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Obama’s regulatory legacy lives on

David Forst and Adam Halpern of Fenwick & West look at the legacy left by the Obama administration’s regulations.


Donald Trump may now sit in the White House, but Barack Obama’s administration has left a long regulatory shadow

During the last four months of the Obama administration, the Treasury Department and IRS promulgated several major regulations affecting international transactions and operations. To a great extent, these regulations reflect the administration's legislative proposals – proposals that Congress refused to enact (or even seriously consider) during Obama's eight-year tenure.

More than mere administrative interpretations of existing law, these 11th-hour regulations impose significant regulatory burdens, tax increases, or both on US corporate taxpayers. Many were issued with retroactive effect. As such, these new rules raise significant questions about the scope of the executive branch's authority to change existing tax laws to the detriment of taxpayers. Under the United States Constitution, the power to write laws and the power to levy taxes are expressly reserved to the legislature.

Outbound property transfers – Section 367(a) and (d)

The Treasury and the IRS finalised without any substantive changes the § 367(a) and (d) regulations proposed in September 2015. The final regulations eliminate the favourable treatment for foreign goodwill and going concern value that had been in effect under the prior regulations for more than 30 years. Now, intangible property, including foreign goodwill and going concern value, cannot qualify for the active trade or business exception to § 367(a). The specific § 367(d) exception for foreign goodwill and going concern value has been eliminated. The final regulations apply retroactively to outbound transfers occurring on or after September 14 2015, the date the proposed rules were issued.

In forcing through this regulatory package, the Treasury and the IRS ignored the very clear legislative history, the relevant statutory language, numerous written comments, and testimony at the hearings. In the preamble to the final regulations, the Treasury and the IRS discussed and rejected virtually every taxpayer comment or suggestion regarding the proposed regulations.

The final regulations allow taxpayers to apply § 367(d) to certain property (including foreign goodwill and going concern value) that otherwise would be subject to § 367(a). If the election is not made and full gain is recognised in the year of transfer, the IRS reserves the right to make § 367(d)-equivalent periodic adjustments on audit.

The final regulations modify the long-standing 20-year cap on the useful life of § 367(d) intangible property. Taxpayers can elect to take into account § 367(d) inclusions only during the 20-year period, but income inclusions during that period must include amounts that, in the absence of the 20-year limitation, would have been included after the end of the 20-year period. It's difficult to see why anyone would make this election.

Transfers to controlled partnerships – Section 721(c)

Temporary regulations issued under § 721(c) address certain "outbound" transfers to partnerships. The regulations implement the rules announced in Notice 2015-54, 2015-34 I.R.B. 210 (the Notice), with certain changes. They are intended to ensure that, when a US person contributes certain property to a partnership with related foreign partners, the income or gain attributable to the appreciation in the property at the time of the contribution will be taken into account by the US transferor, either immediately or over time.

The temporary regulations apply to contributions of Section 721 Property, which generally consists of built-in gain property. The partnership must be a Section 721(c) partnership, i.e. a foreign person related to the US transferor must be a direct or indirect partner, and the US transferor and related persons must own (directly or indirectly) 80% or more of the partnership capital, profits, deductions, or losses.

When they apply, the temporary regulations turn off the general non-recognition rule of § 721(a). The US transferor must either recognise all of the built-in gain in the contributed Section 721(c) property, or elect to apply the gain deferral method set forth in the regulations. The gain deferral method requires the partnership to elect the "remedial" allocation method under § 704(c) with respect to the Section 721(c) property, thereby ensuring that the built-in gain will be recognised by the US transferor over time. Certain reporting requirements also apply. The remaining built-in gain can be accelerated if the rules are not fully complied with.

Debt-equity rules – Section 385

Treasury and the IRS also finalised the § 385 regulations and included certain of the § 385 rules in temporary regulations. At 518 pages, the final and temporary regulation package is a monster.

The big news internationally is that the regulations reserve on all aspects of their application to foreign debt issuers. Thus, they do not apply in an outbound context, such as when a US parent company makes a loan to its controlled foreign corporation (CFC), or when one CFC makes a loan to another CFC. It was this area of the proposed rules that caused the most problems from an international tax perspective. Foreign tax credits could have been lost and other serious collateral damage would have resulted.

The final § 385 regulations thus apply primarily to US subsidiaries of foreign corporations. For these US debt issuers, there are some significant changes from the proposed rules. The documentation requirements of Treas. Reg. § 1.385-2 will have a delayed effective date: they will apply to debt instruments issued (or treated as issued) on or after January 1 2018.

The blacklisted transactions rules of Treas. Reg. § 1.385-3 have been largely retained, including the per se funding rule causing a debt issued within three years of a distribution, stock acquisition, or certain reorganisations to be treated automatically as equity. The retroactive effective date of April 5 2016 is also retained for the blacklist rules.

However, the final regulations add several new exceptions, exclusions and limitations to the blacklist rules. Perhaps most importantly, the final regulations (i) expand the E&P exception to include all of the US issuer's E&P since the April 5 2016 effective date, and (ii) include an important new exception for ordinary course cash-pooling arrangements.

