Section 78 Reg Challenge May Be Dropped

The U.S. government may have avoided a challenge to a controversial section 78 regulation by issuing the taxpayer a refund. In Kyocera, 1 the taxpayer challenged the validity of a regulation purporting to deny domestic corporations a deduction for section 78 dividends deemed received from their fiscal-year foreign subsidiaries between January 1, 2018, and the end of the subsidiaries' first tax year ending after December 31, 2017.2

Kyocera has received a refund, which, according to the government's April 25 filing, renders the case moot.

The case involves a quirk in the effective date of a statutory amendment and the validity of the Treasury Department's attempt to "fix" that quirk via a regulation. Before enactment of the Tax Cuts and Jobs Act, section 78 treated the gross-up for deemed paid foreign taxes as a dividend; taxpayers receiving a foreign tax credit were deemed to have received the income that was paid over to the foreign government in taxes. The TCJA amended section 78 to deny dividend treatment for the gross-up for purposes of the dividends received deductions under sections 245 and 245A, so as to deny taxpayers a deduction for credited taxes.

The amendment, however, was applicable "to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of United States shareholders in which or with which such taxable years of foreign corporations end."3 Thus, shareholders of fiscal-year foreign corporations appeared to be able to deduct deemed dividends of creditable tax. Reg. section 1.78-1 purported to change the effective date so that the denial of a deduction applied to "section 78 dividends that are received after December 31, 2017, by reason of taxes deemed paid under section 960(a) with respect to a taxable year of a foreign corporation beginning before January 1, 2018."

Kyocera's complaint alleges that the regulation is invalid because it "contradicts the clear and unequivocal statutory effective date." Issuing the taxpayer a refund may have protected the IRS from an adverse ruling on the regulation's validity.

Proposed Section 367(d) Regulations

New proposed regulations may offer some relief and clarity to taxpayers who transfer intangible property back to the United States after transferring it out of the United States in a transaction to which section 367(d) applies. The proposed regulations (REG-124064-19), published May 3, terminate the continued application of section 367(d) when a transferee foreign corporation repatriates the IP to a "qualified domestic person" and certain reporting requirements are met.

A qualified domestic person generally is the U.S. transferor or a U.S. person that is a successor to, or related to, the U.S. transferor.

Section 367(d) generally requires a U.S. transferor of IP to a foreign corporation pursuant to a transaction described in section 351 or 361 to be treated as having sold the IP in exchange for payments that are contingent upon the productivity, use, or disposition of the property. Under current law, repatriations of that property do not result in termination of those payments, which ordinarily continue annually for the useful life of the property. The result can be that after repatriation, the owner of the IP is taxed in the United States on the income generated by the property, and the original U.S. transferor is taxed on the payments required to be received under section 367(d). If the owner of the IP is in the same consolidated group as the U.S. transferor, this double taxation can sometimes be eliminated via a ruling under reg. section 1.1502-13(c)(6)(ii)(D).

The proposed regulations are in line with LTR 202107011 (released Feb. 19, 2021), which was issued under reg. section 1.1502-13(c)(6)(ii)(D) and led to the same result; the background file with the details of the facts for the ruling was made public in June 2022.

The proposed regulations would eliminate the need for such rulings and would provide relief in situations in which a ruling would be unavailable under current law. The proposed regulations are intended to be effective for repatriations occurring after the date that the proposed regulations are finalized.

Perrigo Transfer Pricing Settlement

The U.S. competent authority has agreed to withdraw $843 million in tax adjustments and penalties relating to royalty payments for IP rights, Perrigo Co. PLC announced in an April 25 SEC filing. The IRS had proposed the adjustments and penalties in notices of proposed adjustments (NOPAs) for Perrigo's 2011-2013 tax years. The NOPAs claimed the company should have paid a substantially higher royalty rate for the right to exploit IP in various developmental products, including the immunosuppressive drug Tysabri.

The U.S. competent authority agreed to fully withdraw the adjustments proposed by IRS Exam and considers the case closed, Perrigo announced in its Form 8-K. Perrigo stated that it believes that any prior uncertainty regarding the tax treatment of the royalty is resolved. The company filed its requests with the Advanced Pricing and Mutual Agreement Program (APMA) and the Irish Revenue in April 2020.

Perrigo announced the resolution of another international tax controversy on May 9. The settlement agreement concerned proposed reductions of Perrigo U.S.'s interest expense deductions for $7.5 billion in intercompany debts incurred as part of Perrigo's 2013 Irish inversion. The agreement resolves a 2020 NOPA that included a downward adjustment of gross interest expenses of over $400 million for 2014 and 2015. The agreement provides "for settlement of the May 7, 2020, NOPA of $153.4 million of gross interest expense reduction for the 2013-2015 tax years."

