountain. Hidden within it are another 50 well-known financial terms or expressions. This is a slightly edited extract from my recent book, Tax Commandments for Business, which explains practical tax management with a little fun. There are no anagrams in the passage below, although parts of words in sequence may be used (sometimes with other words in between) along with some slightly odd spellings and somewhat stretched homophones. The previous Tax Accounting Challenge (Tax Notes Int’l, May 17, 2021, p. 949) should give you a feel for how this works. However, two financial terms are revealed in the first paragraph. See if you can find the other 48. Good luck!

Sometimes crows swooped down to consume remains of animals, but I did not waiver from carrying on forward up this mountain. The blazing sun overhead would shade bits of the rocky banks over draughty gorges. I would pass through caves ‘cos to follow the current cliff path edge was not worth slipping without investment in a holding rail and accompanying line to proceed safely.

I climbed in a local historical costume with a livestock mark etched on it. For this trip, a yellow backpack held articles of my fondest association. It carried a water reserve for liquidity, food provisions for this tough job so less sense of hunger, a supply of chains for climbing, and a sharp stake safely in its holder. At night I realised the value, on balance, of a sheet for warmth.

I recognised in this great expanse that no person alas would guarantee my security. My left leg already ached in its entirety, and I was reconciled to being deferred days in completing my mission. I hoped someone would presently value the book I was keeping due to my diligence of writing a journal entry every day, as I did not rate my chances of returning home. I would invent stories of my rescue to exude positivity, but my mind voluntarily added: “The end is close for sure, my friend!”

In my surreal state, my best option was to call out loud in voice, and this paid dividends. A fixed-wing plane was setting down near me, just in time. I would be able to direct orally my report back at base to transfer priceless information to every ear endlessly listening.

Nowadays, my audience in the lecture all properly writes useful notes about my venture. As I was able to fully recap it, a list has been formed which is, as everyone rousingly agreed, meant to be of benefit in climb expeditions in future.

(See page 648 for the solution.)

Peter Mason is a tax, treasury, and finance consultant and the author of Tax Commandments for Business (2020). He is based in London.




TAX HUMOR







COUNTRY DIGEST

AUSTRALIA

Australia’s Crown Resorts Pays $45 Million Toward Tax Liabilityby William Hoke

Australia’s Crown Resorts Ltd. has paid AUD 61 million (around $45 million) of casino tax liability, a figure that may only be a fraction of its ultimate liability.

On June 7 Mark Mackay, Crown Melbourne Ltd.’s executive general manager of gaming machines, told the commission for the state of Victoria that the company lowered its gambling taxes by almost AUD 200 million over nine years by including the promotional costs of its Melbourne casino as “winnings,” which reduce a casino’s taxable base. Mackay said he believed Crown was entitled to the deductions.

In a July 27 regulatory filing, Crown said that it had paid approximately AUD 37 million in casino tax and AUD 24 million in interest “relating to the incorrect deduction of certain bonus rewards provided to patrons in connection with play on Crown Melbourne’s electronic gaming machines” for the 2012 financial year “to date.”

The company said it is reviewing other aspects of its casino tax payments. “Crown’s review includes a review of Matchplay, the loyalty promotion pursuant to which Crown Rewards Points are redeemed for credits for use in electronic gaming machines,” it said.

In his earlier testimony, Mackay said Crown Melbourne deducted the cost of loyalty program benefits, including free parking, hotel rooms, meals, and loyalty points, in determining its gambling tax liabilities. The deductions reduced the company’s taxes by a total of AUD 167 million for the 2014-2019 fiscal years. Asked how much the total would be if the two following tax periods were included, Mackay said, “It could be over 200 [million].”

In a July 20 hearing on Crown’s license, commission lawyer Adrian Finanzio said the company’s liability, including interest, could be approximately AUD 480 million. Finanzio

recommended that Crown be stripped of its license. “The evidence reveals serious misconduct, illegal conduct, and highly inappropriate conduct, which has been encouraged or facilitated by a culture which has consistently put profit before all other considerations,” he said.

There have also been allegations that Crown Resorts had engaged in money laundering.




COUNTRY DIGEST


BELGIUM

Belgium Sues U.S. Pension Plans Over Dividend Withholding Schemeby William Hoke

The Belgian government has filed seven lawsuits in U.S. federal court alleging that it was defrauded by individuals and entities that used U.S. tax-deferred retirement plans to claim refunds for tax that was never withheld.

On July 27 Belgium’s Federal Public Service Finance (FPSF) filed separate lawsuits in the U.S. District Court for the Southern District of New York against the following defendants:

• Xiphias LLC Pension Plan, Richard Markowitz, Matthew Stein, John Van Merkensteijn, FGC Securities LLC, Alicia Colodner, and Stephen Wheeler, 1:21-cv-06392;

• Traden Investments Pension Plan, Adam LaRosa, FGC Securities LLC, and Stephen Wheeler, 1:21-cv-06399;

• Lion Advisory Inc. Pension Plan, Richard Markowitz, Luke McGee, John Van Merkensteijn, FGC Securities LLC, and Stephen Wheeler, 1:21-cv-06402;

• Delvian LLC Pension Plan, Alicia Colodner, Richard Markowitz, John Van Merkensteijn, FGC Securities LLC, and Stephen Wheeler, 1:21-cv-06404;

• Michelle Investments LLC Pension Plan, Richard Markowitz, John Van Merkensteijn, FGC Securities LLC, Alicia Colodner, and Stephen Wheeler, 1:21-cv-06405;

• Ganesha Industries Pension Plan, Adam LaRosa, Jerome L’Hote, FGC Securities LLC, and Stephen Wheeler, 1:21-cv-06407; and

• AOI Pension Plan, Adam LaRosa, Matthew Stein, FGC Securities LLC, and Stephen Wheeler, 1:21-cv-06408.

Under Belgian law, domestic companies are required to withhold 25 percent of any dividends paid to shareholders. The Belgium-U.S. tax treaty entitles pension funds that qualify as tax exempt under U.S. law to refunds of any tax withheld.

The FPSF in a July 28 release accused some of the defendants of creating the appearance that the pension funds owned shares in Belgian companies that had paid dividends and withheld

the corresponding amount of tax. The pension funds then claimed refunds totaling €44.9 million on the tax that was said to have been withheld, the tax agency said. Other defendants, including FGC Securities LLC, aided and abetted the alleged fraud by creating false and misleading documentation for the purported shareholdings and dividends received, the FPSF said.

Each of the lawsuits alleges that Solo Capital Partners LLP, which is not named as a defendant, provided dividend credit advice and documentation about the pension funds’ ownership of shares in Belgian companies. In one document, “Solo Capital stated that it was crediting [the pension fund’s] account to reflect payment of dividends in connection with the relevant shares,” the FPSF said.

The Danish government has filed similar lawsuits in U.S. federal court alleging that pension funds and others had fraudulently received refunds totaling approximately DKK 12.5 billion (around $2 billion) for withholding tax that had not been paid. In the lawsuits, Denmark also alleged that Solo Capital Partners was involved in the scheme.

The FPSF said the pension plans were not associated with a legitimate employer, were not funded by employer or employee contributions, and did not exist for the exclusive benefit of employees and their beneficiaries. It also alleged that the pension funds had not purchased or owned the shares or received any dividends on them. “To the extent [a pension fund] was involved in any purported transaction involving a share purchase or receipt of dividends relating to these securities, any such transaction was a sham designed to create the false appearance that [the pension fund] owned the shares, received dividends, and/or was entitled to a tax refund,” the FPSF said.

The only defendants named in all seven of the lawsuits are FGC Securities LLC, a New York-based provider of brokerage services, and Stephen Wheeler, who was described as FGC’s head of operations. FGC didn’t respond by press time to a request for comment.

In a possibly related legal action, German prosecutors in August 2020 charged two former managing directors and four ex-employees of a German bank for their alleged roles in laundering




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€160 million in a cum-ex dividend trading scheme involving Belgium and Denmark. The public prosecutor’s office said its indictments were preceded by investigations carried out by Belgian and Danish law enforcement authorities who were looking into commercial tax fraud that ultimately benefited U.S. pension funds. The prosecutor’s office said the Danish Tax Administration was swindled out of approximately €153 million in the scheme, with Belgian authorities losing out on the remainder.

The FPSF is represented in the lawsuits by Jeff E. Butler, John P. Alexander, Meredith George, and Robert Price of Clifford Chance.

CANADA

Canada to Examine Allegations of Bias In Charity Auditsby Amanda Athanasiou

The Canadian government has vowed to conduct a study addressing the concerns of Muslim-led charities amid public outcry over potential anti-Muslim bias in Canada Revenue Agency audits.

Minister of National Revenue Diane Lebouthillier has asked the Office of the Taxpayers’ Ombudsperson to head the study, according to a July 22 release issued at the conclusion of a national summit on Islamophobia.

“There’s no question that there is . . . more work to be done within government to dismantle systemic racism and Islamophobia because, from the CRA to security agencies, institutions should support people, not target them,” Prime Minister Justin Trudeau said during the summit. “Part of the path forward must be a public service that is inclusive rather than just diverse.”

The government appears to have stopped short of a moratorium on audits of Muslim charities by the CRA Review and Analysis Division (RAD), which is what the Muslim Association of Canada called for in anticipation of the summit. Islamophobia has been on the rise in Canada since 9/11, and “the government must invest resources to tackle both violent hate across the country and systemic institutional Islamophobia that we are witnessing” in the CRA, the Canada Border Services Agency, the Royal Canadian Mounted Police, the Canadian Security Intelligence Service, and other government agencies, the association said in a July 20 release.

The application of anti-radicalization and anti-terrorism-financing policies by the RAD, which is tasked with preventing the use of charities for terrorist financing, and the CRA’s Charities Directorate has created “conditions for potential structural bias against Muslim-led charities,” according to a report released in March by the University of Toronto’s Institute of Islamic Studies and the National Council of Canadian Muslims. Muslim-led charities have voiced concerns about the frequency and logic behind their audits for years, says the report, titled




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“Under Layered Suspicion: A Review of CRA Audits of Muslim-Led Charities.”

“Muslim-led charities are uniquely vulnerable to penalties or even deregistration at the hands of the CRA,” the report says. It presents case studies of audited charities that it says were suspected of hosting speakers that promoted radicalization, financing terrorism, and having links to Hamas in Palestine. “How does the CRA ensure [that] the evidence it uses counters dominant and reductive frames that link Muslims, Arabs, and Islam to terrorism?” the report asks.

The report makes several recommendations, including that the CRA suspend the RAD “pending review of Canada’s risk-based assessment model and its national strategy to combat extremism and radicalization.” The Charities Directorate should not have discretionary deregistration power in audits of Muslim-led charities as long as the terrorism financing risk-based assessment model and counter-radicalization policies are structured the way they are, it adds.

“The CRA does not select registered charities for audit based on any particular faith or denomination,” the agency said in a statement emailed to Tax Notes May 10 in response to an inquiry about the report’s recommendations. “Nor does it maintain statistics that track audits based on the denominations of faith-based charities.” The CRA only makes its actions public “when they result in a charity being revoked, annulled, suspended, or penalized,” it added.

Anver Emon, a professor at the University of Toronto and co-author of the report, said that because the CRA admittedly “does not keep data on its charities that would lend itself to a systemic racism audit,” it’s difficult to see how the agency can be held accountable. “There is data-blindness on this issue, and until that is rectified, I suspect meaningful accountability is going to be limited,” he said.

EUROPEAN UNION

EU Pushes Back Against Trading Partner Criticism of CBAMby Sarah Paez

The EU is defending its proposed carbon border adjustment mechanism (CBAM) against complaints from China and Russia that it poses a threat to trade relationships.

“The CBAM is not a trade tool nor a protectionist instrument,” a European Commission spokesperson said in a July 28 statement emailed to Tax Notes. “It is there to help fight climate change by addressing the risk of carbon leakage.”

As long as there is a risk of carbon leakage globally, the EU must address it, the spokesperson said, adding that without a CBAM, sharper reductions in greenhouse gas emissions in the EU would translate into increased emissions outside of Europe.

Using carbon pricing derived from the expanded EU emissions trading system, the CBAM would effectively tax carbon-intensive imports to the EU based on their greenhouse gas emissions while providing deductions for countries with a carbon pricing system in place. It is part of the commission’s Fit for 55 package to reduce greenhouse gas emissions by 55 percent from 1990 levels by 2030, which was announced July 14.

China has criticized the proposed CBAM for allegedly violating international trade rules, bringing climate issues into trade relations, and threatening China’s economic growth. In a July 26 press briefing, Liu Youbin, a spokesperson for the Chinese Ministry of Ecology and Environment, called the CBAM “a unilateral measure” to impose the climate change issue on the trade sector, according to media reports.

Russian Economic Development Minister Maxim Reshetnikov also took aim at the proposed CBAM during July 23 meetings with Peter Altmaier, Germany’s minister for economics and energy, and Frans Timmermans, European Commission executive vice president for the European Green Deal, during a G-20 ministerial event in Naples, Italy.

“It is clear that the [CBAM] will substantially alter, and in some cases even stop, traditional




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bilateral trade. We have already seen the effect on the global trading system from the imposition of U.S. duties on steel and aluminum,” Reshetnikov said, according to a July 24 release from Russia’s Ministry of Economic Development.

A CBAM could also increase the cost of raw materials, said Reshetnikov, which could cause issues for importers of materials covered under the mechanism, including Germany. He said some aspects of the European Green Deal “are already being assessed” as WTO-incompatible because they are protectionist, although he did not offer any examples.

The commission spokesperson said that “the CBAM will be applied in an even-handed manner in a way that does not constitute arbitrary or unjustifiable discrimination for third-country producers, or a disguised restriction to trade.”

GERMANY

Germany’s High Court Upholds Cum-Ex Convictions and Finesby William Hoke

Germany’s highest court has upheld the convictions of two British stockbrokers for their roles in cum-ex dividend trading, and a €176 million fine assessed to M.M. Warburg & Co. for its involvement in the schemes.

In a July 28 statement on its decision (1 StR 519/20), the Federal Court of Justice said it upheld a March 2020 ruling by the Bonn Regional Court. While the full names of defendants aren’t disclosed in German court cases, Hamburg-based M.M. Warburg said it was the financial institution involved in the proceedings.

The stockbrokers convicted in the case are former employees of UniCredit Bank AG, which is commonly known as HypoVereinsbank. The first man, who was convicted of tax evasion and abetting tax evasion, was sentenced to 22 months in prison and ordered to pay €14 million. The other stockbroker, who was convicted of aiding and abetting tax evasion, was sentenced to 12 months in prison. Both prison sentences were suspended.

A cum-ex trading scheme typically involves the cross-border sale or swap of shares around the time a dividend is to be paid out on the shares. A hedge fund, brokerage firm, or bank agrees to sell or lend the shares to a buyer in a second country immediately before the dividend payout. Depending on the timing of the sale or loan and the dividend payment, a party to the transaction will claim credit for taxes paid on the dividend even though no tax was withheld in that country on the dividend income.

The Federal Court of Justice said the case involved the failure to pay capital gains tax on cum-ex trades during the years 2007-2011. “As bankers, everyone involved knew that this tax was not withheld, either by the short sellers or otherwise,” the Court said. “Nevertheless, [the bank] issued tax certificates for submission to the tax authorities with which it incorrectly confirmed the alleged tax withholding.”

The lower court didn’t commit a legal error in ruling that the parties involved in the case




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“deliberately worked toward the payment of unpaid capital gains tax around the dividend cut-off date,” the Federal Court of Justice said, adding that its decision is final.

M.M. Warburg said July 28 that the decision will have no economic impact on it because it has settled all tax claims related to cum-ex trading that were asserted against it. The bank said it will review the ruling once the Court’s written decision is released.

On June 1 the Bonn Regional Court sentenced a former M.M. Warburg banker to five and a half years in prison for his role in a cum-ex dividend trading arrangement that allegedly cost the government €396 million.

HUNGARY

Hungary Flags Global Minimum Tax Base Plan Concernsby Stephanie Soong Johnston

Hungary can’t agree to a global corporate tax overhaul under development through the OECD framework until its concerns about minimum tax base calculations under pillar 2 of the plan are addressed, a government official said.

