Publications

UNITED STATES DEPARTMENT OF THE TREASURY

INTERNAL REVENUE SERVICE

TELECONFERENCE PUBLIC HEARING ON PROPOSED REGULATIONS

"GUIDANCE RELATED TO THE FOREIGN TAX CREDIT; CLARIFICATION OF FOREIGN-DERIVED INTANGIBLE INCOME"

Washington, D.C.

Wednesday, April 7, 2021

[Testimony of Jeffrey Gould]

My name is Jeffrey Gould. I’m giving testimony on behalf of Frank Hirth Plc, a London-based accountancy firm which provides U.S. tax consultancy and compliance services in an international setting. We are grateful for this opportunity to share our views on the proposed foreign tax credit regulations.

I will address Proposed Regulations Section 1.905-1(d), and then Proposed Regulations Section 1.905-1(e)(1). As explained in our outline, neither regulation is consistent with current law, and both will result in double taxation contrary to the objectives of the foreign tax credit.

Proposed regulations section 1.905-1(d) would adopt the so-called “end of the foreign tax year” rule. This rule was originally set out sixty years ago in Revenue ruling 61-93, which concerned a taxpayer liable to both U.S. and Hong Kong tax. The Hong Kong tax year ended on March 31 while the U.S. tax year ended December 31. For its 1961 U.S. tax year, the taxpayer was liable to both U.S. and Hong Kong tax on income earned in the nine-month period between April 1 and December 31, but the ruling held that credit for the Hong Kong tax on this income could not be claimed under the accrual method until 1962 when the Hong Kong tax year ended.

Revenue ruling 61-93 reached the wrong result because it ignored Code §461, which sets out rules for the taxable year of deduction. Regulations under §461 provide that two conditions must be met to accrue an expense, namely (1) that “all events” have occurred that establish the fact of a liability, and (2) that the amount of the liability be determinable at the accrual date with “reasonable accuracy”. Where the fact of liability for foreign tax on income earned during a U.S. tax year has been established, in normal circumstances the amount of liability should be determinable with reasonable accuracy at the end of the U.S. tax year because both the amount of income and applicable foreign tax rate will be known. However, Revenue ruling 61-93 asserts that “all events” must have occurred to determine not only the fact but also the amount of the liability, which clearly is not what the §461 regulations require. This led to the ruling’s erroneous conclusion.

The enormity of the end of the foreign tax year rule is illustrated in A.M. 2008-005, a 2008 letter from Associate Chief Counsel (International) concerning the allowance of credits for U.K. income tax, imposed on the basis of an April 5th year end.

Consider the case of Mr X, a U.S. citizen with a calendar year U.S. tax year who has previously elected to claim the foreign tax credit on the accrual method. Mr X becomes a U.K. resident on April 6, 2021 and commences to earn a large salary. U.K. income tax will be withheld from his salary at the rate of 45%. However, according to A.M. 2008-005, Mr X cannot accrue and claim any credit for that U.K. tax against U.S. tax on the 2021 U.K. salary because the relevant U.K. tax year will not have ended until April 2022. As a result, Mr X will have an additional U.S. liability on the 2021 U.K. salary of nearly 40%, so will be paying 85% income tax on his 2021 U.K. salary. While the U.K. tax on the 2021 income will be creditable against Mr X’s U.S. tax in 2022, in the normal case that credit will be needed to offset U.S. tax on income earned by Mr X during 2022, so there will be no unused credit available to carry back to 2021 and the 85% liability will have become permanent.

While A.M. 2008-005 asserts, without any analysis, that this is a correct application of the reasonable accuracy standard, no accountant would consider Mr X’s 2021 financial statements correct without an accrual for the anticipated U.K. liability.

As the following brief history illustrates, over the past 60 years the IRS has shown a consistent unwillingness to consider the validity of the end of foreign tax year rule.

First, Rev. rul. 61-93 did not reference the controlling §461 regulations.

Second, in the sixty years since the ruling, the IRS has never asserted the end of foreign tax year rule in a reported case. Evidently the IRS has been prepared to give way on the issue in individual cases rather than risk setting an adverse precedent.

Third, when the IRS issued proposed regulations under Code §960 in 2018, they incorporated the end of the foreign tax year rule.

The ABA Tax Section commented on the §960 proposed regulations, noting that the end of the foreign tax year rule was not generally considered absolute. It recommended that this part of the proposed §960 regulations be withdrawn and made a separate regulations project so that the issue could receive proper attention.

