Proposed regulations under Section 404A of the Internal Revenue Code.

On January 6, 1994, Tax Executives Institute filed the following comments with the Internal Revenue Service on proposed regulations under section 404A of the Internal Revenue Code, relating to limitations on deductions and adjustments to earnings and profits with respect to certain foreign deferred compensation plans. The comments were prepared under the aegis of TEI's International Tax Committee, whose chair of the committee is Lisa Norton of Ingersoll-Rand Company, and its Employee Benefits Subcommittee, whose chair is David L. Klausman of Westinghouse Electric Corporation. The following TEI members also contributed materially to the preparation of the submission: Robert J. Arthur of Johnson & Johnson, Anne M. Maher of General Motors Corporation, Susan A. Williams of Hewlett-Packard Company, R. Douglas Kyle and David Crawford of Weyerhaeuser Company, and Joseph W. Tierney and Joyce Fukami of Digital Equipment Corporation.

On May 6, 1993, the Internal Revenue Service issued proposed regulations under section 404A of the Internal Revenue Code, relating to limitations on deductions and adjustments to earnings and profits with respect to certain foreign deferred compensation plans. The notice withdraws proposed regulations that were issued on April 8, 1985. The new proposed regulations were published in the Federal Register on May 7, 1993 (58 Fed. Reg. 27219), and in the Internal Revenue Bulletin on May 24, 1993 (1993-21 I.R.B. 10). On October 5, 1993, the IRS held a public hearing on the proposed regulations.(1)

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our approximately 4,900 members represent 2,400 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works as one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 404A, relating to limitations on deductions and adjustments to earnings and profits with respect to certain foreign deferred compensation plans.

Overview

Section 404A of the Internal Revenue Code permits taxpayers to elect to deduct from earnings and profits (E&P) contributions to certain foreign pension plans designed for nonresident aliens who work outside the United States, even though the plans do not meet the requirements of U.S. law. The deduction is generally limited to the lesser of the amount allowed under foreign law or the amount allowable under standards comparable to those applied to U.S. retirement plans.

Section 404A was enacted in 1980 and essentially blends complex technical concepts involving employee benefits, international taxation, and tax accounting. A "qualified foreign plan" is defined under section 404A(e) as a written plan of an employer (who elects to apply section 404A) for deferring the receipt of compensation, if (i) the plan is for the exclusive benefit of the employer's employees or their beneficiaries; and (ii) 90 percent or more of the amounts taken into account for the taxable year are attributable to services performed by nonresident aliens whose compensation is not subject to U.S. tax. There are two types of qualified foreign. plans under section 404A: qualified reserve plans and qualified funded plans.(2)

With respect to qualified reserve plans, the proposed regulations generally follow prior IRS announcements. The proposed regulations' treatment of qualified funded plans, however, is seriously flawed, and raises significant compliance problems for taxpayers. The administrative burdens imposed by the proposed regulations (e.g., the requirement for filing amended returns at least back to 1980 and possibly before) are substantial. Rather than redressing taxpayers' concerns about the treatment of foreign deferred compensation plans, the proposed regulations constitute a dramatic and unjustified shift from the IRS's prior announced positions and they raise more questions than they answer. This situation is untenable--the statute was passed more than a decade ago and taxpayers have been struggling in the interim to comply as best they can. To mitigate the confusion and burden caused with respect to section 404A, TEI recommends that taxpayers be permitted to compute their contributions to foreign pension plans in accordance with U.S. generally accepted accounting principles.

Moreover, because of the drastic changes and reversals of position set forth in the proposed regulations, the Institute strongly recommends that the final regulations apply with respect to qualified funded plans only on a prospective basis--with sufficient lead time to permit taxpayers to gather the necessary data to ensure compliance. Our comments on the specific provisions of the proposed regulations document the need for this prospective-only treatment and are set forth below.

Use of U.S. GAAP Rules to Compute E&P

The legislative history of section 404A specifically recognizes that U.S. employers should be permitted to take deductions and make adjustments to E&P in respect of their obligations under their foreign plans. S. Rep. No. 96-1039, 96th Cong., 2d Sess. 12 (1980) (hereinafter referred to as the "Senate Report"). Congress also acknowledged that, except as necessary to prevent distortion of income or the allowable foreign tax credit, "[i]t is unnecessary to burden qualification for these tax benefits with many of the provisions intended to protect employees and their beneficiaries applicable to domestic plans." Id.

