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By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
For most of this commentator's professional life, the IRS Chief Counsel's Office responsible for promulgating regulations and rulings has been "resource constrained" — they never have the people or the time to publish all the guidance that taxpayers wish they would. Since Chief Counsel's Office's reorganization of 20 years ago or so, many of the same people responsible for publishing guidance are also responsible for providing counsel to the field regarding potential litigation. Because of this, it is sometimes the case that a lack of upfront guidance ends up costing Chief Counsel's Office more time and effort on the back end — in advising the field regarding the development and prosecution of a case (or several cases). Like the auto transmission company's ads from years ago said, "You can pay me now, or you can pay me (more) later." Often, however, the IRS advice provided in a case is far less definitive than upfront guidance. A regulation plugging holes in statutory provisions would generally be followed by most taxpayers and have the force of law. An advice memo stating the Chief Counsel's views on how those holes should be plugged, on the contrary, is no more than a potential litigant's point of view.
An example of this problem is presented by the intersection of §199 and the ExtraTerritorial Income (ETI) regime.1 Had issues regarding the interaction and ordering of application of those provisions been addressed in regulations back in 2005-2006, questions now being raised in the field and making their way to the Chief Counsel's Office would be moot. Taxpayers and their advisors wouldn't have struggled to fill the gaps in the law themselves. The IRS field wouldn't now be struggling with whether taxpayers filled those gaps properly. Because there was no such upfront guidance, however, the Chief Counsel's Office is now compelled to devote resources to providing such guidance in a form far less persuasive than regulations. GLAM 2009-009 is such guidance. Given the result of this guidance, Chief Counsel's Office may well also be forced to devote resources to future litigation.
GLAM 2009-009 is a Chief Counsel generic legal advice memo signed by both the Associate Chief Counsel (International) and the Associate Chief Counsel (Passthroughs & Special Industries) and addressed to an LMSB Industry Director and an LMSB Area Counsel. It addresses several issues dealing with the intersection of §199 and the ETI regime.
Perhaps the most surprising aspect of the GLAM is that it purports to require taxpayers both to reduce the §199 deduction by the ETI exclusion and, at the same time, to reduce the ETI exclusion by the §199 deduction. Although the GLAM allows taxpayers to use "any reasonable method" to do this, it appears that this will require either simultaneous equations (solving for both the ETI exclusion and the §199 deduction at the same time using multiple variables) or what the GLAM calls "the iterative method (i.e., repeatedly re-determining the ETI exclusion and the §199 deduction until there is little or no variance in the ETI exclusion and the §199 deduction)." This is surprising, first, because there is nothing in the legislation, the legislative history, or the regulations that even hints that such a complicated and onerous computation is required. One would have thought that the outcry, years ago, over the promulgation of "CFC netting rule" regulations that required solving a simultaneous equation might have made the IRS more cautious in suggesting such complexity.
The GLAM is seemingly defensive about requiring what it calls "the simultaneous computation method" in that it cites Rev. Rul. 79-347 and Shell Oil v. Comr., 89 T.C. 371 (1987), as past examples where such a method was required. What the GLAM fails to cite, however, is Lastarmco v. Comr., 79 T.C. 810 (1982), a case that rejected the IRS's requirement of "simultaneous computations" in Rev. Rul. 79-347 and held instead that two deductions that both are percentages of taxable income but that modify taxable income must be ranked, one placed before the other. It seems odd, having had one Rev. Rul.-imposed simultaneous equation requirement rejected by the Tax Court, that the IRS would try again to impose, by non-regulatory guidance of even lesser authority than a Rev. Rul., a simultaneous equation requirement where an ordering rule would suffice.
The GLAM's conclusion is surprising, second, because it is far from clear that either the statute or the §199 regulations require that the §199 deduction be reduced by excluded ETI. Qualified production activities income (QPAI) under §199(c)(1) is domestic production gross receipts (DPGR) less allocable deductions. It is awkward to reduce DPGR by the amount of excluded ETI because excluded ETI is an amount of gross income whereas DPGR is an amount of gross receipts. If DPGR were to be reduced by excluded ETI, then the amount of the reduction to DPGR would need to be derived by determining the amount of excluded ETI attributable to DPGR and then grossing up that amount by the amount of its allocable COGS. Nothing in the statute, the legislative history, or the §199 regulations suggests that this is required or even correct. The GLAM attempts to finesse this technical and computationally complex impediment by first explaining that QPAI "includes" gross income attributable to DPGR and then stating:
To the extent QPAI includes a taxpayer's gross income attributable to FTGR [foreign trading gross receipts], a taxpayer's ETI exclusion attributable to the same transactions (or other permitted basis) that generates DPGR should be excluded from QPAI because the ETI exclusion is an exclusion from gross income under [former] §114(a).
Further, the IRS has indicated that gross receipts attributable to tax-exempt interest income should be included in DPGR. Regs. §1.199-3(c), which defines the term "gross receipts" for purposes of computing DPGR, states that gross receipts includes tax-exempt interest. It seems inconsistent for the IRS to require that gross receipts attributable to tax-exempt interest be included in DPGR while at the same time requiring that gross receipts attributable to excluded ETI be excluded from DPGR.
Finally, the Senate version of §199 provided that gross receipts attributable to ETI excluded from gross income pursuant to the ETI's repeal binding contract rule were to be excluded from DPGR. This exclusion, however, was not in the final version of §199 as enacted. Nor is there any indication in legislative history that, despite its omission, Congress thought it appropriate for the IRS to restore the exclusion by regulation or other guidance, like the GLAM. Indeed, one might assume Congress made an explicit decision to not provide for such an exclusion.
Had the IRS promulgated the guidance now provided by the GLAM in regulations back in 2005 or 2006, there would have been a good deal of complaining and some claims that such regulations were invalid, but most taxpayers would probably have followed them. Now, however, taxpayers have filed returns almost certainly not following the GLAM. Because of the GLAM, IRS examiners around the country will be setting up adjustments for such taxpayers. Because the GLAM has much less authority than a regulation, and some of the conclusions of the GLAM are questionable under the statute and the regulations, it would not be surprising if many taxpayers choose not to acquiesce to such adjustments. Particularly as this issue might well be litigated, the total resources committed by the IRS to this issue are likely to far exceed the resources that would have been consumed in writing a regulation. And the resources committed by taxpayers, first in deciding how to comply back in 2005 and 2006, and now in fighting the IRS, will be enormous where they should have been minimal. This is not how our tax system should work.
This commentary also will appear in the February 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Benko and Glover, 510 T.M., Section 199: Deduction Relating to Income Attributable to Domestic Production Activities, and Thompson and Zuraff, 934 T.M., Export Tax Incentives, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.
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