In a July 26 EU Observer op-ed, Norbert Izer, state secretary for tax affairs at the Hungarian Ministry of Finance, said Hungary was unable to sign on to the two-pillar tax reform plan because it “lacks guarantees on some critical questions.”

The plan, which follows up on action 1 of the OECD/G-20 base erosion and profit-shifting project, received the backing of nearly all 139 countries in the BEPS inclusive framework on July 1. However, Hungary was among a small group of countries that did not join the agreement. Three EU member states in the inclusive framework — Estonia, Hungary, and Ireland — have cited concerns about pillar 2.

Pillar 2 proposes ensuring that large multinational enterprises pay a minimum level of tax of at least 15 percent, relying primarily on a global anti-base-erosion (GLOBE) mechanism. The GLOBE mechanism contains the income inclusion rule and the undertaxed payments rule, which were inspired by the global intangible low-taxed income regime and the base erosion and antiabuse tax of the Tax Cuts and Jobs Act, respectively.

Pillar 1 of the plan calls for revamping profit allocation and nexus rules to allow countries a new taxing right over a portion of in-scope corporate residual profits tied to sales in their jurisdictions, regardless of an MNE’s physical presence. The new taxing right would initially apply to MNEs with global turnover exceeding €20 billion and profitability above 10 percent.

Although the inclusive framework intends to hammer out final details on both pillars by October and Hungary will continue participating in the project, it won’t formally join the agreement “until every detail is clear,” Izer wrote.

Hungary has specific concerns about the minimum tax base carveout for normal profits




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tied to substantial economic activity under pillar 2, according to Izer.

The inclusive framework’s July 1 statement indicated that the GLOBE rules would exclude at least 7.5 percent of the book value of tangible assets and payroll costs from the minimum tax base. That exemption would decrease to at least 5 percent after a five-year transition period.

“Taking into account that the average revenue of MNEs is significantly higher than the sum of tangible assets and payroll, ‘normal’ profits exempted under pillar 1 is on average three to four times higher than the profit carved out under pillar 2,” Izer wrote.

The inclusive framework is also considering delaying the application of the undertaxed payments rule, which would apply to the ultimate parent entity of an in-scope MNE. “Within the EU, any differentiation between the parent and the subsidiary would go against fundamental freedoms,” Izer wrote. “Consequently, the EU could only adopt the rules by covering parent entities from the beginning — a serious disadvantage for EU-based MNEs.”

Moreover, if the EU implements pillar 2 before the undertaxed payments rule takes effect worldwide, then EU member states would be left at a disadvantage compared with non-EU countries because they would not be able to provide tax incentives, Izer wrote.

Hungary is also concerned about whether pillar 2 rules would be flexible enough to account for the treatment of tax base differences among countries, Izer added.

“The minimum tax base will be established using accounting standards of the parent jurisdictions, which differ from those in the subsidiaries’ jurisdictions,” Izer wrote. “Many of the differences affect only the timing of the tax liability, which may lead to double taxation if not treated adequately.”

The Hungarian government is also concerned that there is no one global accounting standard to align global tax bases, which can lead to major distortions and the uncertain tax treatment of international investments, according to Izer. It is also unclear whether the pillar 2 plan will comprise a legacy plan for existing tax credits, such as the ones Hungary already offers, Izer added.

Although Izer listed several concerns about pillar 2, he did not explicitly mention Hungary’s 9 percent corporate tax rate.

“Finding adequate solutions to address these concerns is a prerequisite for Hungary to join the final agreement in October,” Izer wrote.




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INDIA

Indian Raids Uncover Alleged Tax Evasion On $94 Million of Incomeby Kiarra M. Strocko

Investigations into a large business group have unveiled unpaid taxes on business income of more than INR 7 billion (about $94 million) over the course of six years, according to India’s Income Tax Department.

The business group appears to be the Dainik Bhaskar Group, which recently reported being raided. In a July 24 release, the Income Tax Department said a search operation found that “a prominent business group” involved in the media, power, textiles, and real estate sectors was conducting business through various companies using the names of its employees. The department said the employees of the group, which has turnover of over INR 60 billion and 20 residential and 12 business premises in India, knowingly signed director and shareholder agreements but have admitted that they were unaware of the companies’ existence or any of their business activities.

According to the release, the companies were used for “booking bogus expenses and siphoning off the profits from listed companies, routing of funds so siphoned into their closely held companies to make investments, making of circular transactions, etc.” The investigations also revealed violations of Securities and Exchange Board of India’s rules, the department said.

The Dainik Bhaskar Group said in a July 22 release that the department searched the residences of many of its employees and that office employees had their mobile phones confiscated and were told they couldn’t leave the premises. The group said the searches were conducted at its offices in Delhi, Madhya Pradesh, Maharashtra, Gujarat, and Rajasthan.

The department said it carried out its searches under section 132 of the Income Tax Act, 1961, and confirmed that those searches were conducted on July 22. According to its release, the department is conducting further investigations to uncover “the entire money trail” and carrying out additional searches.

Indian TV channel Bharat Samachar also reported being investigated by the department. It

said July 22 that searches were carried out at the residence of its editor in chief, Brijesh Mishra, and the home of its state head, Virendra Singh.

Both news outlets were skeptical about the timing of the searches and claimed that the tax raids occurred because they have been criticizing the Indian government for its handling of the second wave of the COVID-19 pandemic. The companies said they have been keeping the public informed about the truth behind the government’s management during the pandemic.




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India’s Income Tax Department Ramps Up Anti-Evasion Effortsby Kiarra M. Strocko

The Indian government has filed over 107 prosecution complaints and raised INR 82 billion (about $1.1 billion) from assessment orders in its efforts to uncover undisclosed foreign assets.

In a July 26 release, the Ministry of Finance said that the government filed the complaints and issued assessment orders in 166 cases under the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015 (the Black Money Act).

The Black Money Act aims to curb tax avoidance and evasion by imposing taxes and penalties on undisclosed overseas assets and incomes of Indian residents earned after April 1, 2015. The act defines “undisclosed asset located outside India” as a foreign asset or financial interest in an entity that has an unexplained source of investment or an explanation that is “unsatisfactory” to an Income Tax Department assessing officer.

Union Minister of State for Finance Pankaj Chaudhary told the Lok Sabha, India’s lower house of Parliament, that the “Income Tax Department takes appropriate action under relevant laws against the tax evaders. Such action under direct tax laws includes searches, surveys, enquiries, assessment of income, levy of tax, interest, penalties, etc. and filing of prosecution complaints in criminal courts, wherever applicable,” according to the release.

The MOF said that as of May 31, the government had uncovered undisclosed income of approximately INR 84 billion resulting from investigations into HSBC Private Bank (Suisse) SA and levied penalties of approximately INR 12.9 billion in the HSBC cases. It noted that the government discovered undisclosed credits of approximately INR 200 billion based on information from the Panama Papers leak, with an additional INR 2.46 billion from the Paradise Papers leak.

The government also noted its discovery of undisclosed income of approximately INR 110 billion from cases revealed by the International Consortium of Investigative Journalists, which in late 2014 exposed confidential tax rulings issued

by Luxembourg to hundreds of private companies.

India has been taking steps to tackle its black money economy. In 2017 it introduced measures to discourage shell companies from engaging in money laundering and tax evasion, including the establishment of a task force to monitor and enforce disciplinary actions against individuals involved in evasion schemes. Shell companies have characteristics such as low turnover and operating income, nominal paid-up capital, no dividend income, and minimal fixed assets. According to the MOF, research conducted in 2017 found that of the estimated 1.5 million registered companies in India, only 600,000 file an annual tax return.

India’s Central Board of Direct Taxes launched an electronic portal in January that individuals can use to file complaints related to tax evasion and undisclosed foreign assets.




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IRELAND

Ireland Must Cut Capital Gains Tax Amid OECD Reforms, Group Saysby Stephanie Soong Johnston

The Irish government should slash the capital gains tax by 8 percentage points, considering the unavoidable changes to Ireland’s corporate tax rate under an OECD-led global tax reform plan, a small business lobby group said.

In a letter published July 26, Neil McDonnell, chief executive of the Irish SME Association (ISME), urged Irish Finance Minister Paschal Donohoe to join a two-pillar global tax reform plan that more than 130 countries backed politically on July 1.

A few countries, including Ireland, have refused to sign on to the plan, citing concerns about pillar 2. That part of the plan calls for a global minimum taxation system based on a tax rate of at least 15 percent.

The plan, which builds upon the work done on action 1 of the OECD base erosion and profit-shifting project, also contains pillar 1, a revamp of profit allocation and nexus rules to reflect an increasingly digital economy.

Although Ireland supports pillar 1 of the plan, Donohoe said he could not agree to pillar 2 because he was concerned about how the plan could affect the country’s 12.5 percent corporation tax rate. Talks are still ongoing among countries involved in the BEPS inclusive framework as they work to finalize the details of the agreement, including the exact minimum tax rate for pillar 2, by October.

The Department of Finance started consulting on the two-pillar plan on July 20, shortly after the Irish Examiner reported that Ireland expects to change its corporate tax rate.

Although Donohoe’s position on pillar 2 has been clear, “Ireland’s official stance for many years has been to fall into line with the OECD BEPS process,” McDonnell wrote. “Departure from that framework relatively late in the day, even though justifiable in principle, is problematic in practice.”

Ireland’s tax code should be reviewed ahead of the 2022 budget, McDonnell said. “In particular, we believe that the inevitable increase

in [corporation tax] to 15 percent should be accompanied by a revision of our [capital gains tax] rate,” he added.

Ireland’s capital gains tax is the fourth highest in the OECD at 33 percent, so the rate should drop to 25 percent, according to McDonnell. Doing so “would increase the rate of capital churn in the domestic economy and would generate a permanent uplift in yield,” the letter says.

McDonnell acknowledged concerns about lower capital gains tax rates on passive assets, including land, which could lead to smaller yields on disposal. As a result, ISME calls for imposing lower capital gains tax on investments in productive businesses and retaining the 33 percent rate for property.

“However, we also believe that a ‘standard’ rate of [capital gains tax] should be dynamic and encourage the investment in and retention of productive companies,” McDonnell wrote. If a taxpayer retains a productive company for longer than five years under a regime with a 25 percent capital gains tax rate, then the rate could decrease to 15 percent, he said. That rate could slip further still to 10 percent if retention exceeds 10 years, he added.

“This would incentivize the long-term development of strong Irish companies instead of the current trend where successful start-ups sell out at a relatively early state of maturity,” the letter says.

McDonnell also said it is pointless for the OECD to set a global minimum corporate tax rate without an agreement on acceptable deductions against it.

The publication of the ISME letter coincides with a July 26 op-ed from Norbert Izer, state secretary for tax affairs at the Hungarian Ministry of Finance. In the op-ed, Izer explained Hungary’s decision to hold off on joining the OECD agreement because of pillar 2 concerns.




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KOREA (R.O.K.)

South Korea Proposes Tax Breaks For Key Technologyby William Hoke

South Korea’s Ministry of Economy and Finance (MOEF) has proposed a series of stimulus measures that include additional tax credits for the purchase and development of high-technology products.

On July 26 the MOEF said its plans focus on promoting new industries and supporting recovery from the COVID-19 pandemic, pursuing inclusive growth by expanding tax support for low-income individuals and small enterprises, and broadening the tax base and making the tax system more convenient. If all the measures are enacted as proposed, the net cost to the government through 2026 would be around KRW 1.5 trillion (around $1.3 billion).

The MOEF proposed research and development tax incentives for investments in “national strategy” technologies, including batteries, semiconductors, and vaccines. The proposals include three years of additional tax support “of over 10 percentage points” for R&D investments and more than “3 to 4 percentage points” for investments in related facilities, according to the government’s announcement.

In May the government said it would provide tax incentives and other financial support to encourage the production of vehicle semiconductors, which are in short supply worldwide, and other strategic parts and materials.

The MOEF proposed tax breaks for purchases of intellectual property and an additional 3 percent deduction for purchases of equipment used in its development, but only to the extent that these equipment purchases exceed the buyer’s three-year average of such acquisitions.

According to a March 15 blog post by the law firm of Yulchon LLC, the law currently allows tax credits for qualifying R&D expenditures and a 50 percent corporate tax credit to small and medium-size enterprises for income resulting from transfers of patents and eligible technology. SMEs can also take a 10 percent tax credit on the purchase of qualifying technology, Yulchon said.

Income tax reductions for reshoring qualifying corporate activities would be extended under the proposals through the end of 2024 for businesses completing the relocation within two years, up from one year currently. The 100 percent tax reductions, which last for five years, would be reduced by half for the sixth and seventh years, the MOEF said.

Companies that move their headquarters outside the Seoul metropolitan area would have their corporate taxes cut by 100 percent for seven years and then by 50 percent for the following three years.

Tax deferrals would be allowed for capital gains invested in new industries, such as those that are carbon neutral, the MOEF said.

SMEs would be allowed to carry back and offset losses to the previous two years, up from one year currently.

The government also proposed increasing the tax cut for employee profit sharing from 10 percent to 15 percent through the end of 2024. Another measure would allow deductions for the cost of employee stock options.

On the compliance and enforcement side, the MOEF proposed increasing the tax rates for controlled foreign corporations. Business transactions carried out through liaison offices would also have to be reported under the proposals.

The MOEF also said it will ask the legislature to require reporting of the ownership, acquisition, and sale of foreign property. Another proposal would allow the National Tax Service to seize cryptocurrencies held by delinquent taxpayers.

Taxpayer-friendly proposals in the package include exemption from the late-payment penalty for tax liabilities below KRW 1.5 million and a reduction in the penalty rate to take into consideration market interest rates.

The MOEF said it will submit the proposals to the National Assembly before September 3.




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MULTINATIONAL

Latest Corporate Data Show Need For Global Tax Deal, OECD Saysby Stephanie Soong Johnston

New data collected by the OECD indicate ongoing profit shifting and declining statutory corporate tax rates, highlighting the need for countries to finalize and implement a two-pillar global tax reform plan, an OECD report says.

The third edition of the OECD’s Corporate Tax Statistics database report, published July 29, continued to show a dip in statutory tax rates among the majority of 111 jurisdictions surveyed. It also analyzed more aggregated, anonymized country-by-country data collected under action 13 of the OECD base erosion and profit-shifting project. The OECD started publishing CbC data in July 2020.

Among the jurisdictions covered, 94 reported lower corporate income tax rates in 2021 than in 2020, 13 maintained the same rate, and four had higher rates. The average statutory tax rate across all covered jurisdictions was 20 percent in 2021, slightly below 20.2 percent in 2020 and significantly down from 28.3 percent in 2000, the report notes.

Eighteen of those jurisdictions had corporate tax rates of 30 percent or higher in 2021, while 12 jurisdictions either lacked a corporate tax regime or had a corporate tax rate of zero in 2021.

The report also comprises aggregated and anonymized CbC reporting data from 2017, drawn from CbC reports filed in 38 jurisdictions that cover nearly 6,000 multinational enterprise groups.

Under action 13, one of the four minimum standards that members of the BEPS inclusive framework must implement, jurisdictions must require CbC reporting by the ultimate parent entity of MNEs with at least €750 million in consolidated annual revenue.

The action 13 report’s CbC reporting template requires a jurisdiction-by-jurisdiction breakdown of economic activity indicators, including unrelated- and related-party revenue, pretax profit, income tax paid and accrued, and number of employees. The collection of aggregated and anonymized CbC data is part of action 11 of the

BEPS project, which focused on measuring the scale and effect of BEPS. The data have several limitations, set out in a disclaimer. Some MNEs may have included intracompany dividends when reporting profit numbers, “possibly introducing a downward bias when calculating effective tax rates,” according to an OECD frequently asked questions document.

The CbC reporting data only cover 2016 and 2017, before many parts of the BEPS project and the U.S. Tax Cuts and Jobs Act were implemented. As a result, the CbC data provide a snapshot of the years at issue, rather than a full picture, but some initial observations can be made, according to the report.

“There is evidence of misalignment between the location where profits are reported and the location where economic activities occur,” the report says. MNEs on average had a higher share of profits (about 26 percent) in investment hubs compared with the share of employees (3 percent) and tangible assets (14 percent), the report found. Investment hubs are defined as jurisdictions attracting inbound foreign direct investment exceeding 150 percent of GDP.