The IRS rejected the ABA’s recommendation, and adopted the language of the proposed §960 regulations without material modification. In the preamble to the final §960 regulations the IRS stated that the ABA’s comment was clearly wrong. “By definition, net basis foreign income taxes can only be determined with reasonable accuracy after the foreign taxable year has ended”. No authority was cited for this robust statement.

Thus, even in the context of the notice and comment procedure, the IRS avoided engagement on the end of the foreign tax year rule.

Fourth and finally, the end of the foreign tax year rule has now been incorporated in the proposed §905 regulations. The preamble to the proposed regulations mistakenly cites Rev. rul. 61-93 as authority for the proposition that the “reasonable accuracy” standard cannot be satisfied until the end of the foreign year. However, Rev. rul. 61-93 didn’t even acknowledge that the “reasonable accuracy” standard existed, much less apply it.

Given this history, adoption of the end of the foreign tax year rule as set out in proposed regulations section 1.905-1(d) might be considered arbitrary as well as contrary to applicable law.

I now turn to proposed regulations §1.905-1(e)(1), which would generally invalidate a §905(a) accrual method election made on an amended return.

§905(a) permits a cash method taxpayer to elect to accrue credits for foreign tax. §905(a) does not specify the date by which the election to accrue foreign taxes must be made.

Congress enacted §905(a) to permit taxpayers to achieve a more accurate matching of credits for foreign tax against U.S. tax on foreign source income, a fundamental objective of the foreign tax credit rules.

Where, as in §905(a), no deadline is specified for making an election permitted under the Code, it follows that the election may be made on amended return. In particular, if the decision to make such an election can be affected by facts that could not have been known at the time the original return was filed, the courts have consistently upheld the taxpayer’s right to make that election on an amended return.

A cash method taxpayer’s decision to accrue foreign tax credits is inherently one which can be affected by facts not known when the original return is filed. One of many examples is a taxpayer whose foreign tax liability is increased as a result of a tax audit in his foreign country of residence. Such audit adjustments may cover a number of prior tax years. If the taxpayer originally claimed the foreign tax credit on the cash method in those years, then unless able to amend his prior year returns to switch to the accrual method, increased foreign tax credits arising from the audit adjustments will not be related back to the U.S. tax years in which the relevant income was reported, matching of credits against liability will be impossible and the potential cost to the taxpayer enormous.

In the preamble to the proposed regulations the sole relevant authority cited for the IRS’ refusal to permit a §905(a) election on an amended return is a 1935 case called Strong v Willcuts, decided by a U.S. District Court in Minnesota. The court in that case quite properly denied the taxpayer’s accrual claim because “all events” necessary to establish the fact of liability had not occurred at the end of the tax year. The Minnestota court’s comments on whether an accrual method election could be made on an amended return, not being essential to its decision, were obiter dictum and not legal authority.

It is incumbent on the IRS to provide strong justification for the rule of proposed regulations section 1.905-1(e)(1), bearing in mind that it is inconsistent with what the courts have held in analogous cases and would lead to double taxation.

Has the U.S. Treasury Had the Last Word on the ‘End of the Foreign Taxable Year’ Rule?

Posted on Aug. 8, 2022

By Jeffrey L. Gould

To the Editor:

The final foreign tax credit regulations published by the Treasury Department in January (T.D. 9599) have been a source of significant controversy. Much of this is focused on the restrictive new definition of what constitutes a foreign income tax, a matter of concern primarily to U.S. multinationals.1

There are other questionable changes in the new regulations that affect all U.S. taxpayers with a foreign tax liability, including U.S. citizens residing overseas subject to local taxation of worldwide income. One of these is the “end of the foreign taxable year” rule,2 now contained in reg. section 1.905-1(d), that sets out “Rules for accrual method taxpayers.” It now reads in relevant part as follows:

A taxpayer who uses the accrual method of accounting may claim a foreign tax credit only in the taxable year in which the foreign income taxes are considered to accrue for foreign tax credit purposes under the rules of this paragraph (d). Foreign income taxes accrue in the taxable year in which all the events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy. See reg. sections 1.446-1(c)(1)(ii)(A) and 1.461- 4(g)(6)(iii)(B). . . . A foreign income tax liability determined on the basis of a foreign taxable year becomes fixed and determinable at the close of the taxpayer’s foreign taxable year. Therefore, foreign income taxes that are computed based on items of income, deduction, and loss that arise in a foreign taxable year accrue in the United States taxable year with or within which the taxpayer’s foreign taxable year ends. [Emphasis added.]