In 1992, the IRS issued proposed regulations under sections 952 and 964 of the Code that expressly recognized the need to reduce the administrative burdens associated with computing E&P for foreign corporations. Those regulations eliminated the need to adjust financial statements prepared in accordance with U.S. generally accepted accounting standards (GAAP) to reflect the Internal Revenue Code's uniform capitalization and depreciation rules. In the Institute's October 8, 1992, comments on these GAAP E&P regulations, we expressed the belief that the regulations represented "the first step in the development of a simplified method for computing E&P that will significantly reduce the existing compliance burden." We also said that more needed to be done.

TEI believes that the GAAP E&P method should be broadened beyond the limited items enumerated in the proposed section 964 regulations. Specifically, taxpayers should be permitted to use U.S. GAAP rules as an alternative to making book-to-tax adjustments for foreign pension plan contributions. Statement of Financial Accounting Standards (FAS) No. 87 provides comprehensive rules for contributions to foreign pension plans. The use of the GAAP E&P method would therefore represent a major simplification of this area. At a minimum, the U.S. GAAP rules should be adopted with respect to noncontrolled foreign corporations. Such an approach would substantially reduce complexity and result in a significant decrease in compliance burdens for the taxpayer and government alike.

Prop. Reg. [section] 1.404A-l(a): Exclusive Means for Deduction

a. In General. Prop. Reg. [section] 1.404A-l(a) provides that, if an employer's plan does not satisfy the requirements of section 404, section 404A provides the exclusive means by which an employer may take a deduction or reduce E&P in respect of contributions to foreign pension plans.(3) The proposed regulations stand in stark contrast with the 1985 regulations providing that E&P may be reduced with respect to payments by an employer to a funded foreign deferred compensation plan that are not deductible under section 404(a) even where an election under section 404A has not been made. See also IRS Announcement 81-148, 1981-39 I.R.B. 15 (taxpayer's decision not to elect section 404A will not affect the computation of E&P with respect to contributions to plans as allowed under prior law). This reversal in position is blithely explained in the preamble to the proposed regulations, as follows:

Upon reexamination of the Congressional intent underlying the enactment of section 404A, the Service now believes that the position reflected in the prior proposed regulations is inconsistent with the purposes of section 404A (and the limitations thereunder).

2993-21 I.R.B. at 12. The IRS cited no authority for this change in interpretation. TEI submits that the 1985 regulations better effectuate congressional intent.

In enacting section 404A, Congress reasoned that the provisions of present law applicable to deferred compensation plans were "ill-suited to plans maintained for the benefit of foreign employees":

These plans must frequently comply with provisions of foreign law which are either inconsistent with U.S. law or can be made consistent only through the surrender of major tax benefits under these plans. The committee believes that U.S. employers should be able to obtain deductions (and adjustments to earnings and profits) which take into account their obligations under these plans. It is unnecessary to burden qualification for these tax benefits with many of the provisions intended to protect employees and their beneficiaries applicable to domestic plans. However, in order to prevent distortions of income or of the allowable foreign tax credit, the bill includes certain limitations on the allowable amount of deductions.

Id.

In other words, section 404A was intended to liberalize the rules relating to foreign deferred compensation plans, not tighten them. Section 404A vitiated Letter Ruling No. 7904042 (Oct. 25, 1978) holding that if a plan operated by a foreign branch for the benefit of nonresident aliens did not meet all of the requirements for qualification under the Code (including the Employee Retirement Income Security Act (ERISA)), no deduction would be allowed for contributions to the plan. Senate Report at 10. With respect to foreign subsidiaries, the statute similarly reversed Technical Advice Memorandum No. 7839005 (June 21, 1978), which held that a taxpayer could reduce E&P only to the extent of pension payments actually made, rather than accrued, to an unfunded plan. Senate Report at 12.

There is nothing in the legislative history to suggest that Congress intended section 404A and section 404 to be the sole means for securing a deduction or E&P adjustment for foreign pension plan contributions. Indeed, the implication is just the opposite: Congress believed that it was "ill-advised" to force foreign pension plans to rigidly comply with U.S. plan requirements. The statute was intended to constitute a safe harbor for taxpayers affected by two limited private rulings. It did not represent a wholesale revision (or rejection) of the general principles for computing E&P.