The analysis also suggests that revenue per employee was higher in jurisdictions with a statutory corporate income tax rate of zero and in investment hubs, compared with other jurisdictions. Moreover, the average share of MNE related-party revenues among total revenues appears to be greater in investment hubs, the report says.

The analysis also indicates that the top MNE business activity in investment hubs was holding equity instruments, such as shares. Meanwhile, sales, manufacturing, and services dominated MNE activity in other jurisdictions, according to the report. A concentration of holding companies could be evidence that an MNE is using tax-planning structures, it adds.

“Evidence of continuing BEPS behaviors as well as the persistent downward trend in statutory corporate tax rates reinforce the need to finalize agreement and begin implementation of the two-pillar approach to international tax reform,” the OECD said in a release.

The inclusive framework is working to finalize a two-pillar global tax reform package by




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October after the majority of its members reached political agreement on the plan July 1.

Pillar 1 would change profit allocation and nexus rules to give market jurisdictions a new taxing right over residual profits that multinationals earn in those jurisdictions, regardless of physical presence. Pillar 2 would ensure large MNEs pay a minimum level of tax based on a global minimum tax rate of at least 15 percent, although countries must still decide on an exact rate.

The report also notes that the corporate tax statistics database now comprises new indicators related to the use of research and development tax incentives. The indicators, together with a July 29 working paper, show that those incentives cut the effective tax rate on R&D investments by about 10 percentage points compared with non-R&D investments across the OECD countries offering such breaks.

Corrective Action

Thirty-eight inclusive framework members submitted aggregated and anonymized CbC reporting data to the OECD for the 2021 report, up from 26 in the previous year.

The United Kingdom opposed including the data it had collected in the OECD’s 2020 report, citing data quality and consistency issues.

The U.K. government had concerns about data distortions related to intragroup dividends receivable because some MNEs were including those figures in their CbC reporting profits, while others weren’t. Such inconsistencies could artificially lower effective tax rates when MNEs calculate profit or loss before income tax, according to the FAQ.

In response to concerns that MNEs were taking an inconsistent approach on including intracompany dividends they have received in their CbC reports, the inclusive framework released further interpretive guidance in late 2019. That guidance had clarified that MNEs should exclude intragroup dividends receivable from profits in their CbC reports.

For the 2021 report, the U.K. government approved inclusion of 2017 data but carried out its own analysis of the data. HM Revenue & Customs had received 394 CbC reports from U.K. ultimate parent entities in 2017 that represented about £110

billion in profit, but those reports weren’t adjusted to leave out intragroup dividends receivable, according to U.K. analysis.

About 25 percent of U.K.-headquartered MNEs included those dividends in their CbC report profits, “resulting in a substantial inflation of U.K. reported profit,” the analysis adds. Approximately £55 billion in dividends was extracted from HMRC’s analysis.

The United Kingdom noted that the 2019 guidance “will not filter through into the reports HMRC and other tax authorities receive until 2020.”

Ireland, Italy, the Netherlands, and Sweden also conducted their own analyses.




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Most Favored Nation Clauses Problematic for Developing Countriesby Sarah Paez

A common clause in tax treaties may disadvantage source countries, which are mostly developing countries, and circumvent the clause’s original intent, according to a paper from South Centre, an intergovernmental organization of developing nations.

Most favored nation (MFN) clauses are starting to cause negative consequences for source countries because of “the interpretative issues related to these provisions in the tax treaties,” says Deepak Kapoor of the Indian Revenue Service in a July 23 paper.

Under the MFN principle, favorable treatment provided to one party on a given subject laid out in an agreement must be extended to all other parties to the agreement equally regarding that subject, the paper says.

“The MFN principle ensures that a treaty partner under one agreement is not subjected to a treatment which is less favorable than treatment provided to other treaty partners under similar agreements. Thus, MFN clauses are generally intended to bring parity, nondiscrimination, and a level playing field among treaty partners. However, the actual benefits of the MFN clause are also dependent on . . . whether the agreement is between two equal income level countries or otherwise,” writes Kapoor.

Although MFN clauses in tax treaties were engineered to encourage nondiscriminatory policy between treaty partners, their usage has “started to trigger their unexpected negative spill over effects exposing the source jurisdiction to risk of reduced taxation and erosion of their tax bases,” according to Kapoor.

Kapoor referenced recent court decisions that have made tax treaties between developing countries and other countries vulnerable, such as the April 22 decision in Concentrix Services Netherlands BV v. Income Tax Officer, in which the High Court of Delhi found that Indian tax officials incorrectly required two resident companies to impose a 10 percent withholding tax on dividends paid to their Dutch shareholders. The court also held that the MFN clause only applies if, after the signing of the India-Netherlands tax treaty, India

enters into a treaty with another OECD member state, regardless of whether it was an OECD member when the relevant treaty was reached with the source state.

As a result, source country policymakers should “undertake a comprehensive impact assessment of existing MFN clauses in view of such kind of interpretations which are unfolding potential dangers for the tax base of source countries,” Kapoor wrote. He added that policymakers should review MFN clauses for formulation and relevance to prevent them from being liberally interpreted.

MFN clauses in tax treaties between two equally developed countries generally don’t create outsized risk, Kapoor said. However, there are risks for source countries when one party to a treaty is developed and the other is developing as a consequence of one trading partner receiving more investments from the other than it makes, he wrote.

Fallout for India from the Concentrix decision — that the third country in a tax treaty need not be an OECD member on the date of the signature of the treaty — may lead to instances in which treaty partners with higher dividend tax rates try to slash their rates by transferring lower tax rates from countries that were not part of the OECD when they signed tax treaties with India, Kapoor said. India’s tax treaties with Colombia, Lithuania, and Slovenia pose this type of threat, according to Kapoor.

The multilateral instrument — developed under action 15 of the OECD’s base erosion and profit-shifting project — does not have a direct effect on MFN clauses since they are not stand-alone treaty articles, according to the paper. However, some types of income covered under MFN clauses may be affected by the MLI if the country chooses to adopt those provisions, the paper says. The MLI also provides new anti-treaty-abuse standards via a new preamble and principle purpose test. However, the MLI only has an impact if a country has signed it and notified its treaty partner, the paper notes.

Kapoor recommends in the paper’s conclusion that developing countries terminate their MFN clauses to avoid legal interpretations like those in the Concentrix case.




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OECD’s New Round of Action 14 Peer Reviews Reports Mixed Progressby Ryan Finley

The OECD has found that India, South Africa, and six other countries still do not fully comply with the minimum standards on dispute resolution set by action 14 of the base erosion and profit-shifting project.

In its latest round of stage 2 peer reviews, the OECD has reported that six of the eight countries reviewed — Argentina, Chile, Colombia, Croatia, India, Latvia, Lithuania, and South Africa — have made progress on issues identified during stage 1. However, neither Argentina nor Croatia has resolved any of the shortcomings noted during the stage 1 review, and the remaining countries still fall short of action 14’s minimum standards, according to the reports.

One of the biggest areas of noncompliance concerns the provisions of each country’s bilateral tax treaties on mutual agreement procedures and transfer pricing. Each of the eight countries has some bilateral tax treaties that do not comply with the action 14 minimum standard, according to the reports. All countries reviewed except Latvia have treaties that do not stipulate that the MAP resolutions will be implemented irrespective of time limits imposed by domestic law, and every country besides Lithuania has treaties that do not provide for consultation to eliminate double taxation in cases not provided for in the treaty, the reports say.

The rates of noncompliant treaties are particularly high for Chile, for which 85 percent of treaties lack the required time limit provision and 90 percent have no provision on cases of double taxation not provided for in the treaty. However, Chile intends to make the required revisions and has begun some of the bilateral negotiations necessary for treaties that will not be amended by the multilateral instrument, the report on Chile says.

Four of the eight countries reviewed failed to meet the action 14 minimum standard regarding the prevention of disputes, according to the reports. Chile, Colombia, Croatia, and Lithuania have bilateral advance pricing agreement programs in place but do not allow for the rollback of bilateral APAs as required under

action 14, the reports say. Of the countries reviewed, only India and Latvia have bilateral APA programs that allow rollbacks. Argentina and South Africa do not have bilateral APA programs and therefore received no rating on this measure, the reports say.

Although Chile and Colombia appear to provide adequate resources to their MAP programs, the other countries reviewed may need to devote additional resources, according to the reports. This is the case even in Argentina, whose average MAP case resolution time of 13.44 months falls well below the 24-month OECD target, according to the report on Argentina. “MAP inventory as on 31 December 2019 increased substantially as compared to 1 January 2016. Therefore, additional resources are necessary to cope with the increase in the number of MAP cases, such to be able to resolve them in a timely, efficient, and effective manner,” the report says.

Citing peer input, the report on South Africa says that more resources may be necessary to prevent delays in receiving position papers from the South African competent authority. The report on India cites the country’s large and growing caseload as evidence that further resources are required.

“While India has taken several steps to resolve cases in a timely manner, these statistics indicate that India’s competent authority does not have adequate resources to conduct the MAP function and that additional resources are necessary to ensure a timely resolution of both type[s] of MAP cases and also to cope with the increase in the number of MAP cases,” the report on India says. “Such addition of resources should enable India to timely submit position papers to treaty partners as well as to more frequently communicate with the other competent authorities concerned on the status of the case and discuss the impact of domestic court procedures on the MAP case, in particular when such procedures would lead to a closure of the MAP case.”

The reports also fault Colombia for not seeking to resolve MAP cases when the taxpayer does not withdraw domestic remedies within 15 days of the competent authority’s acceptance of a case and Croatia for failing to offer clear guidance




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and procedures. “Croatia’s position on including MAP arbitration, as set forth in its MAP profile, is not clear and deviates from its practice, which is to include an arbitration provision in its tax treaties,” the report on Croatia says. “Croatia has not yet [put] in place a documented bilateral notification process for those situations in which its competent authority considers the objection raised by taxpayers in a MAP request as not justified.”

Google Confirms New Fees Linked To Indian, Italian Digital Taxesby Stephanie Soong Johnston

Google and YouTube clients showing ads in India and Italy will soon see new regulatory operating costs tacked onto their invoices in response to the digital taxes in those jurisdictions.

In a July 27 email, Google told customers that as of October 1 they would have to pay surcharges for ads they buy through Google Ads and for YouTube ad placements purchased on a reservation basis if those ads are served in Austria, France, India, Italy, Spain, Turkey, and the United Kingdom. The surcharges were added to cover part of the costs that Google must pay to comply with the digital services taxes in those countries.

Google previously confirmed that clients would see extra surcharges in France and Spain starting in May 2020 and in Austria, the United Kingdom, and Turkey starting in November 2020.

A Google spokesperson verified the content of the email to Tax Notes and confirmed that the fees for ads served in India and Italy were new and would start October 1. Google customers will have to pay a 2 percent regulatory operating cost for ads served in India if their billing address is not in India, according to the Google Ads help page.

India has a regime that comprises a 6 percent equalization levy on gross payments to nonresident businesses for online advertising services and a 2 percent equalization levy on the revenues that nonresident e-commerce operators earn from sales of goods and services to Indian consumers. The former took effect in June 2016, while the latter started in April 2020.

Advertisers will also have to pay a 2 percent regulatory operating cost for ads served in Italy, regardless of billing address. Italy’s 3 percent DST has been in force since January 2020. It applies to companies with annual global revenue of at least €750 million and annual Italian revenue of at least €5.5 million that offer online advertising, provide intermediary platforms, and transmit user data from digital interface activities.

Google calculates surcharges based on the number of ad clicks or ad impressions in affected jurisdictions, according to the help page.




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The Google fee announcement comes shortly after Amazon notified advertisers that it would include new fees on their invoices for ads served in Austria, France, Italy, Spain, Turkey, and the United Kingdom. Apple has announced similar fees in response to DSTs.

DSTs have become hot-button issues over the past few years. The United States, which views DSTs as discriminatory against American companies, has threatened retaliatory tariffs against several countries, including the seven countries singled out by Google. In March, the Office of the U.S. Trade Representative proposed imposing retaliatory 25 percent tariffs on imports from Austria, India, Italy, Spain, Turkey, and the United Kingdom. However, in June the tariffs were suspended for up to 180 days to give more time for countries to conclude multilateral negotiations on a global tax reform agreement.

More than 130 countries involved in OECD-led tax reform negotiations backed a two-pillar global corporate tax system overhaul on July 1 and are aiming to finalize details and an implementation plan by October. Part of the plan will require countries with DSTs and other relevant similar measures to withdraw them and refrain from introducing new measures in the future, but it remains to be seen how countries will coordinate on the issue.

SINGAPORE

Wealth Tax Could Lower Inequality, Singapore Monetary Head Saysby William Hoke

The head of Singapore’s central bank said the implementation of a property gains or inheritance tax could make the city-state more inclusive.

“To promote an inclusive society, it might make sense to shift the balance in our tax structure away from taxing income toward taxing wealth,” Ravi Menon, managing director of the Monetary Authority of Singapore, said in a July 22 lecture at the Institute of Policy Studies.

Menon said Singapore’s Gini coefficient, a calculation used by economists and development agencies to measure income equality, is relatively high at 0.46. A Gini coefficient of zero represents perfect equality, whereas 1 implies perfect inequality, meaning that one person earns all of a country’s income. Menon said the Nordic countries have a Gini coefficient of 0.27, while the United Kingdom, China, and the United States have coefficients of 0.35, 0.39, and 0.41, respectively.

New York, Paris, and Hong Kong have coefficients between 0.51 and 0.54, Menon said. “This is not surprising because cities tend to have higher Gini coefficients and we are a global city,” he said. “But unlike these cities, Singapore is also a country, and a country cannot afford to have such high inequality.”

Menon acknowledged that taxing wealth hasn’t worked well for many countries. “In 1990, 12 European countries levied an annual tax on net wealth,” he said. “By 2018, eight out of the 12 countries had abandoned the wealth tax, citing high administrative costs, risk of capital flight, and, ironically, the failure to meet redistributive goals. This is not necessarily a reason for not imposing a wealth tax, but it is a strong caution that designing a good wealth tax is not a trivial exercise.”

Singapore’s social inclusion agenda must be centered on jobs and wages, Menon said. “Redistribution through taxes and transfers also has an important role in fostering inclusion but [is] secondary to a labor-market-centered model of inclusion,” he said.




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SWITZERLAND

Swiss Close Probe Into Alleged Russian Money Launderingby William Hoke

Swiss prosecutors have closed a money laundering investigation following an alleged $230 million tax fraud in Russia and determined that a U.K.-based fund company should not have been recognized as a complainant in the case.

On July 27 the Swiss Office of the Attorney General (OAG) said its investigation had not turned up evidence that would justify indicting anyone for the alleged crime. “Nevertheless, in view of the fact that a link has been established between some of the assets under seizure in Switzerland and the predicate offence committed in Russia, the OAG has ordered the forfeiture of assets and recognized a compensatory claim in favor of the Confederation” of more than CHF 4 million (around $4.4 million), it said. The prosecutor’s office had said in November 2020 that it intended to end the investigation.

The investigation was started after a complaint was filed by Hermitage Capital, a London-based fund company that invested heavily in privatized Russian companies after the breakup of the Soviet Union. Hermitage liquidated its assets in 2006 after being warned that it was being targeted by politically connected individuals. In 2007 its offices in Russia were raided and official records and corporate seals seized. Soon after, the companies were re-registered under the names of new and unknown owners, with documents backdated to indicate that the fund had liabilities of $973 million. That was almost exactly the amount of taxable income reported by Hermitage companies for 2006, and on which they had paid $230 million in Russian taxes. The new owners successfully claimed a refund of that amount in late 2007.

Bill Browder, Hermitage’s founder, hired Russian lawyer Sergei Magnitsky to determine what had happened. After Magnitsky publicly reported his findings, he was jailed for almost a year, during which time he was allegedly denied medical treatment. Magnitsky died in prison in 2009. Browder has successfully campaigned for several Western countries to sanction the

individuals allegedly involved in the fraud and in Magnitsky’s subsequent incarceration and death. In 2013 Russia charged Magnitsky, posthumously, and Browder, in absentia, with tax fraud. Both were found guilty. Hermitage alleged that some of the funds from the fraud ended up in Switzerland.