The new section 905 regulations thus begin by citing the two-pronged requirement for the year-end accrual of liabilities set forth in the section 461 regulations, namely that a foreign tax liability may be accrued when:all the events have occurred that establish the fact of the liability; and the amount of the liability can be determined with reasonable accuracy.

In this context, the all-events test is met if the taxpayer is subject to tax in the foreign jurisdiction — for example, if the taxpayer is a resident. The amount of liability test is met if the liability can be determined with “reasonable accuracy,” which should prove no difficulty if the amount of net income at the close of the U.S. tax year and rate of foreign tax are known. However, the new section 905 regulations go on to imply that a foreign tax imposed based on a foreign taxable year is not “determinable” until the close of that year. This ignores the fact that accrual requires only that a liability be determinable with reasonable accuracy. The regulations conclude with a statement of the

end of the foreign taxable year rule — that foreign income taxes imposed on net income accrue in the U.S. tax year “with or within which” the foreign taxable year ends.

The preamble to the final regulations purports to address the criticism that the end of the foreign taxable year rule ignores the “reasonable accuracy” standard, stating that “an estimate does not meet the standard required by the all-events test to accrue a foreign tax expense.” This is patently untrue — to determine a liability with “reasonable accuracy” clearly contemplates the use of estimates. See, for example, Rev. Rul. 98-39, 1998-2 C.B. 198, which states that a liability can be accrued if it can be “reasonably estimated.” The preamble goes on to say that when the U.S. and foreign taxable year are not coterminous, an estimate of foreign tax liability for the portion of the foreign taxable year up to the U.S. year-end is inherently unreliable because “any number of events” could occur after the U.S. year-end that could affect the foreign liability — for example, a “large loss” could be incurred late in the foreign taxable year. A similar argument could be raised against the accrual of any expense when it is conceivable that post-year-end events could affect the liability, but this would read the “reasonable accuracy” standard out of the regulations.

The “end of the foreign taxable year” rule can have brutal consequences for an individual taxpayer. Consider the case of Mr. X, a U.S. citizen with a calendar-year U.S. taxable year who has previously elected under IRC section 905(a) to claim credit for foreign income taxes in the year in which those taxes “accrued.” Mr. X becomes a U.K. resident on April 6, 2021, and commences to earn a large salary. U.K. income tax will be withheld from his salary at the rate of 45 percent.

According to the IRS, Mr. X cannot accrue and claim any credit for that U.K. tax against U.S. tax on his 2021 U.K. salary because the relevant U.K. taxable year will not have ended until April 5, 2022.3 Mr. X will have an additional U.S. liability on the 2021 U.K. salary of nearly 40 percent and will be paying an aggregate 85 percent income tax on his 2021 U.K. salary.

While the U.K. tax on the 2021 income will be creditable against Mr. X’s U.S. tax for 2022, in the normal case that credit will be needed to offset U.S. tax on income earned by Mr. X during 2022. There will therefore be no unused credit available to carry back to 2021, and the 85 percent liability will become permanent. This is true double taxation, the precise result that the FTC rules and the option to claim the accrual method are intended to prevent.

What makes the Treasury’s insistence on the end of the foreign taxable year rule perverse is that IRC section 905(c) provides that when an accrual of a foreign tax liability proves to be overstated, the taxpayer is obliged to amend the tax return to reduce the credit claimed and pay the additional U.S. tax liability plus interest to the IRS. Thus, in the unlikely event of a large loss incurred late in the foreign taxable year or any other event after the U.S. taxable year-end that reduces accrued foreign tax, the government is fully protected.

In cases in which a right to claim FTCs is conferred by treaty, the new regulations may not be the final word on the time of accrual. The FTC provisions of U.S. treaties typically state that “in accordance with the provisions and subject to the limitations of the law of the United States . . . the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income . . . the income tax paid or accrued to the” other treaty party (emphasis added).

The “law” of the United States is the statutory law and the U.S. Constitution, not federal regulations.4 The two-pronged test for accrual of a liability set out in reg. section 1.461-4(g) represents the accepted interpretation of the meaning of “accrued” as established by the accounting profession and in numerous court decisions.5 It seems possible that a U.S. expatriate adversely affected by the end of the foreign taxable year rule in respect of taxes payable to a U.S. treaty partner could claim accrual based on a reasonable estimate of his foreign tax liability as of the end of the U.S. taxable year, relying on the protection afforded by the applicable treaty.