No compelling U.S. tax policy is served by extending the U.S. pension rules to foreign plans by administrative fiat. Moreover, there is a certain arrogance in seeking to impose U.S rules on pension plans established for non-U.S. persons in foreign countries. Section 404A should not be distended to impose a form of fiscal imperialism on foreign plans. The applicable standards are (and should be) provided by local law. E&P is an economic concept that is intended to measure the funds available to a corporation for paying dividends; contributions to a funded pension plan reduce those funds without regard to whether those contributions are greater or lesser than they would be if the plan were subject to ERISA. By accepting the fundamental purposes of the E&P calculation and resisting the ethnocentric impulse to impose U.S. standards on foreign pension plans, the 1985 regulations clearly provide the better reasoned interpretation of section 404A and better matching for foreign tax credit purposes. Moreover, there is a built-in safeguard for the risc because the taxpayer's deduction under the statute is generally limited to the lesser of the amount allowed under foreign law or the amount allowable under standards comparable to those applied to U.S. plans. TEI recommends that taxpayers be permitted to deduct contributions to qualified funded plans from their E&P under the general rules for determining E&P.

b. Effective Date. Prop. Reg. [section] 1.404A-7(a)(1) provides that the regulations are applicable to taxable years beginning after December 31, 1979. For taxpayers making the election under the 1980 law to apply section 404A retroactively, the regulations are effective with respect to certain prior taxable years beginning after December 31, 1970. As a result, taxpayers may be required to amend their tax returns to the extent that deductions or credits claimed are inconsistent with the final regulations.

As previously noted, Prop. Reg. [section] 1.404A-l(a) provides that, if a foreign pension plan does not meet the requirements of section 404, section 404A provides the exclusive means of securing a deduction (or reduction in E&P). This rule of exclusivity represents a drastic change in the IRS's position. Section 404A was enacted fourteen years ago and since that time the IRS has twice issued guidance reinforcing taxpayers' view that the statute was not the exclusive means for obtaining adjustments to E&P. Hence, in 1981, the IRS announced that section 404A did not have to be elected to obtain a deduction from E&P for payments made to a separate trust. See Announcement 81-148, 1981-39 I.R.B. 15 (reprinted at 1993-21 I.R.B. at 18-19). In 1985, the IRS released proposed regulations reiterating the position that section 404A was not exclusive. Prop. Reg. [section] 1.404A-l(e) (1985). Now--eight years after that last guidance was promulgated-the IRS retroactively seeks to change the rules for funded deferred compensation plans.

TEI submits that if the exclusivity rule is retained, it should apply only on a prospective basis. To impose such a regulatory flip-flop on a retroactive basis is not only fundamentally unfair, but also poor tax policy.(4) Taxpayers that have in good faith relied upon the IRS's. announced position for more than a decade should not be penalized for having taken reasonable steps to comply with the law. Any other approach will undermine taxpayers' confidence in the integrity of the tax system and may even discourage them from taking steps to comply with regulations during the interregnum between proposed and final regulations.

Moreover, it may be impossible for taxpayers to comply with the requirement for retroactive calculations. The proposed regulations require calculations for taxable years beginning after December 31, 1979, and in some cases back to 1971. The actuarial data necessary to make the calculations may have been discarded, lost, or otherwise disposed of, for example, through a sale of the foreign subsidiary. TEI strongly recommends that the final regulations for qualified funded plans be applicable no earlier than one year after promulgation of the final regulations.(5)

c. Closed Years. The proposed application of the regulations on years that are closed by the statute of limitations or by closing agreements is perhaps the most disturbing aspect of the proposed regulations. TEI seriously doubts that the IRS has the authority to reopen closed years or to require taxpayers to file amended returns for such years. Moreover, no mechanism currently exists for receiving payments of tax or processing refunds for closed years. The proposed regulations fail to discuss this issue. TEI submits that final regulations should not be applied with respect to closed years.

Prop. Reg. [section] 1.404A-7: Election of Section 404A

Prop. Reg. [section] 1.404A-7 specifies the rules for making, revoking, or perfecting retroactive elections under section 404A. In general, such elections must be made within 365 days after final regulations are published in the Federal Register. The proposed regulations provide that prior elections that are not perfected are considered retroactively revoked. Taxpayers failing to perfect an election for a funded plan will, in most cases, lose all deductions or adjustments for amounts paid to a trust.

