The TCJA’s International Tax Schemes

The tax bill signed into law by then-President Trump on December 22, 2017 (TCJA, an acronym for the “Tax Cuts and Jobs Act” unofficial title) is the most expansive and complex international tax reform made in a single piece of congressional legislation. The TCJA is plagued with ambiguities, gaps, uncertainties, and errors. The current economic crisis stemming from the COVID-19 pandemic makes one thing clearer than ever about the TCJA’s provisions: the need to fix them.

Taxpayers have begun to bring forward cases attacking the validity of the new international tax rules. These cases expose the inept lack of coordination among the various relevant statutory rules. Treasury simply will not be able to provide taxpayer certainty through regulations integrating scattered, incoherent, and nonexistent policies to argue that the clearly disjointed provisions sufficiently resemble an organized scheme. Congress placed an unfair burden on Treasury to expect it to justify these partisan piecemeal provisions cobbled together at lightning speed. Ultimately, this lack of coherence will result in taxpayer wins, which was perhaps the underlying unifying goal of the TCJA, which used explicit and implicit tax cuts (available through planning) to find more favorable revenue estimates but should not be allowed to survive a more thoughtful Congress.

This article makes the case that the claim that the TCJA’s international tax provisions represent a coherent statutory scheme is patently false: it is essentially one of those “alternative facts” concocted by the prior administration to conceal the true winners and losers of its single significant legislative achievement. The provisions fluctuate in their application to controlled foreign corporations (CFCs) and specified foreign corporations (SFCs) and their owners, which sometimes must only be corporations and sometimes include individuals and passthrough entities. The effective dates, like the provisions’ scope, do not align. Contrary to Treasury’s amusing concoction, the TCJA in no way created an “interlocking statutory scheme” through sections 245, 965, 951A, and subpart F. This is becoming ever clearer as the lawsuits begin to surface.

I. The Cases Against the TCJA Rules

On November 11, 2020 in Moore v. U.S., the U.S. District Court for the Western District of Washington incorrectly determined that the TCJA’s change to “a territorial tax model” is “a change in subpart F to incentivize U.S. taxpayers to repatriate foreign earnings.” The Moore court went on to explain that section 965’s mandatory repatriation tax (MRT) is not a wholly new tax but merely resolves an uncertainty because “it was unclear when and if a CFC’s earnings attributable to U.S. shareholders would be subject to U.S. tax. The TCJA and MRT remove that uncertainty.” This is the essence of the notion—that the TCJA’s international tax provisions flow from a seamless integrated statutory scheme—promulgated by the Trump Treasury in order to market the legislation as well as conceal its winners and losers.

A week after the court’s decision in Moore, Liberty Global, Inc. (a U.S. subsidiary of U.K. telecommunications giant Liberty Global PLC) sued after the government denied its section 245A deduction for the 2018 tax year. Liberty Global argues that “the section 245A Temporary Regulations are substantively and procedurally invalid” and that they are “contrary to the controlling statutes.” It asserts that the regulations improperly disallow the section 245A territorial dividends-received deduction (DRD) because such disallowance rules are “not found in or supported by the statute.”

These two cases have more in common than one would think at first blush. While Moore is focused on the unconstitutionality of section 965’s repatriation tax and Liberty Global on the invalidity of the section 245A regulations, the best argument supporting the taxpayers is that the TCJA’s plain language (muddled as it is) simply does not support the government’s positions.

Section 965 was not intended to remove the uncertainty of timing of taxation of a CFC’s earnings and profits: the section does not even apply to CFCs. Subpart F, of course, is the part of the Code that deals with CFCs and something of which the government could argue realistically that taxpayers had notice. To qualify as a CFC, a foreign corporation must be more than 50 percent owned by U.S. shareholders. Section 965’s new jurisdictional link, in contrast, is merely predicated on a single corporate U.S. shareholder owning 10 percent of a foreign corporation, an unusually limited jurisdictional link for international taxation. How could a foreign corporation or its owners anticipate that subpart F would (i) be expanded to govern corporations for which a de minimis portion of stock is owned by U.S. shareholders and (ii) result in retroactive taxation of 30 years of earnings and profits (E&P) that in no way reflect earnings accrued to the current 10-percent shareholder. That shareholder could well hold loss shares rather than shares with any built-in gain or other accession to wealth.