Section 956 partnership regulations

The Treasury and the IRS finalised the § 956 regulations relating to partnerships, largely as proposed in September 2015. The final anti-avoidance regulation is generally the same as the temporary rule. The anti-avoidance rules apply where a CFC funds a related foreign corporation by any means, including through capital contributions or debt, with a principal purpose of avoiding the application of § 956 to the funding CFC. The rules also can apply in a partnership context.

The Treasury and the IRS also finalised the various proposed rules on partnerships, Treas. Reg. § 1.956-4. Under one rule, a CFC partner is treated for § 956 purposes as holding its attributable share of partnership property, determined in accordance with the partner's liquidation-value percentage with respect to the partnership. Thus, for example, if the partnership makes a loan to a related US person, a CFC partner is treated as holding a percentage of the loan, resulting in a § 956 investment.

Another rule generally treats an obligation of a foreign partnership as an obligation of its partners for purposes of § 956. This is perhaps the most important part of the new § 956 partnership regulations. If a CFC lends to a foreign partnership in which the CFC's US parent company is a partner, the CFC will be treated as holding an obligation of a US person, again resulting in a § 956 investment. If the partnership distributes the borrowed funds to the US parent company, the amount of the § 956 investment can be increased.

Branch currency regulations – Section 987

The Treasury and the IRS finalised the 2006 proposed § 987 regulations, generally adopting the proposed regulations' substantive approach, with changes that at the margins reduce the proposed rules' complexity. The final rules remain exceedingly complex, and are likely to be challenged as they clearly contradict the statutory mandate in certain respects.

Section 987 contains two rules. The first rule provides that the owner of a branch using a non-dollar functional currency translates the branch income or loss into dollars using the average exchange rate for the year. The Treasury and the IRS chose not to follow the statutory rule in the final regulations. Instead, the final regulations require separate translations of amount realised, basis, and other income from local currency into dollars.

The second rule provides that when a branch using a different functional currency makes a remittance, proper adjustments must be made to account for currency fluctuations since the income was earned. The final regulations describe those "proper adjustments" in great detail. At a high level, the regulations require currency gain or loss on a remittance based on a running pool of unrecognised currency exchange exposure in the branch. The foreign exchange exposure pool (FEEP), reflects changes in the home office currency value of the branch's earnings and financial assets, but not its hard assets or interests in other entities.

When a branch experiences a "termination" it is deemed to have made a remittance of all of its assets and liabilities to the home office, resulting in full recognition of the currency gain or loss inherent in the FEEP. Certain transactions will unexpectedly give rise to a branch "termination" under the final regulations. Corporate taxpayers will need to be mindful of these rules once the final regulations become effective in 2018.

The final regulations also prescribe important transition rules for companies that need to switch from their current method of applying § 987 to the final rules.

Denial of foreign tax credits – Section 901(m)

The Treasury and the IRS issued temporary and proposed rules under § 901(m). Section 901(m) denies certain foreign tax credits following a covered asset acquisition (CAA). A CAA means a stock purchase for which a § 338 election is made, a "hybrid" transaction treated as an asset acquisition for US tax purposes only, certain acquisitions of partnership interests, and any similar transaction identified in regulations. Following a CAA, there will be a basis step-up for US tax purposes. Section 901(m) denies a portion of otherwise available foreign tax credits in a (misguided) attempt to neutralise the benefit of the basis step-up.

The temporary regulations codify the rules described in Notice 2014-44, 2014-32 I.R.B. 270, and Notice 2014-45, 2014-34 I.R.B. 388. These notices addressed the application of § 901(m) to dispositions of acquired assets (relevant foreign assets or RFAs) after a CAA.

The proposed regulations attempt to provide a more comprehensive set of rules governing § 901(m) issues. Like the other regulations described, the proposed § 901(m) rules are highly technical and detailed, and unfavourable to taxpayers. At a high level, they would (i) expand the scope of the term CAA by adding three new categories to the definition; (ii) define the scope of RFAs; (iii) provide rules for computing the disqualified portion of foreign taxes, (iv) provide rules for determining and allocating basis difference to taxable years, including a newly-invented aggregate basis difference carryover rule designed to maximise the amount of disallowed foreign tax credits; and (v) provide for certain de minimis exceptions.

Dividend equivalents – Section 871(m)

The Treasury and the IRS finalised the 2015 temporary and proposed § 871(m) regulations addressing the US taxation of foreign persons' income from certain dividend equivalent transactions, for example, a notional principal contract linked to dividends and share price of a particular US corporate stock. Notice 2016-42, 2016-29 IRB 67, provided guidance for complying with the final and temporary § 871(m) regulations in 2017 and 2018.