Announcement 81-114, 1981-28 I.R.B. 21 (reprinted at 1993-21 I.R.B. at 17-18), provided two methods of election under section 404A. Under Method 1, a taxpayer could claim the permissible deduction or credit on the taxpayer's income tax return for the first taxable year ending on or after December 31, 1980, including extensions. Method 2 permitted taxpayers to make a protective election by attaching a statement to their return. Under Method 2, a taxpayer would not include deductions or adjustments to E&P; these deductions or adjustments were to be included on an amended return to be filed no later than the deadline for revoking the election (i.e., 90 days after publication of final regulations).

The failure to perfect prior elections, coupled with the separate account requirement for funded plans,(6) will generally result in taxpayer's failing to qualify for any deduction for most foreign funded plans. It is difficult to believe that Congress intended such a Draconian result from a statute that was, after all, intended as a relief provision.

TEI believes that taxpayers electing Method 1 (as described in IRS Announcement 81-114) should be permitted to implement the final regulations on a wholly prospective basis. They should not be required to do more to perfect earlier elections and recalculate 13 or more years of section 404A amounts. In addition, all taxpayers--including those electing Method 2--should be allowed more than 365 days to perfect, revoke, or make retroactive elections for prior years. TEI submits that, depending on how many years are involved, 365 days may well be inadequate time in which to compute the actuarial calculations required for both funded and reserve plans. It will take many taxpayers several "staff years" to locate, accumulate, and process the actuarial data necessary to determine which election is appropriate for a particular plan. We suggest permitting such elections until the expiration of the time for filing an amended return for the first taxable year following issuance of final regulations. At a minimum, the District Directors should be granted discretion to grant extensions of time for taxpayers to perfect, revoke, or make elections under section 404A.

Prop. Reg. [section][section] 1.404A-l(e) & 1.404-2(b)(4): "Equivalent of a Trust"

a. In General. Section 404A(b) (5)(A) requires contributions to a qualified funded plan to be paid to a "trust (or the equivalent of a trust)" that meets the requirements of section 401(a)(2). "Equivalent of a trust" is defined in Prop. Reg. [section] 1.404A-l(e) as a fund --

* Whose assets are separately identifiable and segregated through a separate legal entity from the employer;

* Whose assets are not subject to the claims of the employer's ,creditors prior to the claims of the employees and their beneficiaries;

* Whose assets cannot be diverted to any purpose other than providing benefits; and

* Whose assets are held by a person with a legally enforceable duty to operate the fund prudently.

Prop. Reg. [section] 1.404A-2(b)(4) excludes trusts that contain a reversionary feature from qualifying as valid trusts, thereby disallowing deductions for contributions to such trusts until payment is made to the participant or beneficiary.

Regrettably, the proposed regulations would disqualify many legitimate arrangements. For example, countries such as the United Kingdom may actually require excess funds to be distributed to the employer prior to the satisfaction of all liabilities. Other countries (including Mexico) permit the reversion of excess assets where sufficient assets exist to meet plan liabilities. Even in the United States, section 420 of the Code permits certain excess assets to be transferred to a retiree health plan--a transfer that would be disallowed for foreign plans under the proposed regulations.

Moreover, failing to qualify a funding vehicle as "equivalent of a trust" will have dire consequences under other provisions of the tax law. Taxpayers failing to qualify will be forced to include the pension assets as passive assets for purposes of the passive foreign investment company (PFIC) rules and section 956A--a tremendous and surely unintended cost for multinational corporations. Since both the PFIC and section 956A rules were enacted after section 404A became law, penalizing a taxpayer in this manner is inconsistent with congressional intent.

TEI submits that entities complying with a foreign country's laws and regulations should qualify as valid funding vehicles under section 404A. The IRS may wish to publish a list of foreign countries whose laws adequaTEIy protect the employees' pension funds. If a reversion out of surplus is made that (i) accords with local country rules and practices and (ii) is based on an actuarial calculation demonstrating that the funding vehicle's ability to meet future obligations is not impaired, then the funding vehicle should not be disqualified. (The foreign corporation's E&P, however, should be increased by the amount of the reversion.) Such an approach would further congressional intent not to impose U.S. legal restrictions on foreign pension plans that "must frequently comply with provisions of foreign law which are either inconsistent with U.S. law or can be made consistent only through the surrender of major tax benefits under these plans." Senate Report at 12.(7)

b. Security Contracts. The preamble states that several commentators had urged the IRS to endorse the "Security Contract" or "Security Concept" developed in Germany which combines a book reserve commitment by an employer with a pledge and guaranty.(8) 1993-21 I.R.B. at 12. Asserting that "it is unclear under German law that the arrangement provides such protection [from the employer's creditors]," the preamble concludes:

Until the Service is satisfied that the corpus and income of the subsidiary are to be used to satisfy the claims of the employees and their beneficiaries (or those exercising their rights under the plan) before those of an employer's creditors, the Service cannot endorse this arrangement as equivalent of a trust.

