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.