Tax Executives Institute - U.S. Department of Treasury Office of Tax Policy and Internal Revenue Service Office of Chief Counsel joint liaison meeting: March 11, 2005.

On March 11, 2005, Tax Executives Institute met with representatives of the Office of Tax Policy of the U.S. Department of Treasury and the Internal Revenue Service Office of the Chief Counsel. The agenda for the meeting was published in the January-February 2005 issue of The Tax Executive. Note: These minutes were prepared by Tax Executives Institute, and have not been approved by the Treasury Department or the IRS Office of Chief Counsel.

I. Introductory Comments

On behalf of the U.S. Treasury Department's Office of Tax Policy, Acting Deputy Assistant Secretary for Tax Policy Eric Solomon welcomed TEI President Judith P. Zelisko and the other members of the delegation from Tax Executives Institute to the liaison meeting. On behalf of the Internal Revenue Service's Office of Chief Counsel, Nicholas J. DeNovio, Special Assistant to the Chief Counsel, also welcomed the TEI delegation. Mr. Solomon expressed regret that the previously scheduled meeting was postponed because of the congressional hearings on President Bush's fiscal 2006 budget proposals. He said that he was pleased to join the teleconference. Ms. Zelisko thanked the government representatives for taking time to meet with the Institute.

II. 2004 Act Guidance

a. Commendation. Ms. Zelisko expressed the Institute's appreciation and commendation for the prompt release of comprehensive guidance on the many provisions in the American Jobs Creation Act of 2004 (AJCA). She also expressed appreciation to the Treasury and IRS for drawing TEI into the process. Messrs. Solomon and DeNovio thanked TEI for its input provided following enactment of the legislation, saying that the ongoing dialogue initiated with TEI in November is helping to shape the government's guidance priorities.

b. Section 965 Repatriation and Notice 2005-10.

1. Section 5.02. Mr. Traubenberg referred to Notice 2005-10, which provides guidance on section 965 relating to incentives to reinvest foreign earnings in the United States. Under section 5.02 of the Notice, he said, all expenditures for worker compensation and benefits, other than expenditures for executive compensation, for new and existing employees seemingly qualify as permitted worker hiring and training reinvestments. He inquired whether the Notice was intended as broadly applicable to all non-executive compensation and benefits for existing U.S. employees.

Mr. Hicks said that the provision was written as broadly as possible and acknowledged that a number of practitioners have questioned whether the IRS "really meant" the provision should cover compensation and benefits for existing employees. Mr. DeNovio explained that, although the IRS is reluctant to say that all compensation and benefits for all non-executive U.S. employees always qualifies under section 5.02, the IRS and Treasury's view is that Congress intended to broadly promote the retention and creation of jobs in the United States. Hence, section 5.02 permits expenditures for compensation and benefits for existing workers to be considered qualified reinvestments as worker hiring and training expenses. Mr. Traubenberg commended the government for promulgating the rule and observed that, since Form 1120 requires an allocation between executive compensation and other employee compensation and benefits, companies with an existing workforce would be able to easily estimate how much of their repatriation will qualify as worker hiring and training expenditures.

2. Section 5.05. Mr. Traubenberg next referred to section 5.05(b) of the Notice and the example in the written agenda. He inquired whether a repatriation of funds by a controlled foreign corporation (CFC) to the U.S. parent followed by a contribution of the funds to a second CFC would be a qualified reinvestment where the U.S. parent is required to cure the second CFC's underfunded pension obligation.

Mr. Hicks said that equity contributions to CFCs are not a permissible use of repatriated funds. He added that there is no special "pension rule" in the statute or Notice. Ms. Evans noted that a payment may be able to be structured as a permitted reinvestment if the CFC's plan is qualified under section 401(a) of the Code. Ms. Brown observed that few CFC pension plans qualify under section 401(a). Mr. Traubenberg said that, for discussion purposes, the plan should be assumed to be a nonqualified plan. Mr. DeNovio explained that the IRS believes that the funding of pensions for non-executive U.S. workers is clearly a desirable policy goal and hence a qualified reinvestment. Consequently, references to pension funding as a permitted form of reinvestment are included in the worker hiring and training provision as well as the financial stabilization provision. But as Mr. Hicks noted, he said, there is no special rule that permits funding of pensions outside the United States. Ms. Zelisko noted that, under the assumed facts, the U.S. parent would be obliged to cure the funding deficiency and that, absent the dividend from a sister CFC, the U.S. parent might be financially impaired upon making a payment to cure the CFC's underfunded plan. She queried whether the financial stabilization provision should be expanded to address this situation. Mr. Hicks noted that it would be difficult to draw a line between funding a CFC's pension obligation and making equity contributions to repay other CFC debts. The latter is clearly not a permitted use of repatriated funds, he said. Mr. DeNovio reiterated that section 5.05(b) is not intended to cover contributions to CFCs, even if for a CFC's underfunded pension plan.