Although the OAG had recognized Hermitage as a complainant in 2011, it said on July 27 that “other parties” had objected to that decision. The OAG “concluded that despite extensive enquiries, it had not been possible to demonstrate that the funds under investigation in Switzerland originated from an offence committed to Hermitage’s detriment,” it said. “The OAG has therefore decided to revoke Hermitage’s status as a complainant.”

On July 27 Browder tweeted his disappointment with the prosecutor’s decision. “Swiss prosecutors drop Russian money laundering inquiry in Magnitsky case,” he said. “This happened after one of their key officials was caught taking bribes from the Russians to do just this. A very dark stain on Switzerland.”

Browder was apparently referring to an unidentified investigator in the Magnitsky probe who was reportedly convicted in 2019 for accepting gifts from his Russian counterparts.

Parties objecting to the decision have 10 days to appeal, the OAG said.




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UNITED KINGDOM

HMRC May Challenge Compound Interest Claims, U.K. Court Findsby Kiarra M. Strocko

HM Revenue & Customs may challenge compound interest claims and use its methods for calculating interest in a long-standing dispute about the United Kingdom’s former regime for taxing foreign dividends, the U.K. Supreme Court has held.

In its July 23 decision in Test Claimants in the Franked Investment Income Group Litigation v. HM Revenue & Customs, the Supreme Court unanimously allowed HMRC’s appeal related to HMRC’s ability to refute the claimant’s entitlement to compound interest, saying that HMRC’s challenge “does not amount to an abuse of process.” The Supreme Court noted the complex nature of the case and its “evolving legal backdrop,” highlighting that it is “unsurprising that questions of central importance have only recently or are yet to be decided.”

The Court also agreed with HMRC’s claim that the interest for the corporation tax owed should be calculated on a simple interest basis under section 85 of the Finance Act 2019, instead of on a simple interest basis under section 35A of the Senior Courts Act 1981. The Court said section 85, which has a six-year limitations period, is the appropriate statutory basis for interest during the period when advance tax is paid.

The complex group litigation, which dates back to 2003, involves several companies within the Franked Investment Income Group, including U.K.-resident companies and nonresident subsidiaries. The claimants challenged HMRC’s unequal tax treatment of foreign dividends under corporation tax rules in place at the time, including the advance corporation tax regime, which was abolished in 1999. They are suing HMRC to recoup the corporation tax they wrongly paid, plus interest, under repealed provisions of the Income and Corporation Taxes Act 1988. The tax paid dates back to 1973, when the United Kingdom joined the EU.

The claimants argued that the differences in the tax treatment of wholly U.K.-resident groups of companies violated EU principles of freedom of

establishment and free movement of capital. The claimants appealed the November 2016 decision ([2016] EWCA Civ 1180) of the Court of Appeal (Civil Division) and its February 2010 decision ([2010] EWCA Civ 103). Article 63(1) of the Treaty on the Functioning of the European Union prohibits all restrictions on the movement of capital between member states. The decision noted that article 63 of the TFEU is subject to the “standstill provision” in article 64(1), which provides for an exception to prohibiting restrictions on the movement of capital for any restrictions that existed on December 31, 1993.

Although the Supreme Court allowed part of HMRC’s appeal, it found in favor of the claimants regarding their argument that the inability to carry forward unused double taxation relief violated EU law. The Court said that preventing the claimants from reducing or eliminating their tax liability would give rise to “indirect economic double taxation” and a difference in tax treatment that violates EU law, according to a press summary of the decision.

The Supreme Court also sided with the claimants regarding double taxation treaty credits received by the U.K. group’s U.S.-based parent company, Ford Motor Co. The Court said HMRC was obligated to pay the tax credit to Ford Motor Co., regardless of the U.K.-based group company’s liability to pay advance corporation tax. Therefore, HMRC may not deduct the tax credit paid to Ford Motor Co. from the corporation tax owed to the other claimants.

Regarding the claimants’ argument that the adoption of eligible unrelieved foreign tax rules in 2001 restricted the EU’s principle of the free movement of capital, the Court sided with the claimants and said that those rules do not apply to the standstill provision in article 64 of the TFEU because they “altered the tax regime” for foreign dividends, the summary says.

The appellants in Test Claimants in the Franked Investment Income Group Litigation v. HMRC, [2021] UKSC 31, were represented by Graham Aaronson and Jonathan Bremner, instructed by Joseph Hage Aaronson LLP, and HMRC was represented by David Ewart, Jennifer MacLeod, Elizabeth Wilson, Barbara Belgrano, and Frederick Wilmot-Smith.




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U.K. Tax Bodies Urge Caution On Tax Payments Reformby Andrew Goodall

Some U.K. taxpayers may benefit from a system of “more timely payments,” but “a great many” could be adversely affected by it, according to the Chartered Institute of Taxation.

Tax is calculated on total annual income, profits, or gains, which can only be worked out after the end of the tax year in most cases, the CIOT noted in a July 27 response to a March 23 consultation published by HM Revenue & Customs.

“At the moment calculations based on an up-to-date view of the in-year tax position seem highly aspirational. This is because the U.K.’s tax system does not work in real time, it works in arrears,” the CIOT said, adding that more should be done “to educate taxpayers around the need to put money aside” for tax liabilities.

The CIOT said responding to HMRC’s call for evidence had been challenging because “several significant changes” to the tax system may take effect in the next two years. HMRC had requested feedback by July 13.

“At the heart of the government’s vision is a tax system that works closer to real time, allowing people and businesses to pay the right tax with ease as they live their lives and go about their business,” Financial Secretary to the Treasury Jesse Norman said in a foreword to the consultation document.

“The delays that are at present inherent in the U.K. tax system can make it hard for people to manage their cash flow, particularly for the newly self-employed, whose first tax bill could be up to 22 months after they start trading,” Norman said. “They can thus lead to taxpayers getting into debt, which causes stress and difficulties for them, creates additional cost for [HMRC] to manage, and contributes to the nonpayment tax gap, taking away revenues needed to support public services.” Any reform would be “gradual, structured over the longer term, and carried out in close collaboration with stakeholders,” he added.

The implementation of the Making Tax Digital (MTD) regime for income tax “presents the possibility of using MTD quarterly update information to inform more regular calculation

and payment of income tax in the future,” HMRC said, adding that “no decisions have been made” on changes to the timing of payments.

MTD “would enable tax payments to better track income, increasing or decreasing when income rises or falls, making it easier for some taxpayers to manage their cash flow and reduce the likelihood that tax bills for a period of higher earnings will arise when funds are limited,” HMRC added.

“In our view, if payment of tax is to be based more in real time, then there needs to be a fundamentally different basis of determining tax liabilities in real time,” the CIOT said. “We do not have any objections to a regime of more frequent payments based on a taxpayer’s tax liability for a previous year that is known, effectively accelerating or spreading the current payments on account that are made under income tax self-assessment. More payments on account based on a previous year’s liabilities seems to be the most straightforward way of increasing the frequency of tax payments and present the fewest complications.”

Any decisions about timely payment should be made only after other proposed changes, including MTD and basis period reform, have been implemented and “given time to settle down,” the CIOT argued. In the meantime, further work should be done to understand the drivers of tax debt and to promote the benefits of HMRC’s budget payment plan, it said.

“We are not in any case clear that timely payments would make life easier for taxpayers who are disposed to struggle with their tax affairs,” the CIOT said. Timely payments involving calculations based on in-year information “do not seem to us to be particularly simple,” and the proposals would likely require more frequent engagement by the taxpayer, “albeit possibly with an app rather than directly with HMRC,” it added.

The Institute of Chartered Accountants in England and Wales said the consultation was premature and argued that “priority should be given to other pillars” of the tax administration framework review. Earlier payments of tax should not be based on in-year estimates “without HMRC first demonstrating that they can be a reliable basis for earlier payment,” it said.




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“Earlier payment of income and corporation tax should not be considered until the economy has recovered from the impact of the pandemic; the reassurance that no changes will be made during the current parliament does not allay concerns,” the institute said in a July 13 submission.

The Association of Taxation Technicians recognized that “there may be benefits” to the Exchequer and some taxpayers from bringing tax payments closer to real time, but it argued that the benefits could be outweighed by “practical and cash flow problems.”

Overpayments of tax caused by inaccurate in-year calculations could cause “significant and unnecessary cash flow difficulties,” the Low Incomes Tax Reform Group said.

“Even with reform, it is likely that quarterly information submitted for tax purposes will differ significantly from the figures on which the final liability to tax will be based. There is the need for a system of estimated payments during the period, with a balancing reconciliation as soon as possible after the period end,” the Institute of Chartered Accountants of Scotland said in its response. “A system of estimated payments on account, found in many countries, and followed by year-end reconciliation within pre-determined margins, has much to commend it.”

U.K. Government Urged to Simplify Brexit Support for SMEsby Andrew Goodall

A U.K. government support scheme for small and medium-size enterprises adjusting to new customs and VAT rules was “more of an obstacle course,” according to Hilary Benn, co-chair of the UK Trade and Business Commission.

The government made £20 million available through the SME Brexit Support Fund, which was launched in February and closed to new applicants on June 30. There are no plans to extend the scheme, a government spokesperson told Tax Notes on July 28.

The scheme discouraged applications by “making SMEs jump through too many hoops for a very small return,” Benn, a Labour member of Parliament, said in a July 28 release. The government has paid out “just a third of the money set aside to help businesses cope with the increased bureaucracy and costs resulting from the U.K.’s withdrawal from the European Union,” the commission said, adding that it has called for the fund “to be expanded.”

“We have heard first-hand testimony from businesses continuing to face serious hardships since leaving the EU. If the government really wants to support them, they must hold another round of bidding with a simplified application process and more substantial grants,” Benn said.

“HM Revenue & Customs and PwC have worked extensively to encourage SMEs to complete applications, including by working with representative bodies such as the Federation of Small Businesses and the British Chambers of Commerce to advertise the fund with their members,” the government spokesperson said. “For those who applied but were not eligible, we are continuing to provide support through regular communication, webinars, and guidance on GOV.UK.”

Training and Professional Advice

The Cabinet Office said in a February 11 release that SMEs that trade only with the EU and were therefore new to importing and exporting processes would be “encouraged to apply for grants of up to £2,000 for each trader to pay for practical support including training and




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professional advice to ensure they can continue trading effectively with the EU.”

“You can use the grant for training on how to complete customs declarations; how to manage customs processes and use customs software and systems; [and] specific import and export related aspects including VAT, excise, and rules of origin. It can be used to help you get professional advice so your business can meet its customs, excise, import VAT, or safety and security declaration requirements,” HMRC said in guidance that was withdrawn on July 12.

In a House of Commons written answer on July 22, Financial Secretary to the Treasury Jesse Norman said 5,414 businesses had completed applications and 4,376 had been offered a grant. The total value of grants offered was just over £6.8 million, giving an average payment of £1,554. No extension to the June 30 deadline for applications was planned, Norman had said in a written answer on June 22.

The Financial Times quoted Craig Beaumont, chief of external affairs at the Federation of Small Businesses, as saying that small firms struggled to apply “because it was not a small business friendly, easy-to-use website — it was instead a repurposed customs intermediaries application which was confusing to navigate without knowledge.”

The fund is administered by PwC through a preexisting customs grant scheme, and applications are still being processed. A webpage setting out the conditions for eligibility says the business “must be in good standing” with HMRC.

“A business is deemed to not be in good standing where our records show applicants (including directors/owners/senior staff) have not complied with HMRC requirements. HMRC will make a proportionate decision on whether an applicant will be disqualified from applying on these grounds,” the guidance said.

HMRC Clears Liquor Giant of £277 Million Bill From State Aid Caseby Sarah Paez

British liquor company Diageo PLC will not be assessed £277 million in taxes related to a 2019 EU state aid case after an HM Revenue & Customs review determined the company was not a beneficiary of state aid.

In July 2019 Diageo and other U.K.-based multinational companies appealed a European Commission decision that the U.K. controlled foreign company rules’ group financing exemption constitutes state aid. The commission had argued that tax exemptions for interest income paid on non-U.K.-funded intragroup debt to a CFC between 2013 and 2018 gave an unjustified advantage to corporate taxpayers in some circumstances.

According to a July 29 company filing, HMRC found in a February 2021 review of the facts specific to Diageo that the company was not a beneficiary of state aid and no assessment would be issued. The United Kingdom officially left the EU on January 31, 2020, but participated in the EU customs union and single market during a transition period that ended December 31, 2020.

Diageo had expected to make a payment to the U.K. government as a result of the commission’s 2019 decision and estimated its liability at £277 million if the decision were upheld by the General Court of the European Union.

The company has several ongoing tax cases in Brazil and India, and it estimates potential liabilities of as much as £449 million in Brazil and £140 million in India.

“The group believes that the likelihood that the tax authorities will ultimately prevail is lower than probable but higher than remote,” says the company filing. “Due to the fiscal environment in Brazil and in India, the possibility of further tax assessments related to the same matters cannot be ruled out.”

Diageo has paid Indian revenue authorities £106 million in corporate tax and indirect tax under protest to challenge tax assessments from the periods of April 1, 2006, to March 31, 2017, according to the filing.




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Diageo also reported receiving $129 million from the February 2020 judgment in an April 2019 lawsuit filed against the U.S. Treasury Department and Customs and Border Protection by the National Association of Manufacturers on behalf of industry members, including Diageo North America, that were affected by February 2019 regulations that did not permit substitution drawback for some merchandise. According to the filing, Diageo estimates an additional $12 million in outstanding eligible claims from this judgment, although the case is pending appeal in the Federal Circuit.

Fewer Than 2 Million People Remain On HMRC’s Furlough Schemeby Andrew Goodall

Almost 3 million people have moved off the United Kingdom’s coronavirus job retention scheme (CJRS) since March and fewer than 2 million people remain on furlough, HM Treasury said.

While new data show that more than half a million people left the furlough scheme in June alone, surveys conducted by the Office for National Statistics show that numbers may have fallen even further, Treasury added in a July 29 release.

HM Revenue & Customs introduced the CJRS and the self-employment income support scheme (SEISS) in March 2020 as part of a package to protect jobs and businesses dealing with the economic impact of COVID-19.

“It’s fantastic to see businesses across the U.K. open, employees returning to work, and the numbers of furloughed jobs falling to their lowest levels since the scheme began,” Chancellor of the Exchequer Rishi Sunak said.

Treasury said the CJRS figures published by HMRC, which cover claims submitted by employers up to June 30, show “a striking fall” in the number of young people on furlough. The takeup rates for the youngest age bands decreased dramatically in June and are now in line with the other age bands, and the reduction is “in line with the easing of restrictions across the U.K., particularly in hospitality,” HMRC said.

“Jobs in sectors including hospitality and retail are now also moving off the scheme the fastest — with more than a million coming off the scheme in the last three months,” Treasury said. The scheme is set to end September 30.

HMRC said there were 540,000 employers with 1.9 million staff on furlough on June 30. Since the start of the CJRS in March 2020, a total of 11.6 million jobs have been put on furlough for “at least part of the duration” of the scheme.

HMRC guidance updated on July 15 noted that the government committed to pay 70 percent of a furloughed employee’s wages from July 1, and 60 percent from August 1. The government’s contributions are subject to a cap that is proportional to the hours not worked. For each




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month, employers are required to “top up employees’ wages to make sure they receive 80 percent of their wages (up to £2,500) for the hours they are on furlough,” HMRC said.

BBC News quoted Tom Waters, senior research economist at the Institute for Fiscal Studies, as saying that there was no way to know exactly how many jobs would have been lost, and for how long, if the furlough scheme had not been introduced. “But given that unemployment has only risen slightly since the start of the pandemic, despite the biggest fall in GDP ever recorded, I think it’s fair to say that furlough has had a very significant impact on job retention,” Waters said.

“The number of furloughed employees has fallen below two million for the first time as the economy continues to reopen. But that is higher than many expected, and a cause for concern as the scheme is wound down,” Charlie McCurdy, economist at the Resolution Foundation, said in a release. “With employer contributions to furloughed staff doubling from this Sunday, and the scheme ending completely in just two months’ time, it’s vital that as many furloughed staff as possible return to work soon, in order to limit the rise in unemployment this autumn.”