Jeffrey L. Gould

Youngstein & Gould

London

July 28, 2022

FOOTNOTES

1 See, e.g., letter from the CFOs of 28 U.S. companies to U.S. Treasury Secretary Janet Yellen (June 3,2022).

2 For background concerning the “end of the foreign taxable year” rule, see Gould, “Treasury Must Reexamine the ‘End of the Foreign Taxable Year’ Rule,” Tax Notes Int’l, June 22, 2020, p. 1359.

3 AM 2008-005.

4 The power “to prescribe rules and regulations . . . is not the power to make law — for no such power can be delegated by Congress — but the power to adopt regulations to carry into effect the will of Congress as expressed by the statute.” Manhattan General Equipment Co. v. Commissioner, 56 S. Ct. 397 (1936).

5 See, e.g., United States v. Anderson, 46 S. Ct. 131 (1926).

END FOOTNOTES

United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income . . . the income tax paid or accrued to the” other treaty party (emphasis added).

The “law” of the United States is the statutory law and the U.S. Constitution, not federal regulations.4

The two-pronged test for accrual of a liability set out in reg. section 1.461-4(g) represents the accepted interpretation of the meaning of “accrued” as established by the accounting profession and in numerous court decisions.5 It seems possible that a U.S. expatriate adversely affected by the end of the foreign taxable year rule in respect of taxes payable to a U.S. treaty partner could claim accrual based on a reasonable estimate of his foreign tax liability as of the end of the U.S. taxable year, relying on the protection afforded by the applicable treaty.

Jeffrey L. Gould

Youngstein & Gould

London

July 28, 2022

FOOTNOTES

1 See, e.g., letter from the CFOs of 28 U.S. companies to U.S. Treasury Secretary Janet Yellen (June 3,

2022).

2 For background concerning the “end of the foreign taxable year” rule, see Gould, “Treasury Must

Reexamine the ‘End of the Foreign Taxable Year’ Rule,” Tax Notes Int’l, June 22, 2020, p. 1359.

3 AM 2008-005.

S. Ct. 397 (1936).

5 See, e.g., United States v. Anderson, 46 S. Ct. 131 (1926).

END FOOTNOTES

(C) Tax Analysts 2022. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.liability be determinable with reasonable accuracy. The regulations conclude with a statement of the end of the foreign taxable year rule — that foreign income taxes imposed on net income accrue in the U.S. tax year “with or within which” the foreign taxable year ends.

The preamble to the final regulations purports to address the criticism that the end of the foreign taxable year rule ignores the “reasonable accuracy” standard, stating that “an estimate does not meet the standard required by the all-events test to accrue a foreign tax expense.” This is patently untrue — to determine a liability with “reasonable accuracy” clearly contemplates the use of estimates. See, for example, Rev. Rul. 98-39, 1998-2 C.B. 198, which states that a liability can be accrued if it can be “reasonably estimated.” The preamble goes on to say that when the U.S. and foreign taxable year are not coterminous, an estimate of foreign tax liability for the portion of the foreign taxable year up to the U.S. year-end is inherently unreliable because “any number of events” could occur after the U.S. year-end that could affect the foreign liability — for example, a “large loss” could be incurred late in the foreign taxable year. A similar argument could be raised against the accrual of any expense when it is conceivable that post-year-end events could affect the liability, but this would read the “reasonable accuracy” standard out of the regulations.

The “end of the foreign taxable year” rule can have brutal consequences for an individual taxpayer.

Consider the case of Mr. X, a U.S. citizen with a calendar-year U.S. taxable year who has previously elected under IRC section 905(a) to claim credit for foreign income taxes in the year in which those taxes “accrued.” Mr. X becomes a U.K. resident on April 6, 2021, and commences to earn a large salary. U.K. income tax will be withheld from his salary at the rate of 45 percent.

While the U.K. tax on the 2021 income will be creditable against Mr. X’s U.S. tax for 2022, in the normal case that credit will be needed to offset U.S. tax on income earned by Mr. X during 2022.

There will therefore be no unused credit available to carry back to 2021, and the 85 percent liability will become permanent. This is true double taxation, the precise result that the FTC rules and the option to claim the accrual method are intended to prevent.

What makes the Treasury’s insistence on the end of the foreign taxable year rule perverse is that IRC section 905(c) provides that when an accrual of a foreign tax liability proves to be overstated, the taxpayer is obliged to amend the tax return to reduce the credit claimed and pay the additional U.S.

tax liability plus interest to the IRS. Thus, in the unlikely event of a large loss incurred late in the foreign taxable year or any other event after the U.S. taxable year-end that reduces accrued foreign tax, the government is fully protected.

Document generated for Jeffrey Gould