Mr. Traubenberg said that the Notice is silent in respect of whether the payment of U.S. retiree medical expenses would be considered an item that improves the financial stability of a company. Mr. Hicks acknowledged that the IRS did not consider retiree medical expenses when developing the Notice. He said that future guidance should address the issue and that it may qualify as a permitted reinvestment.

Mr. Bernard observed that the Notice is silent in respect of when the dividend reinvestment plan must be completed. He asked whether the government intends to tighten the rules by specifying a time frame for completing the dividend reinvestment plan. Mr. DeNovio said that, outside of the four-year safe harbor included in the Notice, there is no plan to issue guidance on the time for completion of the company's reinvestment plan. He cautioned that companies should be reasonable in their approach to the timetable for reinvestment of the repatriated funds based on all the facts and circumstances.

3. Section 5.07 Mr. Traubenberg inquired whether section 5.07 of the Notice relating to advertising expenditures is limited to advertising for intangible property such as brand names or trademarks and, if so, how taxpayers should allocate their expenditures between tangible and intangible property. For example, if Ford Motor Company were to advertise a Ford Focus automobile, is the advertising related to the tangible property of the automobile or the intangible brand name? Mr. DeNovio said that the IRS believes that advertising expense is generally incurred with respect to intangibles such as trademarks or brand names, but added that there is no requirement under the Notice to allocate advertising expense between the intangible brand and the tangible automobile. Mr. Hicks concurred, adding that in a different context an allocation may be appropriate where a portion of the intended audience for the advertising is outside of the United States. For example, he said, radio or television advertising expenses incurred in Buffalo, New York, may be allocable in part to the Canadian market and thus not qualify in part as reinvestment expenditures.

Mr. Bernard said that many forms of advertising, e.g., coupons or end-of-aisle displays, are more clearly linked to the promotion of tangible property. He inquired whether such expenditures qualify as a proper reinvestment of the repatriated funds. Mr. DeNovio said that the IRS would reconsider the phrasing of the advertising expense category because there was no intent to "box taxpayers in" on the types of permitted advertising expense.

4. Foreign Tax Credits. Mr. Bernard said that there is some confusion whether the tax liability attributable to the inclusion of 15 percent of a qualified distribution can be offset in whole or part by excess foreign tax credits carried over from other tax years. In response to a question, he said that as recently as two weeks ago a Big-4 tax partner advised that excess credit carryovers can offset the tax liability arising from the 15-percent income inclusion. Ms. Brown said that the upcoming guidance package on the foreign tax credit and expense allocations will address foreign tax credit carryovers.

5. Effect of Acquisitions. Mr. Bernard next inquired whether the base-period computation for the determination of the amount of incremental dividends must be adjusted for acquired companies. As an example, he asked whether it made a difference if the target paid dividends during the base period, but paid no dividends in the taxable year elected by the new parent as the year for the exclusion. Mr. Hicks said that the government is actively working on both the foreign tax credit and the merger and acquisition issues under section 965. Mr. Solomon said that the issues affecting the base-period computation, the dividend ceiling, foreign tax credit calculations, and acquisitions and dispositions are the highest priorities for additional section 965 guidance. Mr. Bernard observed that another area ripe for guidance is the treatment of dividends paid through foreign holding companies where current year qualifying dividends may be commingled with pools of previously taxed Subpart F income at the holding company level. There are ambiguities within the statute, he said, that should be clarified. Mr. Hicks concurred, saying that the IRS is working on holding company issues.