Consistent with the Notice, the final regulations apply to contracts with a delta of 1 (i.e. 100% of the contract value is determined by reference to the underlying securities) beginning in 2017 and to other applicable contracts beginning in 2018., Inc. v. Commissioner: Cost-sharing transfer pricing

In a major victory for the taxpayer, the Tax Court in, Inc. v. Commissioner, 148 T.C. No. 8 (2017) rejected the IRS's attempt to relitigate the same cost sharing transfer pricing issues the IRS lost in Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009). The IRS claimed that Amazon had undervalued the buy-in intangibles by more than $3 billion when it entered into a cost sharing arrangement (CSA) with its Luxembourg subsidiary.

The Tax Court held that Amazon's comparable uncontrolled transaction (CUT) methodology, not the IRS's discounted cash flow (DCF) methodology, produced the most reliable measure of an arm's-length price for the buy-in intangibles. The court stated that by definition, compensation for subsequently developed intangible property is not covered by the buy-in payment. Rather, it is covered by future cost sharing payments, whereby each participant pays its ratable share of ongoing intangible development costs (IDCs). It is unreasonable, the court concluded, to determine the buy-in payment by assuming that a third party, acting at arm's-length, would pay royalties in perpetuity for the use of short-lived assets.

The court stated that one does not need a PhD in economics to appreciate the essential similarity between the DCF methodology that the IRS's expert employed in Veritas and the DCF methodology that the IRS's new expert employed here. Both assumed that the preexisting intangibles transferred had a perpetual useful life; both determined the buy-in payment by valuing into perpetuity the cash flows supposedly attributable to these pre-existing intangibles; and both in effect treated the transfer of pre-existing intangibles as economically equivalent to the sale of an entire business.

The court held that an enterprise valuation of a business includes many items of value that are not intangibles. These include workforce in place, going concern value, goodwill, and what trial witnesses described as growth options and corporate resources or opportunities. The court rejected the Service's aggregation argument, just as it did in Veritas, ruling that aggregation did not yield a reasonable means, much less the most reliable means, of determining an arm's-length price.

The court also rejected the IRS's realistic alternatives argument. The IRS had asserted that Amazon US had a realistic alternative available to it, namely, continued ownership of all the intangibles in the United States. The Tax Court stated that it found this argument unpersuasive for many reasons. Whenever related parties enter into a CSA, they presumably have the realistic alternative of not entering into a CSA. This would make the cost sharing election, which the regulations explicitly make available to taxpayers, altogether meaningless.

Further, as noted in Veritas, the regulation enunciating the realistic alternatives principle also states that the IRS "will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance". Treas. Reg. § 1.482-1(f)(2)(ii)(A). Thus, even where a realistic alternative exists, the IRS is not supposed to restructure the transaction as if the alternative had been adopted by the taxpayer, so long as the taxpayer's actual structure has economic substance.

David Forst


Fenwick & West Tel: +1 650 335 7254

Fax: +1 650 938 5200

David Forst is a partner in the tax group of Fenwick & West. He is included in Euromoney's Guide to the World's Leading Tax Advisers. He is also included in Law and Business Research's International Who's Who of Corporate Tax Lawyers (for the last six years). David was named one of the top tax advisers in the western US by International Tax Review, is listed in Chambers USA America's Leading Lawyers for Business (2011-2016), and has been named a Northern California Super Lawyer in Tax by San Francisco Magazine.

David's practice focuses on international corporate and partnership taxation. He is a lecturer at Stanford Law School on international taxation. He is an editor of and regular contributor to the Journal of Taxation, where his publications have included articles on international joint ventures, international tax aspects of M&A, the dual consolidated loss regulations, and foreign currency issues. He is a regular contributor to the Journal of Passthrough Entities, where he writes a column on international issues. David is a frequent chair and speaker at tax conferences, including the NYU Tax Institute, the Tax Executives Institute, and the International Fiscal Association.

David graduated with an AB, cum laude, Phi Beta Kappa, from Princeton University's Woodrow Wilson School of Public and International Affairs, and received his JD, with distinction, from Stanford Law School.

Adam Halpern


Fenwick & West Tel: +1 650 335 7111

Adam Halpern is the chair of the tax group at Fenwick & West. His practice focuses on the US federal income taxation of international transactions, including Subpart F, foreign tax credits, transfer pricing, tax treaties, characterisation and source of income, inversions, and expense allocation. He regularly advises on the taxation of cross-border operations, acquisitions, dispositions, and restructurings. He has successfully represented clients in federal tax controversies at all levels, including audit, appeals, and litigation in the Tax Court and the Court of Federal Claims.

Adam is a lecturer in law at Stanford Law School, a co-lecturer at UC Berkeley Law School, and the 2013 Distinguished Adjunct Professor at Golden Gate University's masters in taxation programme, teaching classes in international tax. He is a frequent speaker at TEI, PLI and Bloomberg/BNA, among others.

Adam is recognised as a leading tax lawyer by Euromoney, International Tax Review and Chambers USA.

The Fenwick & West Tax Group has advised more than 100 Fortune 500 companies on tax matters, and has served as counsel in more than 150 large-corporate IRS appeals proceedings and more than 70 federal court tax cases. Fenwick has been named San Francisco Tax Firm of the Year eight times by International Tax Review and US Tax Litigation Firm of the Year three times.


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