This situation is worsened since E&P are not the same as taxable income, and the distortion is increased when decades of E&P become subject to a transition tax, raising the question whether the TCJA reflects an appropriate understanding of income. E&P is a poor barometer of income for shareholders that do not receive dividends. For example, E&P doesn’t take into account unrecognized losses. On an annual basis, subpart F generally withstood scrutiny as a way to flow income through to a block of majority U.S. shareholders. In contrast, forcing a minority individual shareholder to take into account decades of E&P of a majority foreign-owned corporation with neither prior notice nor any of the benefits from the new statutory scheme raises serious concerns. Given the 30 years at issue in the Liberty Global case, it is certainly possible that individuals were required to pick up income on loss shares for which there was no accession to wealth. If the E&P had been required to be adjusted, as is done under section 877A by taking into account unrecognized losses upon a jurisdictional shift, a stronger argument could be made that the tax was in fact reaching actual income.

This brings us back to Liberty Global and whether the so-called gap period created by different effective dates for section 245A and the new subpart F rules can be altered by Treasury’s complex regulations that disallow a section 245A DRD. Ultimately, the justification for a regulatory fix, after a proper technical correction failed, illustrates clearly that the TCJA’s international provisions are no part of an integrated statutory scheme.

The Moore decision was incorrect because a CFC isn’t relevant for section 965’s tax, and this tax is certainly far more than a clarification of how a CFC’s earnings should be taxed. A CFC also isn’t relevant for section 245A’s territorial DRD, which is even further removed from subpart F: instead of using the CFC definition of U.S. shareholder that includes individual and passthrough owners, the section 245A territorial tax system only applies to a domestic corporation that owns 10 percent of the foreign corporation. These differences that expand the application of the repatriation tax and minimize the territorial DRD concurrently expand and narrow pre-existing subpart F principles, providing clear evidence of a failure to coordinate the provisions in TCJA’s so-called statutory scheme.

The other international TJCA provisions not at issue in these two cases further illustrate the lack of a coherent statutory scheme. The new subpart F provisions—including section 951A’s global intangible low-taxed income (GILTI) as well as section 965’s repatriation tax—care not who the U.S. shareholder is, while the new deductions—the 50 percent GILTI deduction and 37.5 percent foreign-derived intangible income (FDII) deduction—are only available for domestic corporations. Together, these completely different provisions maximize income for individuals and provide deductions only to corporations so it is unsurprising that neither the provisions’ terms nor their effective dates align.

II. The Disjointed International Provisions of the TCJA.

A. Transition Tax under Section 965

Section 965 imposes a one-time transition tax on post-1986 untaxed foreign E&P of foreign corporations (called “deferred foreign income corporations” or DFICs) owned by U.S. shareholders (including individuals and passthrough entities). Those individuals and pass-through U.S. shareholders of corporations that are not CFCs are likely to have little ability to extract distributions from the DFICs because of the 10-percent ownership threshold. Nonetheless, the transition tax applies to prior foreign earnings without regard to whether any of those profits are actually repatriated. (As already noted, the taxable amount does not accurately reflect income since it fails to take into account up to 30 years of unrecognized losses.)

The applicable tax rate is 15.5 percent for cash and certain cash equivalents and 8 percent for illiquid assets. The reduced tax rate for illiquid assets acknowledges the difficulty the foreign corporation would have securing cash to pay dividends to be used to pay the mandatory repatriation tax. Similarly recognizing the hardship that lumpsum payments of the repatriation tax would cause, the provision allows the repatriation tax to be paid over an eight-year period, with back-loaded payments ensuring that the bulk of payment occurs in the last three years.

While section 965 was enacted in the subpart F section of the Code to give the appearance of taxpayer notice and thus address constitutionality concerns, section 965’s tax on the E&P of DFICs represents a stark contrast to the CFC regime in which U.S. shareholders were required to own more than 50 percent of the corporation and thus could generally compel a distribution and were only taxed currently on “bad” (e.g., passive) earnings. This inability to compel a distribution had also been addressed in the 1986 passive foreign investment corporation (PFIC) reforms to the Code in another situation resulting in pass-through treatment to shareholders of passive earnings, because Congress recognized that “the U.S. investors may not have sufficient ownership in the PFIC to compel distributions.” For PFICs, both the qualified electing fund (QEF) and mark-to-market (MTM) rules provide PFIC owners with considerable flexibility compared to the default regime.