6. FSC Dividends. Mr. Bernard inquired whether dividends paid by a foreign sales corporation (FSC) will be included in the computation of the base-period dividend amounts. Mr. DeNovio said that, even though a number of commenters suggested that such dividends should not be counted in the base, Congress declined to exclude such dividends. As a result, he said, the IRS has no discretion to omit such dividends from the determination of the base-period computation. Mr. Boyle acknowledged that the treatment of FSC dividends in the base-period computation is likely clear, but a question remains whether FSC dividends in the year of the section 965 repatriation are counted for purposes of determining whether the repatriated amount is incremental to the amount of the base period dividends. Mr. Hicks said that the question has been raised and the IRS is currently reviewing it. Mr. Solomon suggested that taxpayers and the Institute should select their most important issues under section 965 and bring them to the attention of the IRS and Treasury Department for resolution. Mr. DeNovio added that it would be helpful for taxpayers to develop templates of broadly applicable fact patterns, especially in the acquisition area, since the temporary nature of section 965 will likely preclude the IRS and Treasury from addressing an endless variety of individual company fact patterns.

7. Other Issues. Mr. Maggin inquired whether more guidance is anticipated on the tracing of dividends, taxes, and tax credits through tiers of subsidiaries. Mr. Hicks said that dividend tracing and the treatment of previously taxed income are currently being studied. Mr. Maggin next inquired whether guidance on expense allocations for purposes of the section 965 calculations would be issued soon. Ms. Brown said the section 965 provision in general, including expense allocation issues, is among the government's highest international guidance priorities.

c. Section 199 Domestic Manufacturing Reduction and Notice 2005-14.

1. Software Used on the Internet. Ms. Twinem referred to section 3.04(7)(d) of Notice 2005-14, which provides that software delivered to customers by downloading the software from the Internet qualifies for the section 199 deduction whereas gross receipts from software offered for use online does not qualify as domestic production gross receipts. She said that the distinction between the two forms of software delivery seems artificial and does not comport with how software vendors offer their products. Mr. Maggin added that offering software for use on the Internet may be more efficient for the vendor and customer and the distinction in the Notice thus seems to be one of form rather than substance.

Ms. Hubbard said that the government has heard from a number of taxpayers and practitioners on the software delivery issue. She said that the statute includes a list of transactions (sale, license, lease, etc.) that qualify for treatment as domestic production gross receipts. The question, she said, is whether the online use of a vendor's software falls into one of those transactional categories. After reviewing the most sophisticated analysis of software transactions in current law, i.e., Treas. Reg. [section] 1.861-18, she said, the Treasury Department concluded that there was no transfer of copyright or copywrighted articles in the case of online software use. In drafting the statute Congress presumably was aware of Treas. Reg. [section] 1.861-18 and the distinctions drawn in the regulations between licenses and services, she added. Mr. Solomon acknowledged that distinguishing services from other transactions is often challenging. Mr. Maggin observed that, regardless whether the customer accesses the software on IBM's servers or uses a CD-ROM in the customer's own computer, the economics of a transaction with a customer are the same and the distinction in the treatment of the two may not be tenable. Ms. Hubbard said that the online use of software includes elements of providing a service and inquired whether an allocation between the license and service components is feasible. Mr. Solomon added that there is a range of transactions where there is an element of a manufactured product combined with a service. Ms. Hubbard said that the statute and notice permit bifurcation of transactions, but the government is struggling with what constitutes a qualifying license. Mr. Solomon invited the Institute to submit comments on how to distinguish between services and licenses or leases.

2. "Item-by-Item" Computation. Ms. Twinem referred to section 4.03 of the Notice and said that taxpayers are confused by the phrase "item-by-item" and whether that phrase means "model-by-model," "part number by part number," or whether it refers to another form of inventory recordkeeping unit. Ms. Maloy explained that the item-by-item phrase and the example illustrating the calculation of the section 199 deduction is a reaction to the FSC transaction-by-transaction (T x T) calculations whereby taxpayers were including income from profitable items in their FSC taxable income calculations but excluding loss-producing items. The example in the Notice is intended to clarify that taxpayers cannot exclude loss-producing transactions when calculating their section 199 deduction. She acknowledged that the IRS has received a number of questions about the "item-by-item" phrase. When proposed regulations are issued, she said, the IRS will endeavor to provide a clear rule explaining the "item-by-item" computation.