Id.

Thus, by baldly asserting that there is a problem with no solution, the IRS consigns companies to limbo concerning the use of German Security Contracts. This is particularly egregious 13 years after the enactment of the statute. The regulations should be revised to permit the use of such contracts, perhaps on the basis of an opinion of German counsel that the pension assets are protected from the claims of the employer's creditors.

c. Effective Date. TEI suggests that, if the definition of "equivalent of a trust" is retained, the rule should be applied prospectively to afford taxpayers the opportunity to amend their trust documents to bring them into sync with the new rules. Because of the long delay in issuing the regulations, we believe that any changes in trust documents made to meet the new requirements should be effective with the effective date of the qualified funded plan election.

Prop. Reg. [section] 1.404A-2(b)(2): Prohibited Transactions

Prop. Reg. [section] 1.404A-2(b)(1) provides that a contribution will not be taken into account unless it is paid to a trust operated in accordance with section 401(a)(2) of the Code. Prop. Reg. [section] 1.404A-2(b)(2) provides that a contribution must be accumulated in the trust for the purpose of being distributed as deferred compensation. The proposed regulations also state that a trust's having been involved in a prohibited transaction under section 4975 of the Code is an "important" factor in determining whether it is operated in accordance with the requirements of section 401(a)(2). They thus effectively extend the Code's prohibited transaction rules on foreign pension plans, effective with respect to all transactions entered into after May 7, 1993.

The proposed regulations would supersede local law, with no legitimate tax policy basis.(9) Indeed, the proposed regulations actually impose a higher standard for foreign plans since domestic plans may apply for an exemption from the prohibited transaction rules; no such rule is provided, however, in the proposed regulations for foreign plans. Moreover, U.S. employers violating sections 4975(a) and (b) would be subject to penalties, not disqualification of their trusts. In these circumstances, we recommend that the complex prohibited transaction rules not be imposed on foreign jurisdictions. At a minimum, the proposed regulations should be revised to provide that the prohibited transaction rules are only one factor (not an "important" factor) to be taken into account.(10)

Prop. Reg. [section] 1.404A-6(a): Section 481 Adjustment

Prop. Reg. [section] 1.404A-6(a)(1) provides that an election with respect to a pre-existing plan constitutes a change in the method of accounting requiring the Commissioner's consent under section 446(e) and an adjustment under section 481(a). Prop. Reg. [section] 1.404A-6(g) replaces the historical computation requirement and permits taxpayers to use a "snapshot" approach to compute the initial cumulative U.S. and foreign law limitations under section 404A(d) as of the beginning of the year of change in method of accounting.(11) Subparagraph (e)(2)(iii) provides for a six-year section 481 adjustment period for a change in method of accounting arising from the termination or revocation of an election under section 404A.

TEI commends the IRS for adopting a snapshot approach for the purpose of reducing taxpayers' recordkeeping burdens. We note, however, that the snapshot method still imposes significant administrative burdens by requiring taxpayers to go back to the initial year of the section 404A election (which could be 1980 or earlier) to compute their section 404A amounts. We recommend that the IRS adopt a cut-off method whereby taxpayers compute their section 404A amount beginning with the year in which the regulations become final. Taxpayers that compiled the data necessary to perform the historical computations required under the 1985 regulations should not now be required to use the snapshot approach.

Section 481(a)(2) requires adjustments only where necessary to prevent duplications or omissions. TEI believes that, with respect to a foreign corporation that has consistently reduced its E&P for cash payments made to a trust, the section 481 adjustment should be zero because no duplicate deduction results from the taxpayer's election to be treated as a qualified funded plan.(12) In this regard, we believe that Example 4 in Prop. Reg. [section] 1.404A-6(f)(5) (which provides for a zero section 481 adjustment) could be expanded to clarify this concept. In the case of a funded plan, a section 481 adjustment is also unnecessary for prior years' payments that exceed either the old full funding limitation or the new 150 percent funding limitation requirements. To the extent the assets are still in the trust, they will affect future funding limitation calculations. Thus, future payments and adjustments to E&P will be smaller, eliminating altogether the need for a section 481 adjustment.