HMRC’s figures show how “some sectors are still struggling to reopen, with around half of all staff in air passenger transport and travel agencies still on furlough,” the Resolution Foundation noted.

SEISS

The online service for the fifth SEISS grant is available, HMRC announced on July 28. Self-employed taxpayers, including members of a partnership, are invited to file claims if they think their business profits “will be impacted by coronavirus” between May and September.

For the first time, claimants will need to consider a “financial impact declaration” test based on the extent to which turnover has reduced in a specified period. A correction to the terms of the test was set out in a Treasury Direction published on July 29.

The Association of Taxation Technicians and the Low Incomes Tax Reform Group have published details on the rules for the fifth grant.

U.K. Court Denies Royal Mail Customers’ Demands for VAT Invoicesby William Hoke

Royal Mail Group customers that paid for business mail services without realizing that the services were subject to VAT are not entitled to receive VAT invoices, the England and Wales Court of Appeal has ruled.

In The Claimants in the Royal Mail Group Litigation v. Royal Mail Group Ltd., the Court of Appeal on July 28 upheld a January 2020 High Court ruling that while services provided under contract by Royal Mail Group Ltd. had been subject to VAT under EU law since 1977, the claimants didn’t have a statutory right to compel Royal Mail to issue them VAT invoices.

The High Court’s decision followed a 2009 judgment by the Court of Justice of the European Union, which said in TNT Post UK Ltd. v. HMRC, C-357/07 (CJEU 2009), that while universal postal services are exempt from VAT, individually negotiated postal services are subject to the tax. Before that ruling, neither Royal Mail, its business customers, nor HM Revenue & Customs realized that those services were subject to VAT. The U.K. Parliament amended the law in 2010 to bring it in line with the CJEU judgment going forward.

Although Royal Mail did not specifically charge VAT, approximately 340 claimants said the amounts they paid were VAT inclusive and that Royal Mail should be required to issue VAT invoices for submission to HMRC in support of claims for input VAT refunds. The claimants gave “a ballpark figure” of £500 million for their total refund claims.

A three-judge Court of Appeal panel made up of justices Kim Lewison, Sarah Asplin, and Timothy Lloyd said in the decision that the invoices supplied by Royal Mail complied with all relevant statutory requirements in force at the time, “as they would have been understood according to domestic principles of interpretation.”

The court said Parliament didn’t intend to create a private law action against a party that complied with domestic legislation as it was ordinarily understood. “To say that Royal Mail had an obligation to supply VAT invoices for supplies that had been made before the [2010]




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amendment came into effect would be to give retrospective effect to the amendment in direct contradiction to the evident intention of Parliament,” it said.

Harry Smith, a solicitor with Reynolds Porter Chamberlain, told Tax Notes that the Court of Appeal “worked logically through the difficulties” with the appellants’ argument that a private law cause of action against Royal Mail arose because of its failure to provide VAT invoices. “If such a cause of action did arise, the point of loss — i.e., the date on which the trader submitted the next VAT return following the supply on which it was unable to deduct input tax because it had no VAT invoice — would be the correct time for that cause of action to accrue,” he said in an email. “The Court of Appeal’s discomfort with its conclusion that an application for an injunction is not time-barred is evident, but it is bound by precedent which can only be overturned by the Supreme Court.”

Smith said that given the amounts involved, an appeal to the Supreme Court is likely. “The Court of Appeal itself seems to anticipate that further litigation will follow,” he said, referring to its comments about a July 8 opinion by CJEU Advocate General Juliane Kokott in a separate U.K. case involving VAT refunds for payments made to Royal Mail.

In April 2020 the Supreme Court referred the case of Zipvit Ltd. v. HMRC, [2020] UKSC 15, to the CJEU, saying the legal question under article 168 of the EU principal VAT Directive is unclear. In her opinion, Kokott said there is no VAT liability in the absence of an invoice stating otherwise.

Smith said that like the claimants in the case before the Court of Appeal, Zipvit argued that VAT was included in the price it paid to Royal Mail. “At the time, both Zipvit and Royal Mail understood the supplies to be exempt from VAT (and so Zipvit was charged a price equal to the commercial price for the supply), so the ability to deduct input tax after the event would constitute a windfall,” he said.

Smith said that while the CJEU’s judgment in Zipvit will not be binding in the United Kingdom because of Brexit implementation legislation stating that U.K. courts “may have regard” to relevant CJEU decisions, it would be “highly persuasive” if the Court of Appeal’s July 28

decision is brought before the Supreme Court. “In practice, it would be surprising if the U.K. courts do not follow it, if there is an appeal,” he said.

The appellants in The Claimants in the Royal Mail Group Litigation v. Royal Mail Group Ltd., [2021] EWCA Civ 1173, were represented by Roderick Cordara of Essex Court Chambers and George McDonald of 4 New Square, who were instructed by Mishcon de Reya LLP. Royal Mail was represented by Javan Herberg and Emily Neill of Blackstone Chambers, who were instructed by Macfarlanes LLP.




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UNITED STATES

Coming FTC Regs Will Be Divided In Twoby Andrew Velarde

Final foreign tax credit regs following up on guidance that added a jurisdictional nexus requirement to the definition of foreign income tax will be delivered in separate pieces, with the first portion coming this year.

The FTC regs “are moving forward. We hope to get those in final form and out the door later this year. Those would be prospective, and they would greatly impact digital services taxes and other types of extraterritorial taxes,” said Jose Murillo, Treasury deputy assistant secretary for international tax affairs.

The IRS released the proposed regs (REG-101657-20) in September 2020. Practitioners were quick to note the monumental nexus change that could affect DSTs as well as taxes imposed under pillar 1, and experts have argued that it was a response to DSTs and OECD developments. But the IRS has asserted that the nexus rule was drafted with more than DSTs in mind.

If the changes go into effect, FTCs would not be permitted unless a foreign country’s tax law requires a sufficient nexus between that country and the taxpayer’s activities, investment of capital, or other assets that results in the income being taxed, the proposed regs state.

Murillo, who spoke at a July 29 virtual event sponsored by the International Fiscal Association USA branch, acknowledged that the FTC rules overlap with the work at the OECD and that “it may not be the last time we have to revisit that issue.”

Pillar 1 of the OECD’s global tax reform plan calls for revamping profit allocation and nexus rules to allow countries a new taxing right over a portion of in-scope corporate residual profits tied to sales in their jurisdictions, regardless of a multinational entity’s physical presence.

Murillo said some rules that had been addressed in the proposed FTC regs would be carved out and included in a second set of rules to come later. However, the primary part of the FTC guidance addressing the new nexus requirement

and other changes to the definition of income tax is on a quicker path to release.

Industry groups representing technology giants Amazon, Facebook, and Twitter have advocated that the jurisdictional nexus requirement be removed from the FTC rules because it would likely result in double taxation.

PTEP Rules Still Months Away

Concerning other guidance nearing the finish line, Murillo said final regs that will follow up on 2019 proposed rules (REG-101828-19) applying aggregate treatment for partnerships in conforming subpart F and the global intangible low-taxed income provision are in the early stages of the clearance process. He pegged the fall for a release of those final rules.

The 2019 proposed rules requested comments on what treatment should apply when considering the passive foreign investment company regime. According to Murillo, Treasury has received several comments on the matter, and a proposed regs package is also advancing.

Long-awaited guidance on previously taxed earnings and profits (PTEP) is “in fairly good shape,” according to Murillo, but its release is at least a few months out and the regs haven’t entered the clearance process yet. Among other issues, the rules will address the timing of adjustments and the midyear transfer of shares, the function of section 961(c), the effects of section 964(e) dividends (related to stock sales by controlled foreign corporations), and how to account for CFCs owned by partnerships, he said.

In April Murillo said the PTEP guidance would be released in multiple rounds. He reiterated that prediction on July 29.

A narrow rule under section 367(d) addressing the consequences of intangible property that is offshored and then onshored again is also nearing completion, Murillo said.

“It’s sort of an issue that doesn’t occur that often, but existing regs don’t contemplate that type of transaction,” Murillo said. “The obvious result that many suggest should be the case is the royalty is just turned off because the [intangible property] is back in the U.S. It doesn’t make sense to continue to have the deemed inclusion. That regulation will identify the conditions that need to exist for . . . [that rule] to be turned off.”




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Many Big U.S. Corporations Paid No Taxes After TCJA, Report Saysby Doug Sword

A left-leaning tax policy group reported that 39 of the biggest U.S. corporations paid no net federal income taxes during the three tax years since the Tax Cuts and Jobs Act went into effect.

The July 29 report from the Institute on Taxation and Economic Policy (ITEP) is sure to add talking points to Democrats’ argument for increasing the corporate income tax rate and bolster claims that neither corporations nor wealthy Americans are shouldering their fair share of the federal tax burden.

In a July 7 speech, for instance, President Biden cited an April 2 report from ITEP that 55 major U.S. corporations paid no taxes for 2020, arguing that “everybody has to pay their fair share.”

The follow-up report says that each of the 39 Fortune 500 or S&P 500 companies that paid no net taxes from 2018 to 2020 were profitable over the period. In all, those companies posted $122 billion in profits, with T-Mobile’s $11.5 billion in net income during the period topping the list. T-Mobile had a net tax refund of $80 million, according to the report.

Next on the report’s list was FedEx Corp., with three-year net income of $8.2 billion but a net refund of $138 million, followed by Duke Energy Corp., with $7.9 billion in profits and a net refund of $1.2 billion.

ITEP noted that several companies made both of its lists by paying no net federal income taxes from 2018 to 2020 and by paying no federal income taxes in 2020. That list includes Archer-Daniels-Midland Co., Booz Allen Hamilton, DISH Network Corp., Duke Energy, FedEx, and Salesforce.com Inc.

Also, 73 profitable companies paid less than half the 21 percent corporate tax rate during the three-year period, according to the report. As a group, those companies had an effective income tax rate of 5.3 percent.

Biden has said he wants to pay for much of $4 trillion in proposed new spending over the next decade with corporate tax increases. His proposals include boosting the corporate income tax rate from the TCJA-enacted 21 percent to 35

percent and overhauling the international tax system.

Some version of Biden’s corporate tax proposals is expected to be included in reconciliation bills Democrats plan to move through the House and Senate later this year.

The last major overhaul of the tax code before the TCJA was the 1986 rewrite, which was spurred in large part by both the Reagan White House and congressional Democrats pointing to reports of major U.S. corporations paying no taxes.




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DOJ, Taxpayers Spar on Appeal Of Transition Tax Constitutionalityby Andrew Velarde

Appellate litigation is advancing in a suit that seeks to invalidate the transition tax on constitutional grounds, and both the taxpayers and the government are focusing on the vitality of century-old Supreme Court decisions.

The Justice Department filed its appellee brief in Moore v. United States with the Ninth Circuit on July 22. The lengthy government brief comes nearly four months after the taxpayers bringing the challenge — Charles and Kathleen Moore — filed their appellant brief on March 29 after their suit was dismissed by a lower court.

The Moores have sought a refund of the $15,000 in taxes they paid on undistributed earnings from an Indian controlled foreign corporation. They have challenged the section 965 transition tax imposed on a taxpayer’s accumulated foreign earnings, arguing that it is not a tax on income and is therefore unconstitutional because it is not apportioned, and that its application is a violation of due process because it is unlawfully retroactive.

As the government notes in its brief, because the transition tax is estimated to bring in $340 billion in revenue, “the real stakes here are quite a bit higher” than the relatively paltry sum the Moores ask for in seeking the invalidation of the tax.

“If this lawsuit succeeds in eliminating the transition tax, U.S. multinational corporations not only would avoid certain future U.S. taxes on the earnings of their foreign subsidiaries, they also would permanently avoid the tax on their substantial (more than $2.6 trillion in all) previously accumulated foreign earnings that cleared the decks for the new regime [that the Tax Cuts and Jobs Act] sets up,” the Justice Department brief asserts.

The district court granted the government’s motion to dismiss in November 2020. In doing so, it rebuffed claims that the tax is a direct tax subject to the Constitution’s apportionment clause, finding instead it is a tax on income. It also held that while the tax is retroactive, it serves a legitimate legislative purpose furthered by rational means since the transition tax prevents

undistributed earnings from escaping taxation following the TCJA’s substantial changes to the international tax model.

“The [transition tax] is not a ‘wholly new tax.’ And it is ‘remedial.’ It is a change in subpart F to incentivize U.S. taxpayers to repatriate foreign earnings,” Judge John C. Coughenour said. It “also resolves uncertainty in the law,” he noted.

The deemed repatriation tax, which applies to taxpayers’ accumulated foreign corporate earnings going back to 1986, was enacted after the TCJA shifted the U.S. business tax regime from a worldwide to a quasi-territorial tax system. The one-time tax is levied at a rate of 15.5 percent on cash and cash equivalents and at 8 percent on noncash/noncash-equivalent assets.

A Century-Old Slender Reed of Support

Despite the district court holding, in their appelant brief, the Moores argue that the transition tax is not a tax on income because there was never a taxable event for the shareholders that would turn the earnings into income. Furthermore, earnings cannot be attributed to shareholders because their income and the retained earnings are better understood as capital, they argue.

“The question of what kinds of event might theoretically qualify as a taxable event matters little here, given that the [transition tax] turns on no event at all: the taxpayer has not ‘clearly realized’ and obtained ‘dominion’ over anything and so has not obtained any ‘income’ that could be taxed as such,” the Moores assert, looking to the standard set forth in Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955). “The [transition tax] simply deems the CFC’s accumulated earnings to be current ‘income’ of its shareholders, in the absence of any event whatsoever.”

Beyond Glenshaw Glass, the Moores look to even older Supreme Court precedent in Eisner v. Macomber, 252 U.S. 189 (1920), as they did at the district court level, in asserting that the transition tax deems “old and cold accumulated earnings” as shareholder income. In the Moores’ case, they lack dominion over the earnings since they are minority owners, the brief asserts. Also, according to the Moores, Macomber supports a finding that accumulated earnings are capital, and the couple faults the district court’s apparent holding that the




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century-old case is no longer binding law on that issue.

In Macomber, the Supreme Court held that a pro rata stock dividend was not income under the 16th Amendment, and that a tax on it was therefore an unconstitutional direct tax. In Glenshaw Glass, the Supreme Court emphasized the definitional breadth of gross income and distinguished Macomber in a case involving money received for punitive damages.

“Rather than explain how the [transition tax] could tax CFC shareholders’ ‘incomes,’ the district court simply said it was so. . . . The district court never accounted for Glenshaw Glass, despite that this Court has recognized that decision to define ‘income’ in its ‘constitutional sense,’” the Moores argue. “Nor did the district court explain how the [transition tax] met Glenshaw Glass’s definition of income. Perhaps the district court failed to do so because the Government also had no explanation for how the [transition tax] could possibly satisfy Glenshaw Glass. Indeed, the Government, in its briefing, declined even to mention that central governing authority.”

In its appellee brief, the Justice Department does address both Macomber and Glenshaw Glass directly. It asserts that it “is far from clear” that a tax on personal property is a direct tax because Macomber did not rule on that matter, and it urges caution from the circuit court.

“Issuing the first decision ever to hold that a tax on personal property is constitutional only if apportioned by population (an impossibility in practice) should give this Court pause,” the Justice Department brief argues. “Fortunately, this Court need not consider that weighty issue because the Section 965 transition tax is not a tax on property. It is a tax on a deemed repatriation of CFC income to certain U.S. shareholders.”

Realization is also not a constitutional requirement for income to be taxed, the Justice Department argues. That realization generally occurs before taxation is for the sake of administrability, the government asserts, citing Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991), a case involving the exchange of property. The brief also asserts that several Supreme Court decisions since Macomber, even though they did not directly overrule that decision on the narrow holding on the taxation of

stock dividends, have also rejected the idea that the Constitution has a realization requirement to tax income.

“Macomber is not good authority on the issue of what counts as income under the Sixteenth Amendment,” the Justice Department asserts, arguing that the “demise” of the decision’s relevance can be traced back to the 1930s and culminated with Glenshaw Glass. “Macomber is a slender reed to support [the taxpayers’] argument,” it says.