3. Contract Manufacturing. Ms. Twinem referred to section 4.04(4) of Notice 2005-14 relating to contract manufacturing, which requires that only the taxpayer with the benefits and burdens of ownership of the property (under federal income tax principles) during the period the qualifying activity occurs is treated as engaging in the qualifying activity. She inquired whether the government anticipated making changes when the regulations are issued. Ms. Maloy said that the statute requires the taxpayer to undertake the manufacturing activity and that the qualifying sale, lease, or other transaction involving the property must take place after the manufacturing occurs. If the sale or other transaction were made by a party that did not manufacture the property, she said, nearly all resales of property would qualify as domestic production gross receipts. Ms. Hubbard said that in order to satisfy the requirements for both qualified production and sale, the statute requires the producer of the property to have the benefits and burdens of ownership and that contract manufacturing arrangements will not qualify unless the taxpayer owns the property during the qualifying production process.

4. Manufacturing Safe Harbor. Mr. Boyle referred to the safe harbor in section 4.04(5) of the Notice for determining whether a taxpayer satisfies the manufacturing activity requirement. He inquired whether the costs for design and development activities, packaging, repackaging, labeling, and minor assembly operations should be included in the cost of goods sold calculation for purposes of determining whether the taxpayer incurs 20 percent of an item's conversion costs. Mr. Manousos acknowledged that the framework prescribing the treatment of such costs in sections 3 and 4 of Notice 2005-14 is ambiguous. Section 3 ignores those costs while Section 4 states that they are not conversion costs. Although design and development costs would likely be deducted by all taxpayers as research and development expenditures (and thus not require guidance), he said, the next round of guidance will likely clarify the treatment of design and development activities, packaging, repackaging, labeling, and minor assembly work. Mr. Boyle suggested that the scope of what constitutes "minor assembly work" might differ from taxpayer to taxpayer. Mr. Harrington inquired whether the determination of the section 199 safe harbor for manufacturing should be different from the section 954 safe harbor. Mr. Boyle said that he was not suggesting that there is or should be a difference under the two sections. Ms. Hubbard said that the question of whether "packaging costs" should be redefined and then included in the denominator for purposes of computing the manufacturing safe harbor percentage is one that would be reviewed in connection with the development of additional guidance under section 199.

5. Circular Computation of Mr. Maggin noted that during the transition years of 2005 and 2006, as the EIE regime phases out and manufacturing deduction phases in, the computation of either deduction may require the other to be taken into account under Treas. Reg. [section] 1.861-8. He inquired whether additional guidance would clarify the order of the computations or whether simultaneous calculations are required. Mr. Manousos acknowledged that the computation of the manufacturing deduction creates a circular calculation for purposes of determining the EIE amount as well as for computing other amounts determined as a percentage of taxable income (e.g., the charitable contribution percentage of income limitation). He said it was an open question whether the EIE or manufacturing deduction should be computed first. Ms. Maloy said that guidance on the calculation of items affecting, or affected by, the computation of the manufacturing deduction would be addressed in the forthcoming proposed regulations or other guidance. Mr. Traubenberg added that, although the statute is clear that the section 199 manufacturing deduction cannot create or increase an operating loss, the effect of a loss carryover (or carryback) on the manufacturing deduction for a particular year is uncertain. Mr. Manousos agreed that the effect of a loss carryover on the section 199 deduction is unclear and should be addressed in forthcoming guidance.

d. Mixed Use of Corporate Aircraft. Mr. Traubenberg referred to section 907 of the AJCA, which amends section 274(e)(2) of the Code to limit deductions for corporate aircraft used for personal purposes by specified individuals. He inquired about the approach the guidance might adopt for the treatment of mixed use of the aircraft, e.g., where a specified individual has a business purpose for the trip but a spouse accompanying the individual is on personal travel. He encouraged the IRS to consider adopting an incremental approach, which would make the cost of the trip in the example entirely deductible since the incremental cost of the spouse's travel is zero. Mr. San Juan said that an incremental approach was adopted for purposes of determining the income inclusion under Treas. Reg. [section] 1.61-21 and others have urged a similar rule be adopted here; he questioned, however, whether that was the proper approach for disallowing expenses under section 274. Ms. Hubbard said that the Treasury Department has received a number of inquiries about the expense disallowance provision and is working to issue guidance. For example, she said, some have suggested that the depreciation cost for the aircraft should not be disallowed because it is not a direct operating cost. She questioned that assertion, but acknowledged that the allocation and treatment of overhead expenses will present challenging line-drawing exercises.