Prop. Reg. [section] 1.404A-6(f)(5): Computation of Section 481 Adjustment

Prop. Reg. [section] 1.404A-6(f)(5) provides examples for the computation of the section 481 adjustment. Example 3 shows the computation required for electing to change from a nonqualified funded plan to a qualified reserve plan. The last sentence of the example states:

Pursuant to the administrative procedures under section 446(e), the District Director, upon challenging the treatment of foreign deferred compensation in years prior to [the year of change], could require any necessary positive section 481 adjustment to be taken into account in one year.

For taxpayers that in good faith reasonably relied on actuarial assumptions and reports for foreign subsidiaries, requiring the section 481 adjustment to be taken into account in one year is unduly harsh. The example does not explain why taxpayers should be penalized in this manner. We recommend that the example be modified to reflect a more tempered approach for taxpayers who reasonably relied on actuarial assumptions and reports.

Prop. Reg. [section] 1.404A-5(b): Recordkeeping Requirements

Prop. Reg. [section] 1.404A-5(b) specifies what records are to be provided by taxpayers under section 404A. The subsection requires the attachment of certain "primary" evidence (e.g., a statement from foreign tax authorities specifying the amount of the deduction allowed under foreign law or a copy of the foreign tax return) or, where the primary evidence is unavailable, certain "secondary" evidence (e.g., a certified statement, excerpts from the employer's books and records, and computations of the deduction relating to the plan).

Even where the required information is accessible, this requirement imposes substantial administrative burdens on taxpayers. In many cases, the documentation will not be available at the time the taxpayer files its returns. Few, if any, foreign tax returns separately identify pension plan deductions and many countries (such as the United States) do not give receipts for taxes paid.(13) The secondary evidence required, such as the excerpt from a foreign employer's books and records, may be difficult, if not impossible, to obtain. Moreover, many foreign laws do not specifically address the deductibility of pension contributions or reserve additions and foreign assessment notices do not generally address pension deductions. TEI recommends that taxpayers be permitted to produce a letter from their local auditors or counsel concerning the deductibility of the contribution under foreign law.

Miscellaneous Provisions

a. Actuarial Assumptions. Prop. Reg. [section] 1.404A-2(d)(1)(ii) requires that actuarial assumptions using U.S. principles be generated each year for reserve plans and every three years for funded plans. This provision is another example of imposing U.S. rules on foreign pension plans. It essentially requires taxpayers to develop an additional set of actuarial assumptions separate and apart from those used by the foreign corporation in determining the appropriate contribution to the fund for local book purposes. (14) This requirement imposes a financial and administrative burden on taxpayers.(15) In order to avoid this result, taxpayers should be permitted to use either local or GAAP actuarial assumptions in computing book and tax adjustments.

b. Local Funding Rules. Prop. Reg. [section] 1.404A-5(c)(2) provides that no amount may be taken into account under section 404A if the amount causes the assets in the trust (or the amount of the reserve) to exceed the funding limitations set forth in section 412(c)(7)(A)(i). We recommend that the requirement not be imposed where local funding rules exist. Many foreign jurisdictions require employers to make certain payments to their pension plans. In countries where such protections exist, the local rules should apply. If the rule is retained, it should be applied on a prospective-only basis.

c. Termination Indemnity Plans. Prop. Reg. [section] 1.404A-l(e) permits only plans, a major purpose of which is to provide for the payment of retirement benefits, to qualify as termination indemnity plans. Under this definition, plans formed for the purpose of providing for the payment of benefits in the event of an involuntary discharge do not qualify as deferred compensation plans. Because many countries require separation benefits to be paid to employees, the final regulations should permit such plans to qualify as termination indemnity plans.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations under section 404A of the Code, relating to limitations on deductions and adjustments to earnings and profits with respect to certain foreign deferred compensation plans. If you have any questions, please do not hesitate to call Lisa Norton, chair of TEI's International Tax Committee, at [phone]; David L. Klausman, chair of TEI's Employee Benefits Subcommittee, at [phone]; or Mary L. Fahey of the Institute's professional staff at [phone].