In sum, the section 965 tax applies to an inaccurate measure of a corporation’s untaxed foreign earnings at an incredibly low rate that benefits large taxpayers but hurts many less liquid taxpayers.

Constitutionality Concerns

The title of section 965 is “Treatment of deferred foreign income upon transition to participation exemption system of taxation”. Yet section 965 taxes those individuals and passthrough entities who do not participate in the exemption system. Section 245A, which is described in the legislative history as the “provision [that] generally establishes a participation exemption system for foreign income,” applies only to domestic corporations. This is where constitutional concerns arise.

A new tax regime for expatriating individuals was adopted in 2008, as part of the HEART Act. Section 877A provides for a mark-to-market tax on the net gain in property of expatriating U.S. citizens, generally applied as though the person’s property were sold at its fair market value on the day before expatriation. The underlying legislative history explored the constitutionality of the tax and explained that a change in a taxpayer’s jurisdictional rights under section 877A is a realization event that permits immediate taxation of built-in gains, even without a transfer to another owner.

[W]hen property effectively is transferred to a new legal situs that alters the taxpayer’s, and the Government’s, legal relationship to the property ... it is possible to characterize expatriation as being accompanied by a ‘realization’ with respect to certain assets in view of the change of the legal attributes of such assets, so that Government’s inchoate interest in its receiving its share of any increase in value need not be extinguished.

This realization argument was drafted in response to “opposing views on the validity” of the tax based on the Sixteenth Amendment, principles of international law, and whether economic gains have nexus to the United States. The TCJA’s new international tax provisions seem designed to fall within this description of a realization event due to the change in jurisdictional taxing rights arising from the new quasi-territorial regime. This justification does not appear to apply, however, for taxpayers who do not fall within the scope of section 245A’s participation exemption. Thus, it is not surprising that noncorporate taxpayers are arguing against the constitutionality of application to them of section 965.

B. Territorial DRD under Section 245A’s Participation Exemption

Although individuals pay the repatriation tax designed for a transition to section 245A’s territorial deduction, they do not benefit from dividend deductions. Nor is the section 245A deduction limited to CFC distributions to shareholders that are taxed under subpart F. Section 245A provides a 100-percent dividends-received deduction to transition to the TCJA’s hybrid territorial regime equal to the foreign-source portion of any dividend received from a specified 10-percent-owned foreign corporation by its U.S. corporate shareholder.

The regulations impose taxes on some offshore earnings in apparent inconsistency with the statutory language, on the grounds that the statutory language as written inadvertently confers a benefit unintended by Congress. The unintended taxpayer benefit arises because section 245A applies to distributions after December 31, 2017, whereas the GILTI provision (discussed further below) is effective for the first tax year beginning after December 31, 2017. Treasury essentially argues that its regulatory grant requires it to read the provisions as intending to leave no gap. Strict textualists will counter, nonetheless, that the regulatory grant should not be able to disregard the difference in wording even if its impact is to provide an unreasonable benefit not intended by Congress. Further, even though Congress acted with undue haste, including without the benefit of any hearings or the ability for congressional representatives, their staffs, and the tax committees adequately to scrutinize the legislative language, it can be argued that the drafters should have been aware of the different wording of the effective dates, the common use of fiscal years rather than calendar years as the taxable year for C corporations, and the gap in time creating the benefit because of the difference in wording.

Final regulations state that the international “framework confirms that the section 245A deduction is intended to apply to residual E&P that is not subject to section 965 and properly determined to be exempt from current taxation under the GILTI and subpart F regimes.” This counters the statutory interpretation principles espoused in Gitlitz, the Constitution’s separation of powers, and which branch of government legislates.

C. Global Intangible Low-Taxed Income under Section 951A

Section 951A requires U.S. shareholders (those who own 10-percent or more by vote or value, taking into account direct, indirect and constructive ownership) of any CFC to include their GILTI in respect of their direct or indirect ownership in gross income. The provision is designed to tax earnings that exceed a deemed return on qualified business asset investment (QBAI) and thus operates effectively as a minimum average foreign tax. The tax base comprises the aggregate net income (with adjustments) of the CFC less a deemed 10-percent rate of return on QBAI. Section 951A applies to the tax years of foreign corporations beginning after December 31, 2017. As previously discussed, the different effective date for section 951A compared to section 965, without the regulatory guidance discussed here, creates a gap period for fiscal-year corporations.