e. Other Issues. Ms. Zelisko noted the many issues discussed during the meeting that will require additional guidance and inquired about the government's priorities. Mr. Solomon said that the section 965 repatriation issues were likely the highest priority. Ms. Hubbard said that proposed regulations under the section 199 manufacturing deduction would likely be issued in the summer of 2005. Mr. DeNovio added that, notwithstanding the many issues under the AJCA that require guidance, the IRS is continuing its work on a plethora of other projects.

Mr. McCormally noted that the Institute discussed the proposed Circular 230 regulations, which regulate practice before the IRS, with representatives from the Office of Professional Responsibility during the TEI liaison meeting with the IRS LMSB Division. He inquired whether the Treasury Department or the Office of Chief Counsel is considering modifications to Circular 230, especially to clarify the application of the rules to in-house tax practitioners. Mr. Solomon acknowledged that the Treasury Department is aware of the potential for applying Circular 230 to in-house professionals, but said that the application to in-house professionals was neither directly considered nor addressed in the rules. He said that the Treasury Department is currently considering the issues and the rules may be clarified before becoming final on June 20. He invited TEI to submit comments. Mr. Desmond explained that a broad carve-out for in-house professionals, such as that set forth in the regulations under section 6112, might create a potential for abuse where an agent or promoter acts in a dual role as a promoter and participant in a transaction. In such a case, he said, the in-house adviser may counsel not only the promoter-employer on the treatment of a transaction, but also give an opinion to a third-party participant.

In response to a question, Mr. DeNovio said that the IRS is committed to finalizing proposed regulations on cost sharing as well as revising the transfer-pricing regulations for services by this spring and summer, respectively.

IV. Conclusion

Ms. Zelisko thanked the Treasury Department and IRS representatives for their participation in the meeting. On behalf of the Treasury Department, Mr. Solomon expressed his appreciation for the time and effort the TEI representatives devote to preparing for the meeting and urged the Institute to continue to bring issues to the attention of the Treasury Department. On behalf of the IRS Office of Chief Counsel, Mr. DeNovio expressed his appreciation to the TEI representatives for their ongoing efforts in focusing IRS attention on areas requiring guidance.

Department of Treasury Delegation

Eric Solomon, Acting Deputy Assistant Secretary (Tax Policy)

Helen M. Hubbard, Tax Legislative Counsel

Michael J. Desmond, Deputy Tax Legislative Counsel-Legislative Affairs

Patricia A. Brown, Deputy International Tax Counsel (Treaty Affairs)

John L. Harrington, Associate International Tax Counsel

Eric San Juan, Attorney-Advisor

George Manousos, Tax Specialist

IRS Office of Chief Counsel

Nicholas J. DeNovio, Deputy Chief Counsel-Technical

Harry J. (Hal) Hicks, Associate Chief Counsel-International

Heather C. Maloy, Associate Chief Counsel--Passthroughs & Special Industries

Camille Evans, Special Counsel

TEI Delegation

Judith P. Zelisko, Brunswick Corporation, TEI President

Michael P. Boyle, Microsoft Corporation, TEI Senior Vice President

David L. Bernard, Kimberly-Clark Corporation, TEI Secretary

Bruce Maggin, IBM Corporation, Executive Committee

Lisa Norton, Amazon.com, Inc., TEI Executive Committee

David M. Penney, TEI Executive Committee

Carita R. Twinem, Briggs & Stratton Corporation, TEI Executive Committee

Paul O'Connor, Millipore Corporation, Chair, TEI IRS Administrative Affairs Committee

Nell D. Traubenberg, Storage Technology Corporation, Chair, TEI Federal Tax Committee

Timothy J. McCormally, TEI Executive Director

Mary L. Fahey, TEI General Counsel

Jeffery P. Rasmussen, TEI Tax Counsel

Gregory S. Matson, TEI Tax Counsel