Further, despite the Moores’ contention otherwise, Glenshaw Glass did not address realization because whether the damages awards were realized was undisputed, and the disagreement was over whether the awards’ source would prevent them from being counted as income, the Justice Department said.

The Justice Department also argues that the realization requirement that the Moores would have installed on the transition tax would also apply to other subpart F provisions. That Macomber-based argument has been rejected by other court decisions, including Garlock Inc. v. Commissioner, 489 F.2d 197 (2d Cir. 1973), which held that that assertion “borders on the frivolous.”

Nonagenarian Precedents on Life Support

To support their second constitutional assault on the transition tax — that its retroactivity violates the Fifth Amendment — the Moores argue that the tax is a “wholly new” one, citing Untermyer v. Anderson, 276 U.S. 440 (1928), and Blodgett v. Holden, 275 U.S. 142 (1927), to support its bar. Both Untermyer and Blodgett involved gift tax provisions in the newly approved Revenue Act, which the Supreme Court held, when applied to gifts made before the law’s enactment, were arbitrary, and thus violated the due process clause.

“These decisions have never been overruled, nor has the Supreme Court ever had occasion to do so: not since Untermyer has [the Supreme Court] been faced with a new tax of truly retroactive application. But it has recognized their vitality,” the Moores assert, arguing that Untermyer is still controlling.

The transition tax imposes liability on transactions never previously subject to tax, and




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the Moores could not have expected a tax on foreign income that is not their own and that is not caught by the “anti-tax-circumvention rationale of subpart F,” the taxpayers argue.

“If this were not deemed a new tax, it would be quite easy for Congress to evade Fifth Amendment scrutiny for imposing new taxes. It could smuggle new taxes into existing provisions of the Tax Code, dressing them up as revisions. Or it could include them in broader ‘tax reform’ bills, tying them to some other, actual revision of the Tax Code,” the Moores assert. “Congress could propound a new ‘income inclusion’ of ‘your wallet and your keys’ — or, less cheekily, the value of all volunteer labor received by nonprofits over the past five years — and taxpayers would have no recourse but to pay up.”

In addition to refusing to concede that the tax is retroactive, the Justice Department faults the Moores for attempting to avoid the Carlton test by asserting that the transition tax is wholly new.

United States v. Carlton, 512 U.S. 26 (1994), involved an amendment to estate tax deduction rules that applied retroactively. The Supreme Court held that the statute did not violate due process because the amendment was not illegitimate or arbitrary.

“Indeed, Carlton, suggests that Blodgett and Untermyer — as well as Nichols v. Coolidge, 274 U.S. 531 (1927), on which the Moores also rely . . . are on life support,” the Justice Department brief asserts, arguing that those decisions do not have much authority on the constitutionality of amendments to how tax laws operate. Rather, they apply to a totally new type of tax, as was the case with the first gift tax.

The Justice Department argues that the transition tax is built on the structure of subpart F. Further, the Moores would always have been subject to tax on the CFC earnings as soon as they were distributed, so their problem is with the timing of the tax only, the brief asserts.

In Moore v. United States, No. 20-36122, the taxpayers are represented by Baker & Hostetler LLP.




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Tax Court Finds Fraud In UBS Document Disclosureby Nathan J. Richman

A taxpayer was found to have committed tax fraud, justifying both an unlimited assessment period and monetary penalties, in part based on documents disclosed when a Swiss bank settled with the Justice Department.

Five tax years as early as 2005 were still open in April 2018 because of the taxpayer’s fraudulent attempt to hide offshore assets, Judge Albert G. Lauber concluded July 26 in Harrington v. Commissioner.

The almost $792,000 in offshore income that George S. Harrington failed to report for tax years 2005 through 2009 is also subject to the section 6663 civil tax fraud penalty, Lauber concluded.

Harrington is a retired forest product industry engineer who splits his time between the United States and New Zealand. Without prompting, he reported his assets in those countries, but he didn’t tell the IRS about his assets in Switzerland, Liechtenstein, and the Cayman Islands until after UBS AG turned over 844 pages of information as part of its deferred prosecution agreement with the Justice Department.

Harrington’s offshore adventure started when he encountered a Canadian lawyer named John Glube. Harrington was owed a large amount of money by a Canadian company that exported lumber to Europe, and he figured that taking over its management might be the best way to collect on the debt. The company’s owners agreed.

Glube was the company’s legal counsel and had designed a corporate structure to reduce the owners’ Canadian and European taxes. Harrington was impressed; as Lauber noted, “Petitioner described Mr. Glube and his associates as ‘the most honorable people I have ever dealt with.’ Mr. Glube was later imprisoned for embezzlement.”

So, Harrington had Glube transfer a $350,000 nest egg to a UBS account in the name of a Cayman entity. Harrington claimed that he’d sold his home and loaned the money to the Canadian company, but Lauber concluded that he just wanted to hide some money offshore and liked what he’d seen from Glube so far.

Harrington didn’t manage to keep the business afloat, and it closed in the mid-1990s after a European import ban.

The paper trail resumed in 2002 with a UBS document describing Harrington and his wife (a dual U.S.-German citizen) as the beneficial owners of the account he’d had Glube fund. That account and another connected to both Harrington and the defunct Canadian company closed in 2007, with the petitioner’s funds ending up in a “conduit” UBS account.

Harrington then experimented with placing his offshore assets in a Liechtenstein stiftung, seemingly named for his wife, and when that entity’s account was closed in 2009, he tried life insurance. That strategy involved two policies worth over $3 million and naming his wife and kids as beneficiaries. Those policies were canceled in 2013, and the money settled in the account of another Liechtenstein entity under his wife’s name.

Let’s Take a Look

UBS settled with the Justice Department in 2009 and turned over account information on hundreds of its U.S.-related clients, including Harrington. The IRS started investigating him using the bank records, statements, and correspondence that the government received from the bank.

A revenue agent (RA) interviewed Harrington twice in 2013. In between the two meetings, two things happened: Harrington changed his story, and he told one of his UBS bankers about the audit so it could tweak some of the transactions to make them look “more explainable, and perhaps less embarrassing.”

After the RA spoke to Harrington’s lawyer, the taxpayer provided amended joint tax returns for 2005 through 2010 with almost $800,000 of previously unreported income, as well as foreign bank account reports that for the first time disclosed the assets. Lauber noted that the RA grew suspicious because Harrington’s old FBARs reported small balances in New Zealand but not the $3 million in the newly disclosed accounts.

The RA decided in 2016 to impose the civil fraud penalty, sending Harrington a closing letter asserting almost $118,000 in tax deficiencies and $94,000 in fraud penalties.




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It Comes Down to Fraud

Lauber noted that the timing of the notice of deficiency left the question whether Harrington committed tax fraud as the predominant issue in the case. All the tax years would be outside most of the section 6501 limitations periods for tax assessments, except for the unlimited one that applies when a taxpayer commits tax fraud.

While Harrington did try to dispute the existence of any undeclared income, asserting that he wasn’t subject to tax because he didn’t control the accounts, Lauber wasn’t convinced. The judge pointed to the UBS records that clearly labeled Harrington as the owner and the correspondence showing his exercise of control.

“It is inconsequential that petitioner did not personally ‘make withdrawals’ or ‘receive disbursements’ from the accounts. A taxpayer need not actually withdraw cash for an investment gain to be taxable,” Lauber wrote.

Turning to fraud, Lauber noted that Harrington challenged the IRS’s proof of its statutory approval of the section 6663 penalty under section 6751. One of the approval forms had the date June 14, 2016, typed on it in a corner, which Harrington said implied it was backdated to March.

Lauber noted that the bulk of the IRS internal records related to the fraud penalty involved March, rather than June, so the notation probably came from the RA’s later decision to add the section 6662 accuracy penalty as a fallback option, or the day the RA closed her report. In other words, there was no clear evidence of backdating to back up Harrington’s assertion, according to the judge.

Lauber upheld the bulk of the IRS’s fraud assertions with two exceptions. He found that the IRS failed to establish an underpayment for 2010 because Harrington’s amended return for that year didn’t have one, and that a portion of the 2007 understatement involved an innocent mistake regarding his wife’s domestic income.

For the rest of the understatements, while some badges of fraud weren’t present, others, like the changing stories, hidden assets, and large amounts of income unreported, juxtaposed against what Harrington did originally volunteer, provided strong evidence of fraudulent intent, Lauber concluded.

Harrington tried to explain away his changing stories at trial based on his age and the decades-old transactions, but Lauber didn’t buy it, writing, “Petitioner testified intelligently at trial; he did not simply misremember a few trivial facts, but mischaracterized facts and events of critical importance.”

The petitioner in Harrington v. Commissioner, T.C. Memo. 2021-95, was represented by Mindy S. Meigs and Alexander Kugelman of the Law Office of Alexander H. Kugelman.




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Second Computer Sciences Tax Court Dispute Centers on $30 Million NOLby Andrew Velarde

Computer Sciences Corp. (CSC) has again petitioned the Tax Court to redetermine a deficiency the IRS says it owes after audit — this time related to a disallowance of a net operating loss carryover.

In its petition in Computer Sciences Corp. v. Commissioner, served on July 23, the former IT multinational disputes a $30 million notice of deficiency related to its fiscal 2011. It alleges that the IRS improperly increased its taxable income by $85 million when reducing its allowable NOL attributable to CSC Computer Sciences GmbH (GmbH).

According to the petition, in 2010 the company claimed an NOL of $153 million that was attributable to GmbH, to which CSC succeeded after GmbH was liquidated. Only $68 million of the loss was claimed in 2010, resulting in a carryover of $85 million that was available in 2011 under section 172(a).

The dispute marks the second time recently that CSC has filed a Tax Court petition because of the IRS audit. In April the company petitioned the court over $320 million in taxes and penalties related to its fiscal 2013. In the petition, it asserted that the IRS wrongly disallowed section 162 ordinary and necessary business expenses related to foreign subsidiary severances and improperly denied capital losses on its sale of its consulting corporation stock to an unrelated party, which also involved a purported section 351 exchange.

Unlike the earlier petition, the dispute over the NOL disallowance lacks significant detail. The IRS explanation of adjustments, attached as an exhibit to the petition, simply states that because of audit changes made to GmbH, the NOL carryover was reduced from $86 million to $1.5 million. The reduction was to non-section 382 NOL carryovers.

Although the petition does not disclose where GmbH was located, CSC’s 2011 Form 10-K identifies CSC Computer Sciences GmbH as a German entity. Common in German-speaking countries, GmbH entities are similar to limited liability companies.

In its 2010 Form 10-K, CSC disclosed that it had $795 million in available unused foreign NOLs.

CSC, which merged with HP Enterprise in 2017 to create DXC Technology, has requested a trial in Washington.

In Computer Sciences Corp. v. Commissioner, No. 7157-21, CSC is represented by Baker McKenzie.




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Loss From LLC’s Related-Party Transaction Deniedby Emily L. Foster

A federal court has disallowed a company’s loss deduction because two “inextricably linked” transactions considered together result in a related-party capital asset sale.

In a July 26 opinion, the Court of Federal Claims in GSS Holdings (Liberty) Inc. v. United States, siding with the IRS, treated a partnership’s payment as part of a capital asset sale to a related party, and therefore disallowed the loss deduction under section 707(b)(1).

The section 707(b)(1) partnership related-party transaction rules disallow any loss on a sale or exchange of property between a partnership and a partner who owns more than 50 percent of the partnership, or between two partnerships in which the same persons own more than 50 percent of the capital or profits interests.

GSS Holdings, a partner in Liberty Street Funding LLC (Liberty) — a commercial paper conduit — argued that the step transaction doctrine doesn’t apply to collapse two different transaction structures and disallow a $22.5 million loss deduction, which it claimed as an ordinary loss under section 165.

The court noted that if instead the payment were deemed an ordinary business loss, the deduction would be allowable under section 165 because it’s irrelevant whether the parties are related.

“Whether we consider the two transactions ‘stepped together’ or if we analyze the substance (purpose) of the transactions as a unified whole, the result is the same,” wrote Senior Judge Eric G. Bruggink in ruling that the loss was properly disallowed when the IRS invoked the step transaction doctrine.

Series of Transactions

The transactions at issue include a liquidity asset purchase agreement — an agreement that Liberty creates for longer-term investment packages it purchases to mitigate or hedge against liquidity risk.

In December 2011 the firm executed a liquidity asset purchase agreement that required the Bank of Nova Scotia (BNS) — an

administrator that controls Liberty’s operations — to purchase distressed financial assets from Liberty at a preset price equal to Liberty’s basis in the assets.

As part of the asset sale, Liberty separately executed a “First Loss Note” to transfer $24 million to BNS and simultaneously received $1.45 million in insurance proceeds, yielding the disputed $22.5 million loss.

BNS’s subsidiary, Scotiabank, was the creditor on the note when the transaction was executed, and thus was Liberty’s partner for federal tax purposes.

Liberty recorded the asset purchase by BNS on Form 4797, “Sales of Business Property,” for tax year 2011, and after netting the applicable amounts claimed the net loss, which was allocated as a flow-through to GSS Holdings.

In June 2013 GSS Holdings filed an amended corporate tax return to carry back the loss from the transaction to tax year 2009, and thus characterized the transaction differently than Liberty had by claiming an ordinary loss under section 165 and reporting it separately from the investment sale on Form 4797.

“Characterized this way — not as a loss on the sale of an asset — the section 707(b)(1) prohibition of deducting losses on the sale or exchange of property with a related party would not apply,” Bruggink explained. “GSS thus claims that the Liberty partnership tax return was incorrect in consolidating the $24,000,000 transfer payment into the sale of a capital asset on Form 4797.”

End Results Test

Although the government argues that the sale and First Note payment were, in substance, a single transaction — which it refers to as the step transaction doctrine — “we think it more useful to view the question under the larger tax concept of ‘substance over form,’” Bruggink wrote.

The purpose of that principle “is to ‘give tax effect to the substance, as opposed to the form of a transaction, by ignoring for tax purposes, steps of an integrated transaction that separately are without substance,’” Bruggink wrote, citing Falconwood Corp. v. United States, 422 F.3d 1339 (Fed. Cir. 2005).

Bruggink pointed out that the government, “rather than extracting unnecessary or fictitious




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transactions, as is often contemplated in applying a step transaction analysis. . . . argues that the linked character of the two transactions becomes clear” when the intent of the First Loss Note, or its effect, is considered.

The court emphasized that the substance-over-form analysis needs to be on the sale in question that gave rise to the alleged tax benefit and “not the underlying business purpose that created the framework that enabled the transaction.”

Under the step transaction end result test, which the government urged the court to apply, the intent of the taxpayer is relevant, with the question being “whether the taxpayer intended to reach a particular result through a series of transactions,” the court explained.

If a series of steps are designed to achieve a particular result, the court said the taxpayer can’t request independent tax recognition of the individual steps unless it can prove that the result from engaging in an individual step was the intended end result.

“Plaintiff insists that the step-transaction doctrine cannot apply because there were legitimate business reasons to create the First Loss Note, and that, under the ‘end results’ test, it could never have intended to make the First Loss Note payment because Liberty never intended to invest in declining assets,” Bruggink wrote.

“Independent non-tax business and regulatory exigencies motivated the transactional form, which in turn compelled the tax treatment,” with each transaction having substance, GSS Holdings argued in its brief. “They cannot be stepped together, irrespective of any particular test.”

But according to Bruggink, GSS Holdings focused on the wrong transaction, because the relevant one is the payment to BNS, not the creation of the First Loss Note Account.

“When the narrower focus is applied, the answer becomes clear,” the court said, noting that there’s no question that the intended result from the $24 million payment was to offset some of the counterparty’s losses.

“The First Loss Note payment was intended to be made in conjunction with a capital sale [and] . . . the two are inextricably linked,” Bruggink concluded. (Emphasis in original.)

“It is plaintiff’s misfortune that, at the time the particular sale was initiated, Scotiabank had become a partner in Liberty,” resulting in the capital losses disallowed under the partnership related-party transaction rules, the court said.

The plaintiff in GSS Holdings Inc. v. United States, No. 19-728T (Fed. Cl. 2021), was represented by attorneys with Mayer Brown.




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Second Circuit Hands Government Win On Foreign Trust Penaltiesby Andrew Velarde

The Second Circuit has delivered the government a victory in its fight to assert that trust beneficiary reporting penalties can also apply to the owner of a foreign trust, vacating a lower court decision.