1 For simplicity's sake, the May 6, 1993, proposed regulations are referred to as the "proposed regulations" and the April 8, 1985, proposed regulations are cited as the "1985 regulations"; specific provisions of the proposed regulations are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

2 A qualified reserve plan is an unfunded plan whereby an accounting reserve is created and the amount taken into account each year is a reasonable addition to the reserve for the taxpayer's liability under the plan. I.R.C. [section] 404A(c)(1). A qualified funded plan is any plan that is not a qualified reserve plan; contributions are taken into account for the taxable year in which they are paid. I.R.C. [section] [section] 404A(b)(1), (f)(2).

3 Under Prop. Reg. [section] 1.404A-l(d), a plan that does not qualify under section 404A will be subject to the section 404 rules applicable to nonqualified funded plans, including the requirement to maintain a separate account for each employee.

4 A significant question exists whether the IRS has the authority to change its published position retroactively. See Addison International Inc. v. Commissioner, 90 T.C. 1207, aff'd, 887 F. 2d 660 (6th Cir. 1989)(reliance on DISC handbook); LeCroy Research Institute v. Commissioner, 751 F. 2d 123 (2d Cir. 1984) (same). But see CWT Farms, Inc. v. Commissioner, 755 F. 2d 790 (11th Cir. 1985), cert. denied, 477 U.S. 903 (1986) (DISC handbook did not bind Commissioner).

5 At a minimum, the method used by taxpayers that made earlier elections should be permissible for those prior years. Taxpayers that reasonably complied with the provisions of Announcement 81-148 and the 1985 regulations should not be required to amend their prior years' returns. Alternatively, the retroactive application of the proposed regulations could be accomplished by making the section 481 adjustment required under Prop. Reg. [section] 1.404A-6 without amending prior years' returns. 6 The proposed regulations provide that plans failing to satisfy the requirements of section 404A will be governed by section 404. Section 404(a)(5) provides that the employer's deductions for contributions will be delayed until amounts attributable to the employer's contributions are included in the plan participant's gross income. In addition, for funded plans, deductions are denied altogether unless separate accounts are maintained for each participant. Foreign funded defined benefit plans, however, generally do not have separate accounts maintained for each participant. (Indeed, funded U.S. defined benefit plans rarely maintain separate accounts.)

7 Alternatively, the final regulations could provide on a prospective basis that an actual reversion of funds will result in the disqualification of the funding vehicle. This approach seems consistent with the public policy underlying the anti-reversion rule.

8 Hence, the employer establishes a book reserve for its pension liabilities for which it receives a deduction under German law. The employer then transfers assets to fund the liabilities to a wholly owned subsidiary. The pension assets are therefore separate and identifiable from the employer's assets; the subsidiary pledges its assets to a custodian who then gives a guaranty to the employees.

9 In many jurisdictions, employers are permitted to engage in transactions (such as loans or extensions of credit) that are prohibited under section 4975(c)(1). Especially with respect to joint ventures, taxpayers may not be in a position to deviate from local (and wholly lawful) business practices.

10 If the rule is retained in the final regulations, taxpayers should be granted an opportunity to modify their overseas practices. The restriction should not become effective until 365 days after the issuance of final regulations.

11 The snapshot approach compares the old and new methods of accounting, based on actual reserve or fund balances existing at the time of the change. The approach generally measures the extent to which an employer, under its old method of accounting, claimed deductions (or reduced E&P) exceeding the amount actually paid to plan participants and beneficiaries that the employer would have claimed for the same period under the new method of accounting. The section 481 adjustment is equal to the difference between the old method closing amount and the new method opening amount. See Prop. Reg. [section] 1.404A-6(f).

12 This should be contrasted with duplication that occurs when a taxpayer elects "pay-as-you-go" status for its foreign corporation's funded plan. In that case, the prior year's cash payments to the trust would be duplicated by payments to beneficiaries and a section 481 adjustment would be appropriate.

13 The requirement set forth in the proposed regulations is reminiscent of an earlier IRS requirement that receipts for foreign taxes be attached to the taxpayer's return. The requirement was subsequently withdrawn in the face of taxpayer opposition because of the irapracticality of enforcement. Notice 88-65, 1988-1 C.B. 552.

14 FAS No. 87 requires taxpayers to perform another set of actuarial calculations in accordance with GAAP principles. In addition, interim evaluations are required under section 404(a)(7) of the Code, thereby exacerbating the cost of compliance.

15 One TEI member estimates that the additional cost to his company of complying with the proposed regulations is between $350,000-$500,000. The ongoing cost for subsequent year actuarial valuations is estimated by that same company to be $100,000 per year.