GILTI is treated as Subpart F income. Consequently, unless individual U.S. shareholders make a section 962 election, the GILTI amount will be subject to tax at their individual rates without the benefit of indirect foreign tax credits or the GILTI deduction (described in the next section). In some cases they would be eligible for lower rates on qualified dividends.

D. FDII and GILTI Deductions under Section 250

Section 250 creates a 37.5 percent deduction for FDII, which reduces the effective tax rate for qualifying income from the (new) standard 21 percent corporate rate to 13.125 percent. The section also allows an initial 50 percent deduction for GILTI income as determined under section 951A, resulting in a GILTI tax rate for corporations generally at 10.5 percent (half of the 21% current corporate tax rate). Both deductions are available only for domestic corporations.

The separate and distinct FDII deduction subsidizes foreign purchases from U.S. corporations, while the GILTI deduction merely reduces this includable type of subpart F income for certain domestic corporate shareholders. Any U.S. corporation can take advantage of the FDII export subsidy regardless of whether it has controlled foreign corporations or GILTI income. They are each stand-alone deductions that can each benefit taxpayers.

III. The Regulations Are Even More Disjointed

In Liberty Global Inc. v. United States, No. 1:20-cv-03501, Liberty Global argues that the section 245A regulations are invalid and are contrary to the controlling statutes. It asserts that the regulations improperly disallow the section 245A territorial DRD because that disallowance is not found in or supported by the statute. The fact that the effective date of the provision encouraging movement of property into the U.S. applies before the GILTI regime’s taxing provision kicks in is not unreasonable: the provisions were not coordinated and do not even apply to the same types of taxpayers. Both the foreign corporations (specified foreign corporations for the DRD and CFCs for subpart F and GILTI) as well as their owners (corporations for the DRD and any U.S. shareholder for subpart F and GILTI) are different.

The executive branch was unable to obtain congressional passage of a technical correction to resolve the conflicting effective dates for the DRD under section 245A and the GILTI regime under section 951A. In lieu of those technical corrections, Treasury has tried to achieve the same result through interpretation intended to coordinate the two regimes. The problem Treasury has is that section 245A explicitly allows a domestic corporation the benefit of a 100-percent DRD for the foreign-source portion of a dividend received from a CFC after December 31, 2017, even if that dividend had not also borne the burden of taxation under the GILTI rules. The taxpayer benefit Treasury claims was unintended stems from the fact that section 245A applies to distributions after December 31, 2017, whereas GILTI is effective for the first tax year beginning after December 31, 2017.

The differing effective date language, likely an implicit tax cut, results in a benefit for corporations with taxable years that are not calendar years. The gap period favors large non-calendar fiscal-year multinational corporations by allowing taxpayers to step up basis in qualified business asset investment and intangibles and generate earnings and profits for tax-free dividends relying on the 100-percent section 245A DRD before GILTI is effective. That also allows increased future depreciation and amortization deductions from the stepped-up basis to offset tested income under GILTI.

Technical corrections were not an option to salvage the partisan overhaul of the U.S. international tax system squeezed through the Senate with 51 votes through the budget reconciliation process. Accordingly, Treasury opted to resolve the issue through an interpretation of the statutory provisions necessary to carry out the congressional purpose. It was a tall tale to say the least. But what better way to help conceal hidden tax cuts used to meet budget reconciliation restrictions than spending government resources to write rules to disavow them. The fact that the rules were certain to fail doesn’t change the narrative – it only changed the financial statements of the well-informed. Perhaps the gap period satiated large constituents who were promised a 20 percent corporate tax rate. Conjecture aside, it can’t be denied that the TCJA is filled with massive congressionally intended benefits for large corporations that took many months to decipher. And back to the point, why would anyone think that immediate DRD benefits provided to corporate 10 percent owners of specified foreign corporations were meant to align with the GILTI regime’s delayed detriments to CFCs and their corporate, passthrough, and individual U.S. shareholders.