On July 28, in Wilson v. United States, the Second Circuit vacated and remanded the earlier decision from the U.S. District Court for the Eastern District of New York and held that Joseph Wilson, who was sole owner and beneficiary of his trust, could be subject to the 35 percent penalty on the gross reportable amount as beneficiary.

The government had appealed the November 2019 adverse ruling, which held that section 6048 requires substituting the 5 percent owner penalty for the 35 percent beneficiary penalty. That 5 percent penalty was zero because Wilson liquidated the trust.

Wilson, who created a $9.2 million overseas trust to which he was the sole owner and beneficiary, failed to timely file his Form 3520, “Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts,” and the trust failed to timely file Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner” for 2007. The IRS imposed $3.2 million in penalties, representing 35 percent of the distributions from the trust in 2007. The issue in Wilson, which was brought by the taxpayer’s estate after he died, is a novel one, and the decision from the Second Circuit focuses on the relevant statutory text.

Section 6048 requires owners of foreign trusts to file annual returns and beneficiaries to file returns on the distributions they receive.

The government asserted on appeal that the district court ignored the plain text of the statute and that section 6048 has multiple and separate reporting requirements, and section 6677 has separate reporting penalties for each violation. Section 6677(a) establishes the 35 percent reporting penalty on unreported distributions. Section 6677(b) substitutes 5 percent for ownership failures to file returns under section 6048(b).

Senior Judge Richard C. Wesley, writing for the unanimous Second Circuit, agreed that the plain text of the statutes weighed in favor of the government. The court looked to section 6048(c)(1), related to beneficiary reporting, and noted it refers to “any United States person,” which would include owners and beneficiaries. It also did not make an exception for beneficiary-owners, the court held.

“The problem with the district court’s analysis is that section 6677(b) leaves untouched the 35 percent penalty that applies to all other reporting requirements under section 6048, including to a return disclosing distributions required by section 6048(c),” Wesley wrote. “The district court and Plaintiffs do not identify any text in the statute that elides the requirement to disclose distributions received as a beneficiary under section 6048(c) when the beneficiary is also the owner of a foreign trust. Nor is there any textual support for the court and Plaintiffs’ view that when the owner and beneficiary are one, a failure to timely report the distribution received violates only section 6048(b) and not section 6048(c).”

The court also concluded that “gross reportable amount” has multiple meanings under section 6677(c) that differ depending on what part of section 6048 is violated. Therefore, contrary to Wilson’s assertion, the 35 percent penalty did not exceed the “gross reportable amount,” which could be $9.2 million. The government was also not limited by the statute to assessing only one penalty simply because section 6677 stated a person was required to pay “a penalty,” according to the court, since the statute also uses the words “any” and “each return.”

Ambiguities

Both the district court and Wilson argued that he was only required to file a single Form 3520, emphasizing the instructions under Part III, which state that distributions do not need to be separately disclosed if the trust filed Form 3520-A. The district court relied on this to hold that Form 3520 “disregards the beneficiary status of the trust owner in favor of his owner status” when tracking owner distributions.

Form 3520 has different sections that are completed by trust owners and beneficiaries, and




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Form 3520-A has separate sections to report distributions to owners and beneficiaries.

But the Second Circuit said the district court’s reasoning was erroneous. Section 6048 relates to disclosure requirements and not the form on which it is made, so filing a Form 3520 without all the necessary information still violates that statute, the court held.

“The [district] court overlooks the fact that regardless of whether the person files Form 3520, Form 3520-A, or both, she must disclose any distributions she received from a foreign trust even if she is the sole owner and sole beneficiary. The option to disclose the distributions that an owner received from the trust in Form 3520-A does not ‘favor’ the owner status,” the Second Circuit held. “The separate reporting for owners and beneficiaries does not erase the owner’s concurrent beneficiary status for the purpose of section 6048(c).”

Robert M. Adler of Nossaman LLP, who is co-counsel for the taxpayer, said he would carefully review the decision and consult with co-counsel and his client when considering possible next steps, including a petition for rehearing. Adler also said he is confident he will prevail on remand on the reasonable cause issue, which would excuse the penalties for a failure due to reasonable cause.

“The evidence will show that Mr. Wilson had no evidence or knowledge that Form 3520 existed or he was required to file one,” Adler said. “We respectfully differ with the court’s view that both obligations existed. . . . The owner’s reporting obligation subsumed the obligation as a beneficiary. The IRS forms and instructions made that clear.”

Adler added that at the very least, the statute is ambiguous as to which provision applies when the owner and beneficiary are the same, and ambiguities need to be resolved in favor of the taxpayer.

“The statute is silent. And even though the court unfortunately didn’t pay any attention to it, the government acknowledged that until the statute was amended, that the IRS itself was not assessing penalties [on the owner’s failure to file Form 3520],” Adler said. “The IRS historically recognized that there was some uncertainty in the statute.”

Section 6048(b) was amended in 2010.

Megan L. Brackney of Kostelanetz & Fink LLP said she was initially pleased with the lower court’s decision because it constrained the IRS from stacking Form 3520 and Form 3520-A penalties. But she added that she had also been troubled by the district court holding.

“It seemed odd that Congress would have intended for a U.S. taxpayer who formed a foreign trust and received distributions from it [to] essentially be given a pass on the failure to report the distributions, while a U.S. taxpayer who had no role in the formation of the trust but failed to report a distribution would have a penalty of 35 percent of the distribution,” Brackney told Tax Notes in an email. “In that respect, I think that the Second Circuit reached the correct result.”

Still, Brackney said she hopes the IRS will exercise caution on penalties going forward and that it won’t see the appellate decision as blessing the agency to “blast taxpayers with as many penalties as possible every time there is noncompliance.”

“Even if the Code permits the IRS to impose penalties, the IRS should exercise its discretion to reach reasonable outcomes that take into account the taxpayer’s specific conduct, the tax loss to the government — if any (as often, there is none, and the failure to report foreign trust activity is merely a technical violation), and the taxpayer’s overall record of compliance, as opposed to the IRS’s current practice of thoughtlessly and reflexively imposing the maximum amount of all possible penalties in every situation,” Brackney said.

Practitioners have accused the IRS of using nonfiling penalties on Form 3520 and Form 3520-A to assess excessive penalties as well as stacking international information return penalties after recharacterizing the income following an assessment of a failure-to-file penalty on Form 3520.

In Wilson v. United States, No. 20-603, Wilson is represented by Nossaman and Winne Banta Basralian & Kahn PC.




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IRS Authorized to Seek Records Regarding Panamanian Law Firmby Nathan J. Richman

A federal judge in New York approved the IRS’s request to serve John Doe summonses for information related to a Panamanian law firm that supposedly helped U.S. taxpayers hide their income.

The IRS can now serve John Doe summonses under section 7609 on FedEx, DHL, UPS, and several banks for information regarding Panama Offshore Legal Services and some related entities, according to the July 15 order in In the Matter of the Tax Liabilities of John Does that was entered July 28.

The summonses are intended to trace courier deliveries and electronic fund transfers in an attempt to find possible domestic taxpayer clients of the Panamanian law firm, the government said in a July 29 announcement. The government is looking for taxpayers that may be trying to use the firm’s services to hide assets from U.S. tax authorities.

“These court-ordered summonses should put on notice every individual and business seeking to avoid paying their fair share of taxes by hiding assets in offshore accounts and companies. These records will empower the IRS and the Department of Justice to find those attempting to skirt their tax obligations and ensure their compliance with the U.S. tax laws,” IRS Commissioner Charles Rettig said in the announcement.

“The Department of Justice, working alongside the IRS, is dedicated to unearthing the use of foreign bank accounts to evade U.S. taxes. We will use the many tools available to us, including John Doe summonses like the ones authorized today, to ensure that taxpayers are fully meeting their responsibilities,” acting Assistant Attorney General David A. Hubbert of the Justice Department’s Tax Division added.

According to the government, Panama Offshore Legal Services helps clients create entities and offshore bank accounts with an eye toward asset protection. The firm promotes the secrecy and anonymity provided by its services. However, some of the related entities also advertise their ability to help taxpayers hide assets and “avoid” taxes.

Panama Offshore Legal Services came to the IRS’s attention from at least one taxpayer who reported using the firm’s services when coming clean about hidden assets in the agency’s offshore voluntary disclosure program.

That pattern echoes the circumstances of Taylor Lohmeyer Law Firm PLLC, a Texas firm on the receiving end of its own John Doe summons through which the IRS looks to find taxpayers using the law firm’s services to park assets offshore after the agency found one client who said that had happened.

In granting the IRS’s request for permission to serve the John Doe summonses involving Panama Offshore Legal Services, the court found that “the information sought to be obtained by the summonses is narrowly tailored to information that pertains to the failure (or potential failure) of the group or class of persons to comply with one or more provisions of the internal revenue law.” The IRS has recently had to narrow several John Doe summonses, particularly for cryptocurrency information, when courts found them too broad.

Correspondent Bank Requests

The same day the judge granted permission to serve the summonses, the assistant U.S. attorney handling the case filed a letter responding to a concern about the breadth of the requests for correspondent bank account information. The IRS plans to work with the banks on strategies to find the documents it wants, the letter stated, adding that prior versions of the correspondent bank summonses were withdrawn and replaced by new documents.

According to court filings in the case, the IRS wants information on Panama Offshore Legal Services’ activities from 2013 through 2020.

The Justice Department filed the IRS’s request May 4.

Panama has drawn a lot of attention for offshore asset hiding in recent years regarding a different law firm: Mossack Fonseca & Co., the subject of the Panama Papers leak.

Talia Kraemer of the U.S. attorney’s office for the Southern District of New York represented the government in In the Matter of the Tax Liabilities of John Does, No. 1:21-mc-00424 (S.D.N.Y. 2021).






TAX CALENDAR

August 10

LB&I Campaign Update — Webcast. The USA branch of the International Fiscal Association will host a webcast discussing the IRS Large Business and International Division’s compliance campaigns covering international and partnership issues such as the recently announced campaign on lending transactions through a U.S. trade or business.

August 17

U.K. Tax Traps for the Unwary American — Webcast. The American Bar Association will host a webcast discussing mistakes made by U.S. lawyers regarding U.K. assets and legal structures, as well as trust funding and taxation and U.K. taxation of limited liability companies and revocable trusts.

Email: [email protected]

August 19

COVID-19 Tax Relief Measures — Webcast. Deloitte will host a webcast discussing COVID-19 tax relief measures in Southeast Asian countries and the tax audit process, including pitfalls and strategies.

August 25

Asia Tax Forum — Webcast. International Tax Review will host a two-day webcast discussing tax developments in Asia.


The U.N. Digital Tax Article 12B — Webcast. The American Bar Association will host part 3 of its webcast series “The Realignment of Taxing Rights in the Global Economy: Impacts & Challenges,” discussing article 12B of the U.N. model tax convention and the implications of changes to the convention.


August 26

Transfer Pricing — Webcast. Deloitte will host a webcast discussing financial technology developments in the Asia-Pacific region and related tax and transfer pricing issues.

September 1

Career Pathway in International Tax — Webcast. The USA branch of the International Fiscal Association will host a webcast discussing tax career opportunities, as well as employer expectations.


September 2

International Tax — Webcast. The Practising Law Institute will host a webcast discussing the effects of international tax rules in a recession and the tax benefits of business and transactional losses.


September 7

International Tax — Webcast. Russell Bedford will host a webcast discussing international tax issues of interest to businesses in the United Kingdom and to U.K. businesses that operate outside of the United Kingdom, including U.K. Budget 2020 measures and the impact of Brexit.

Tel: +44 20 7410 0339

September 8

Brazil Tax Forum — Webcast. International Tax Review will host a two-day webcast discussing transfer pricing, taxation of the digital economy, tax disputes, and the future of taxation in Brazil.


September 9

10th Annual Pacific Rim Tax Conference — Redwood City, California. The Pacific Tax Policy Institute will host a two-day conference on tax issues in Pacific Rim countries that is intended to




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improve relationships between tax professionals and tax administrators.


September 13

Tax Law and Digitalization — Vienna. The Institute for Austrian and International Tax Law of Vienna University will host an event discussing the combination of legal technology and tax technology. This event will also be available via webcast. Contact: Karina Hertle.


September 14

U.S. International Tax Fundamentals Series — Webcast. The Tax Executives Institute will host an eight-part series each Tuesday and Wednesday until October 6 covering U.S. international topics, including foreign tax credits, the Foreign Account Tax Compliance Act, subpart F, and transfer pricing.

Tel: +1 (888) 999-4803

Women in Tax — Webcast. International Tax Review will host a two-day webcast aiming to support the advancement of women in tax and discussing transfer pricing and tax implications associated with COVID-19, tax controversy management, and transfer pricing developments.


International Tax — Webcast. Informa Connect Ltd. will host a three-day webcast discussing DAC6 and mandatory disclosure rules, diversity, and global experiences with indirect taxes.


September 15

The Arm’s-Length Principle, Tax Treaties, and the MLI — Webcast. The American Bar Association will host part 4 of its webcast series “The Realignment of Taxing Rights in the Global Economy: Impacts & Challenges,” discussing pillar 1’s long-term impact on tax treaties, the effectiveness of multilateral instruments, and the arm’s-length principle in the digital age.


September 21

Digital Economy Summit — Webcast. International Tax Review will host a two-day webcast discussing BEPS 2.0 progress, pillar 2, digital services taxes, and the EU’s proposed (and now postponed) digital levy.


Transfer Pricing — Webcast. Informa Connect Ltd. will host a three-day webcast discussing BEPS 2.0 and pillars 1 and 2, the latest U.S. tax updates affecting Asia-Pacific businesses, and Japanese case studies.


September 23

International Corporate Taxation — Webcast. The Chartered Institute of Taxation European Branch and the Young IFA Network will host a two-day webcast discussing the effect of a 25 percent U.K. corporate tax rate and the OECD’s pillar 1 and pillar 2 proposals.


EU Inbound Investment — Webcast. Taxand will host a webcast discussing how multinational enterprises can benefit by establishing regional headquarters, including making operations more cost-effective and taking advantage of opportunities to reduce tax burdens.

September 28

Global Transfer Pricing Forum — Webcast. International Tax Review will host a three-day webcast discussing transfer pricing developments and issues, digital economy taxation, and dispute prevention.


Private Equity Tax Planning and Operations — London. Informa Connect Ltd. will host an event discussing challenges affecting transactions, private equity, and portfolio companies, including hybrid mismatch and beneficial ownership rules.





TAX CALENDAR


September 29

Autumn Virtual Conference — Webcast. The Chartered Institute of Taxation will host a two-day webcast discussing an update on stamp duty land tax, HM Revenue & Customs investigation trends, and corporate transactions.


October 4

Indirect Taxes — Webcast. The Chartered Institute of Taxation will host a two-day webcast discussing VAT-related topics.


October 14

Transfer Pricing — Webcast.The Institute for Austrian and International Tax Law of Vienna University will host a two-day webcast discussing issues, potential solutions, and developments associated with transfer pricing and financial transactions.


October 19

BEPS — Webcast. The American Bar Association will host part 5 of its webcast series “The Realignment of Taxing Rights in the Global Economy: Impacts & Challenges,” discussing the right of pillar 1 to impose tax where ultimate customers reside, as well as the additional tax at stake.


November 5

Scotland Virtual Conference — Webcast. The Chartered Institute of Taxation will host a webcast discussing VAT, partnership taxation, HMRC investigations, and the Finance Act 2021.


November 15

The Shielding Effect of European Tax Directives — Vienna. The Institute for Austrian and International Tax Law of Vienna University will host an event discussing the shielding effect of European tax directives. Contact: Karina Hertle.


November 17

Commodity Tax Symposium — Webcast. Chartered Professional Accountants Canada will host a two-day webcast discussing the latest indirect tax policy changes, critical commodity tax issues, and case law updates.


November 18

Arm’s-Length Principle — Webcast. The American Bar Association will host part 6 of its webcast series “The Realignment of Taxing Rights in the Global Economy: Impacts & Challenges,” discussing the future of the global tax system and the arm’s-length principle.





