Section 954(b)(4)'s high-tax exception.

Section 954(b)(4)'s High-Tax Exception

On October 10, 1989, Tax Executives Institute filed the following comments with Steven R. Lainoff, IRS Associate Chief Counsel (International), on the "high-tax exception" of section 954(b)(4) of the Internal Revenue Code (relating to Subpart F income). The Institute's comments--which supplement TEI's December 14, 1988, comments on the proposed and temporary regulations under section 954(b)(4)--were prepared under the aegis of the Institute's International Tax Committee, whose chair is Bernard J. Jerlstrom.

Background

Section 954(b)(4) of the Internal Revenue Code provides that income otherwise taxable under Subpart F may be excluded if the taxpayer establishes that such income was "subject to an effective rate of income tax imposed by a foreign country greater than 90 percent" of the U.S. tax rate (the "high-tax exception"). Temp. Reg. [section] 1.954-1T(d) adds a gloss to the statutory exemption by providing that an item of income is subject to the high tax exception only if foreign taxes were paid or accrued (or deemed paid or accrued) with respect to that income.

TEI believes that the "paid or accrued" requirement imposed by the temporary regulations contravenes congressional intent and operates to deny the benefit of the high-tax exception to deserving taxpayers.

Discussion

Subpart F was enacted to reach certain types of income that are easily "movable," i.e., the tax situs of which may be subject to manipulation. Although Congress broadened the scope of Subpart F in 1986, it recognized there are some cases where no U.S. tax advantage is gained by routing income through a foreign corporation. In such circumstances, Congress anticipated that the high-tax exception set forth in section 954(b)(4) would be applied in a flexible manner to avoid taxing non-tax motivated transactions under Subpart F. See H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 401 (1985) (hereinafter cited as the "House Report"); Staff of the Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, at 983 (1987) (hereinafter cited as the "General Explanation"). Thus, under the new standard, income is excepted from current taxation under Subpart F as long as it is "subject to foreign tax at a rate substantially equal to the U.S. rate." House Report at 396 (emphasis added).

Our December 1988 submission (at page 5) explains that a taxpayer may have no, or a small, foreign tax liability in a given year, but nevertheless still be "subject to" a high effective tax rate. Such a situation could occur through provisions of foreign tax laws that may allow corporations to carry forward net operating losses, surrender losses to group companies, or defer realization of income on items that must be accrued ratably under U.S. tax principles (such as original issue discount). Because Congress did not intend for Subpart F to exact a tax price where the taxpayer had not availed itself of a foreign corporation for tax avoidance purposes, TEI recommended that the paid or accrued requirement contained in the temporary regulations be eliminated. In making our recommendation, we also explained how the rule set forth in the temporary regulations may compel a taxpayer to make a yearly determination concerning whether certain foreign income was subject to the high-tax exception. Such a requirement would hardly seem the more "objective," "flexible," and "easy" result envisioned by Congress.

Recommendation

TEI continues to believe that the standard set forth in section 954(b)(4) requires a less restrictive approach than that endorsed in the temporary regulations. We appreciate the IRS's reservations concerning our prior suggestion that the IRS publish a list of countries in respect of which the high-tax exception would be available. We submit, however, that there is some "middle ground" that can be productively explored. In this regard, we appreciated your statement during our April liaison meeting that the IRS was willing "to rethink" its position with respect to the high-tax exception. We thus encourage the IRS to provide taxpayers with additional, favorable guidance on the section 954(b)(4) exception. Obviously, the more specific the guidance, the less likely that the high-tax exception will be the subject of future audit controversies.

One alternative that we believe has merit would be to exclude Subpart F income earned in a foreign jurisdiction where the controlled foreign corporation (CFC) would have paid tax at a rate greater than 90 percent of the U.S. rate (i.e., 30.6 percent), but for the reduction of foreign tax by one or more enumerated items. We specifically recommend that the taxpayer be permitted to take the following into account:

* Carryforwards or carrybacks

resulting from excess foreign

tax credits or net operating

losses.

* Differences in the timing of

deductions for items such as

inventory adjustments,

accelerated depreciation, or

capital expenditures.

* Differences in the timing of

the realization of income for

items such as interest or

original issue discount.

* Reductions in the amount of

capital gain subject to tax on

the sale of stock of an

operating company.

* Unrealized exchange losses

required to be recognized

under local law.

In amending section 954(b)(4), Congress clearly intended to impose a more objective and certain test that would tax income deliberately routed through a CFC in a low tax jurisdiction. At the same time, Congress expressed an intent not to "sweep [into the Subpart F net] a greater number of non-tax motivated transactions..." House Report at 401. We submit that our suggested alternative is not only a rational and flexible means of implementing that intent, but would also be a positive step in enhancing the fairness of the regulations. We urge that the modification be made to the Subpart F regulations.