The June 2019 temporary and proposed regulations describe the provisions to address the gap period succinctly:

Section 245A is designed to operate residually, such that the section 245A deduction generally applies to any earnings of a CFC to the extent that they are not first subject to the subpart F regime, the GILTI regime, or the exclusions provided in section 245A(c)(3) (and were not subject to section 965). That is, the text of the subpart F and GILTI rules explicitly defines the types of income to which they apply, and section 245A applies to any remaining untaxed foreign earnings. Under ordinary circumstances, this formulation works appropriately, as earnings are first subject to the subpart F or GILTI regimes before the determination of dividends to which section 245A could potentially apply. However, in certain atypical circumstances, a literal application of section 245A (read in isolation) could result in the section 245A deduction applying to earnings and profits of a CFC attributable to the types of income addressed by the subpart F or GILTI regimes — the specific types of earnings that Congress described as presenting base erosion concerns. These circumstances arise when a CFC’s fiscal year results in a mismatch between the effective date for GILTI and the final measurement date under section 965 or involve unanticipated interactions between section 245A and the rules for allocating subpart F income and GILTI when there is a change in ownership of a CFC.

Why does Treasury think section 245A should not be applied based on its literal meaning? Because of “atypical” circumstances. What circumstances are so “atypical” they could render the words of Congress meaningless? A C corporation with a non-calendar fiscal year. It is as quixotic as Don Quixote charging at a windmill thinking it was a giant.

Treasury said in its 2019 temporary regulations that “where the literal effect of section 245A would reverse the intended effect of the subpart F and GILTI regimes, this conflict is best resolved, and the structure of the statutory scheme is best preserved, by limiting section 245A’s effect.”

Section 245A(g), which the final regulations rely on, provides that the “Secretary shall prescribe such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section.” The final regulations describe the need to coordinate section 245A and section 965 as limiting the availability of the section 245A deduction “in certain limited circumstances where the effect would be contrary to the appropriate application of those provisions in the context of the Act’s integrated approach to the taxation of income, or E&P generated by income, of a CFC.”

The term “appropriate” in section 245A(g) is broader than the “necessary” rules permitted by section 7805(a). Nevertheless, in my view the section 245A regulations at issue are in no way “appropriate to carry out” the section’s provisions. As shown in this analysis, Subpart F, GILTI, and section 965 do not apply to the same taxpayers as section 245A nor does section 245A require the foreign corporation to be a CFC. The transaction tax in section 965 applies to individual and passthrough owners. These provisions are sufficiently different that the Treasury’s efforts to reconcile them seem both overbroad and unauthorized.

It thus seems likely that courts will find Treasury Regulation section 1.245A-5 invalid. It is my view that Treasury cannot exercise its discretionary authority to draft regulations to cover up mistakes that should have been addressed through legislative technical corrections, even if the only way the TCJA could be salvaged as a reasonable international corporate scheme was for Treasury and the IRS to draft rules to complete the law. While it was once thought that these Herculean regulatory efforts could work, most now recognize that the task was impossible. Ultimately, it is taxpayers who will bear the burden of the TCJA’s taxing provisions—not solely by interpreting the burdensome regulations propping up the new laws but also by predicting which regulations the courts are most likely to invalidate as overreaching. This is why within days of the release of the temporary DRD regulations, practitioners warned that the participation exemption anti-abuse rule would spur litigation. Practitioners explored the uphill battle Treasury will have in defending these regulations even with its arguments about aggressive tax planning, when taxpayers should be able to rely on the effective dates provided in the statute for any change in law.

IV. Conclusion

Treasury’s efforts represent the interests of the Treasury secretary as a member of the president’s cabinet to vigorously defend the administration’s trade policies. Treasury is clearly striving to protect executive branch goals and statements and ensure that a hastily drafted statute makes sense. Treasury took on the impossible task of making appropriate connections between the allowed deductions under sections 245A and 250 and the GILTI inclusions that Congress left undone in its haste, yet Treasury cannot ignore the law. As these broad reaches of regulatory discretion accumulate, TCJA interpretation loses any semblance of credibility.

This article argues therefore that the temporary and proposed section 245A regulations should be found invalid. Treasury should not be able to use its interpretative authority to expand the GILTI penalty tax in regulations promulgated under a Code provision intended to provide a 100-percent deduction to create a territorial tax system. These new retroactive burdens go beyond the language of the statute and, although uncertain, may well surpass congressional intent. Taxpayers will inevitably challenge the regulations in the courts, and it is almost certain that taxpayers will prevail. Congress should act now to remedy the statutory TCJA mess.