TAX CALENDAR







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Should U.S. Manufacturers Worry About CBAM?by Robert Goulder

The phone rings. Your biggest client is on the other end of the call — a manufacturer of industrial widgets that exports to buyers in the European Union. Their tax director is asking you how worried they should be about the new EU carbon border adjustment mechanism, or CBAM. You quietly contemplate your

response.

Most U.S. companies don’t want to pay a carbon tax, particularly if the proceeds are collected by European governments, and especially if the amounts paid are not creditable against their income taxes. Most U.S. politicians are hesitant to endorse a carbon tax for fear they’ll be voted out of office in the next election cycle. The typical U.S. voter has figured out that climate change is an actual thing but still doesn’t want to give up their gas-guzzling sport utility vehicle.

You can try explaining to people that CBAM is not the latest extraterritorial tax to emerge from the European Commission. In fact, you can explain that CBAM is not technically a tax at all.

The regulatory structure used to implement CBAM is built around article 192(1) of the Treaty on the Functioning of the Europe Union, which concerns the adoption of environmental measures, not taxing powers. As such, the CBAM legislation will be promulgated under ordinary procedure with qualified majority voting — unencumbered by the unanimity requirement that bogs down direct taxation measures.

Let there be no doubt, the European Commission is going to some length to emphasize that CBAM is not a tax. I doubt their explanations will do much good. If it feels like a foreign tax that

targets U.S. industrial producers, that’s how it will come to be known on this side of the Atlantic.

The bottom line is that your client doesn’t need to worry about CBAM, at least not yet. But eventually they will. It’s probably just a matter of time until U.S. manufacturers are (indirectly) paying CBAM fees when they export to Europe. Strictly speaking, those charges are paid by the importer on the other side of the transaction. Like a tariff, they will increase the price of the affected goods in foreign markets. Note also that EU officials are specifically designing CBAM to comply with WTO trade obligations.

I used to tell friends that all fiscal roads lead to a VAT. Lately I’m less convinced of that. The case for a carbon tax or cap-and-trade system is more persuasive than ever. With CBAM, the European Union is showing us how that might be done.

Fit for 55

CBAM is the logical extension of Europe’s cap-and-trade system, known as the emissions trading system (ETS), which has been in place since 2005. The primary purpose of ETS is to impose a price on domestic carbon emissions, thereby discouraging the consumption of carbon-intensive goods in favor of greener alternatives.

The basic idea of ETS is that European regulators will impose a strict limit on total carbon emissions originating from the 27 EU member states. That’s the cap. In-scope companies will then be required to purchase government-issued certificates that entitle them to pollute. Any polluting that goes beyond what’s permitted by these allowances is severely punished. The allowances are both transferrable and time-sensitive, in that they possess an expiration date. There’s no value to be had in hoarding them.

If a company can reduce its carbon emissions, it can then sell any unused allowances to other polluters. That’s the trade. In theory, this allows a company to reap a nice little profit each time it succeeds in shrinking its carbon footprint. If properly designed and implemented, a cap-and-trade regime aligns private profit seeking with public environmental goals.




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ETS is not well known outside of Europe because it has been structured as an exclusively internal regime. That’s about to change. In mid-July, the European Commission announced a new bundle of environmental priorities known as the “Fit for 55” package. The name relates to the commission’s goal of reducing carbon emission by 55 percent by 2030, relative to a baseline of 1990-level emissions. There are multiple components to the package. Most relevant to this discussion are the expansion of ETS to new sectors of the economy and the introduction of a border adjustment.1

The purpose of CBAM is to achieve a level playing field between in-scope EU companies and rivals based in countries that lack a comparable scheme for imposing a price on carbon emissions. That goes to the concept of carbon leakage, which occurs when carbon emissions migrate from a jurisdiction with these measures to a jurisdiction without them. The best way to visualize carbon leakage is to imagine a balloon: If you firmly squeeze one end of it, the contained air simply moves to the other side, without any reduction in overall volume. Similarly, ETS would be a dismal failure if it resulted in carbon-emitting activities relocating to outside the EU bloc. The point is to reduce overall carbon emission.

Over the first 16 years of the ETS regime, carbon leakage has not been a problem. There’s no hard evidence to be found in economic data suggesting that carbon leakage is occurring. There’s an explanation for that: Thus far, EU regulators have been far too generous in excluding carbon-heavy sectors of the economy from the scope of ETS. Aviation and road transportation have traditionally been exempt. So have shipping and maritime activities.

Further, ETS in-scope sectors have benefited from the issuance of free allowances. It’s predictable that there would be no observable carbon leakage when much of the European economy is out of scope, and the rest is receiving free allowances. For the trading period that ran from 2013 to 2020, the commission estimates that

43 percent of all ETS allowances were given away free of charge.

Has ETS been a success? Not yet. The European Union has placed a regulatory price on carbon, which is a fine start. The problem is that the price isn’t high enough to support the desired behavior change. By implication, the price is also not high enough to trigger carbon leakage. For much of the last decade, the cost associated with emitting a ton of carbon into the atmosphere — as measured by the benchmark price of an ETS allowance — was less than €10. The prices began to creep upward in 2019 and hit a milestone figure of €50 per ton in May. That’s still too low to make a difference.

The price could skyrocket once EU officials wind down the practice of issuing free allowances to polluters in the five sectors to which CBAM will initially apply. Those are aluminum, steel and iron, agricultural fertilizer, electricity production, and cement. According to the commission, four of these five areas (all but electricity) are deemed “at risk” of carbon leakage once the free allowances go away. Once CBAM is fully operational, the commission may expand the sectors to which it applies. The European Parliament has expressed a preference for expanding CBAM to include the paper, glass, and chemical sectors.

The preferred method of distributing ETS allowances is through a public auction, in which firms that are unable to reduce their carbon emissions would (in theory) bid up the sales price. The more desperate the bidder, the higher the auction price. There remains some tension as to whether proceeds collected from these auctions would be an EU own resource or be directed to member states.2

According to the EU’s economic impact assessment, the phasing out of free allowances combined with the expansion of ETS to road transportation, aviation, and shipping, would cause a 17 percent drop in EU carbon emissions — assuming a border adjustment is in place to prevent carbon leakage. Without a border adjustment, there’s no decline in carbon emissions

1For related coverage, see Sarah Paez and Amanda Athanasiou, “EU

Proposes CBAM, Expanded Carbon Pricing to Meet Climate Goals,” Tax Notes Int’l, July 19, 2021, p. 348.

2See Paez, “EU to Delay CBAM, ETS Own Resources Proposals,” Tax

Notes Int’l, July 26, 2021, p. 495.




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at all, as imported goods fill the gap left by diminished domestic output.

In short, not having a border adjustment defeats the purpose of having a cap-and-trade system. The future success of ETS depends on CBAM preventing carbon leakage. Like ETS auctions, the purchase of CBAM certificates by EU traders can also provide a revenue source, though that’s not the mechanism’s primary purpose.

The commission expects to create a centralized CBAM authority, with which EU traders must register to be recognized as an authorized declarant. Only authorized declarants will be permitted to import in-scope products. The authorized declarants will be requirement to purchase a CBAM certificate — each time they do, as summarized in an annual filing due by May 31 of each year. The price for each certificate is the means by which the authority collects the CBAM charge.

The charge will be waived if the country of origin imposes a carbon tax or operates a cap-and-trade regime that’s deemed satisfactory to European standards. That’s because carbon leakage can’t occur when the non-EU country also puts an adequate price on carbon. Without such a waiver, CBAM would result in the double pricing of carbon — once by the country of origin, and again when the authorized declarant causes the goods to enter the EU single market.

CBAM will remind some readers of the border adjustment under VAT rules — apart from the lack of an export rebate, which the commission purposefully omitted. The inclusion of a rebate — applicable when in-scope products are shipped out of the single market — would resemble an illegal export subsidy. Without an export rebate, the CBAM charges looks more like a routine tariff and less like a destination-based environmental charge.

CBAM is designed to apply narrowly at first, but expand over time. Initially, the commission expects the border adjustments to reach only 1.5 percent of all tangible goods imported into the EU. That translates to about €29 billion worth of imports each year, affecting an estimated 1,000 traders and about 500 production sites outside the EU.

When the new system takes effect in 2026, the authorized declarants will be required to buy CBAM certificates corresponding to 10 percent of the equivalent ETS price. By 2035, when the system is fully implemented, importers will be required to buy certificates corresponding to 100 percent of the ETS price. This has the practical effect of extending the ETS pricing model — previously an internal EU concept — to manufacturing that occurs outside the EU bloc. The commission has built in a whole decade to phase in CBAM, which gives other jurisdictions an opportunity to get serious about their own climate change policies.

With the phrase “other jurisdictions” we are mostly talking about the United States — although it will be interesting to see how countries within the EU’s gravitational orbit figure into the CBAM regime. That goes for Switzerland, which is outside of the ETS regime despite being a member of the European Free Trade Association. Other EFTA members (Iceland, Liechtenstein, and Norway) are covered by the ETS regime. Switzerland has operated its own cap-and-trade regime since 2008. The Swiss system has been formally linked with the ETS regime since January 2020. Presumably, Swiss exporters will not have to worry about CBAM charges as they operate an equivalent system. Switzerland also has some of the most stringent environmental laws in the world.

The situation with the United Kingdom is less clear. The country participated in the ETS regime prior to Brexit. Today, it operates its own cap-and-trade system, largely based on ETS. However, the U.K. government has not yet taken the step to formally link its system with that of the European Union, as the Swiss government has done. With the smell of Brexit still in the air, the United Kingdom has a depleted appetite for linking their legal structures with European counterparts.

In the event the United Kingdom is not fully relieved from CBAM obligations, questions will arise about Northern Ireland. The jurisdiction is no longer part of the European Union, but is functionally treated as part of the EU customs area under the Northern Ireland Protocol. The EU customs area is a distinct concept from the ETS regime, but they seem to overlap in spirit.




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Meanwhile in Washington

These developments in Europe were closely followed by a legislative response from Washington. A small group of U.S. lawmakers introduced their own version of a carbon tariff known as the Fair, Affordable, Innovative, and Resilient Transition and Competition Act.3 It was introduced on July 19, less than a week after the commission announced its CBAM initiative. The legislative sponsors are Sen. Christopher A. Coons, D-Del., and Rep. Scott H. Peters, D-Calif.

The bill targets imported products including steel, aluminum, cement, natural gas, and petroleum, which partially overlaps with the list of goods subject to CBAM. Coons and Peters intend for their carbon tariffs to help pay for the Democrats’ massive $3.5 trillion reconciliation bill, expected later this year.

My knee-jerk reaction is to applaud anytime an elected official proposes a measure aimed at limiting carbon emissions. Here, however, there’s something odd about the proposed U.S. carbon tariff. Much like CBAM, it’s being positioned as a defense measure that seeks to level the playing field between U.S. producers and foreign rivals that are getting away with something. The problem is that I can’t quite figure out what needs to be leveled, because the United States doesn’t have a cap-and-trade regime or a carbon tax. True, a scattering of U.S. states have miniature cap-and-trade systems, but that’s hardly an equivalent structure to what Europe has with ETS.

How can the United States justify an equalizing tariff on foreign goods when it isn’t pricing carbon itself? If the carbon tariff is a defense measure, I’m unable to identify the offending behavior to which it responds. This carbon tariff can’t possibly be about curtailing leakage — the primary justification for Europe’s CBAM. A country is not susceptible to carbon leakage until it completes the antecedent step of putting a price on carbon, and the United States hasn’t done that.

Here’s the explanation. The concept behind the proposed carbon tariff is to seek a competitive balance between U.S. companies, which are

subject to various federal, state, or local environmental regulations, and foreign rivals based in countries with more lax regulatory schemes. There you have it. The United States doesn’t have a carbon tax (yet) or a cap-and-trade regime (yet), but we do have the Environmental Protection Agency and its related body of regulatory law. If we construe these regulatory burdens as equivalent to a tax burden, then you can rationalize a border adjustment. There’s your unbalanced playing field, desperately in need of leveling.

What country stands out in the minds of U.S. lawmakers as wantonly lax regarding its environmental standards? China comes to mind. The mere mention of China changes everything about the politics. Many U.S. lawmaker will be attracted to the idea of slapping a tariff on Chinese polluters.

We’ve Seen This Before

You might think CBAM and the proposed U.S. carbon tariff are kindred spirits. That would be understandable, given the timing and the nature of the border adjustment. Allow me to suggest an alternate take.

EU member states have a legitimate reason to defend against carbon leakage, and CBAM is their chosen means of accomplishing that. CBAM is rational in that sense. It’s a stretch, however, to say the United States needs a carbon tariff for the same reason. The existence of EPA regulations is a conceptually weak basis for claiming harm at the hands of Chinese exporters.

Does Congress think EPA regulations alone will be sufficient to earn it relief from CBAM? Do they think Brussels isn’t going to figure out that we haven’t yet imposed a price on carbon? Just as a reminder, the U.S. body politic is a long way from doing anything like that. Heck, we can’t muster the political will to increase the federal excise tax on gasoline and diesel fuel, even when we portray it as a user fee. The gas tax hasn’t changed since 1993, more than a quarter century ago. A recent effort to index the gas tax to inflation was nipped in the bud, by Democrats no less.

I’d feel much better about supporting the proposed carbon tariff if it rationally corresponded to a domestic initiative to reduce carbon emissions. That foundational element is

3Athanasiou, “U.S. Lawmakers Introduce Carbon Border

Adjustment Legislation,” Tax Notes Int’l, July 26, 2021, p. 517.




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absent. It reminds me of past U.S. efforts to replicate the export rebate that European exporters receive under their country’s VAT regimes. You might recall how Congress awkwardly tried to mimic those border adjustments on multiple occasions, without the underlying VAT.

The domestic international sales corporation regime comes to mind, as does the foreign sales corporation regime and the extraterritorial income exclusion regime. Each time, Congress sought the VAT-like export rebate, but without the destination-based consumption tax. That’s like expecting the benefits of a country club without paying the membership dues. These regimes were

nixed by the WTO as illegal export subsidies. What we see here isn’t so different. Congress covets the attractive pieces of a cap-and-trade system — the border adjustment — but doesn’t want to deal with the necessary baggage.

I don’t pretend that Congress genuinely cares about climate change. Yet we know that lawmakers from across the political spectrum take a keen interest in China-bashing when the opportunity presents itself. In a perverse way, the best hope for a responsible congressional stance on climate change is to make the effort all about border adjustments, which is to make it all about China. That approach isn’t pretty, but I suppose it will have to do.




THE LAST WORD







CONTRIBUTORS

Nana Ama SarfoContributing Editor

Carrie Brandon ElliotContributing Editor

Robert GoulderContributing EditorThe Last Word

Lee SheppardContributing Editor

Aleksandra BalIndirect Tax Technology SpecialistLeiden, Netherlands

Richard T. AinsworthTax Tech Boston University Schoolof Law and New York University School of Law

James FullerU.S. Tax ReviewFenwick & West LLPMountain View, California

Mindy HerzfeldPotomac LawUniversity of Florida LevinCollege of Law

Ta ana FalcãoEmerging EconomiesInternational Tax Law Consultant and Policy AdviserMünster, Germany

Allison Chris ansThe Big PictureMcGill UniversityMontreal

Lucas de Lima CarvalhoBrazilian Institute for Tax LawSão Paolo

Lewis J. GreenwaldAlvarez and Marsal TaxandMiami and New York





Global Coverage

Africa/Middle EastHenriette FuchsPearl Cohen Zedek Latzer BaratzTel Aviv

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Jinji WeiBeijing

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Richard KreverUniversity of Western AustraliaCrawley, Australia

Adrian SawyerUniversity of CanterburyChristchurch

EuropeMichael BirkBirk InvestmentsAttenweiler, Germany

Sophie BorensteinKGA AvocatsParis

Francisco de Sousa da CâmaraMorais Leitao, Galvao Teles,Soares da Silva & AssociadosLisbon

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Andrew GoodallStaffordshire, U.K.

Santhie GoundarLondon

Jörg-Dietrich KramerSeigburg, Germany

Maria KukawskaStone & Feather Tax Advisory Sp. z o.o.Warsaw

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Rick MinorInternational Tax LawyerChapel Hill, North Carolina

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Peter MasonMasonryTax, Treasury, and FinanceConsultantLondon