Rawat Partnership Case

A foreign partner is subject to U.S. tax on the portion of her gain from the sale of a partnership interest that is attributable to U.S.-source inventory gain, the Tax Court held in Rawat. 4

The court determined under section 751(a)(2) that the portion of the gain attributable to inventory items may be U.S.-source income under section 865(b). The court denied Indu Rawat's motion for summary judgment, which contended that a nonresident individual is not subject to U.S. income tax on the sale of the individual's interest in a U.S. partnership because those gains would be sourced outside the United States under the general rule of section 865(a)(2), regardless of whether any portion of the gains would be attributable to inventory items under section 751(a)(2).

Rawat's motion relied on Grecian Magnesite, 5 in which a district court held that, as a general rule, the asset to be considered in the sourcing analysis is the partnership interest itself (which is the subject of the sale) and not the underlying partnership assets. The Tax Court held that section 751(a)(2) provides a special rule that trumps the general rule of section 865(a)(2).

The partnership in Rawat, Innovation Ventures LLC, manufactures and sells consumer products, including 5-Hour Energy drinks. Rawat sold her 30 percent partnership interest to another individual for $438 million. It was undisputed that at the time of the sale, the partnership had inventory items worth $6.5 million with a basis of $6.4 million that it held for future sale.

The record did not show whether the inventory would be sold within or without the United States; for purposes of deciding the summary judgment motion, the court assumed that all the inventory was for sale in the United States and thus U.S.-source income.

The court stated that under section 741, the gain or loss "shall be considered as gain or loss from the sale or exchange of a capital asset" — but section 741 immediately provides "except as otherwise provided in section 751 (relating to . . . inventory items)." Section 751(a)(2) provides that inventory items of the partnership are considered as an amount realized from the sale or exchange of property other than a capital asset.

Rawat asserted that she did not sell inventory but instead an interest in a partnership that owned inventory. She argued that under section 741, her partnership interest was a singular "capital asset" and that she is taxable under section 871(b)(2) only on income that is "effectively connected with the conduct of a trade or business within the United States." Under section 864(c)(3), "all income, gain, or loss from sources within the United States . . . shall be treated as effectively connected," while under section 864(c)(4)(A), "no income . . . from sources without the United States shall be treated as effectively connected." And under section 865(a)(2), "income from the sale of personal property [such as a partnership interest] . . . by a nonresident [such as Rawat] shall be sourced outside the United States."

The commissioner argued, and the court agreed, that the general approach of section 741, which calls for the sold partnership interest to be analyzed not asset by asset but rather as a singular "capital asset," gives way to the specific provision in section 751(a)(2) that the portion of the sold partnership interest attributable to inventory items must be separately "considered" as pertaining to "other than a capital asset."

Rawat argued that this makes an unwarranted use of section 751. She noted that the issue is the source (U.S. or non-U.S.) of the proceeds, and she asserted that "section 751 is not a sourcing rule." In her view, the effect of section 751, where it applies, is to ensure that the proceeds of a sale will take on the character (noncapital) of "property other than a capital asset" and will therefore be taxed — if at all — as ordinary income, not capital gain. The court stated that both sections 741 and 751 are provisions that define the character of the property sold and of its proceeds, to which the sourcing rules must then be applied.

The court stated that section 741, by its own terms, does not apply to the "inventory items" portion addressed by section 751, to which section 741 yields. The singular "capital asset" treatment of section 741 is thus partially disaggregated by section 751.

IRS Firm on Cryptocurrency as Property

Two years after El Salvador adopted bitcoin as legal tender, the IRS has revised the background section of a 2014 notice to concede that "[i]n certain contexts, virtual currency may serve one or more of the functions of 'real' currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance."

However, Notice 2023-34, 2023-19 IRB 1, published on April 24, did not change the IRS position that virtual currency is treated as property for U.S. federal tax purposes, that transactions using virtual currency must be reported in U.S. dollars, and that a taxpayer realizes gain or loss on the disposition of virtual currency. In fact, Notice 2023-34 appears to be simply an assertion that although one underlying fact has changed regarding the use of virtual currency, the treatment of virtual currency under U.S. tax law remains unchanged from the guidance published in Notice 2014-21, 2014-16 IRB 938.

NII Tax Application

A U.S. district court denied the government's motion to dismiss a taxpayer's claim that the net investment income tax is a supplemental tax covered under a totalization agreement, which is an agreement for avoiding double taxation with respect to social security taxes. In Kim, 6 the court said it needed to see evidence regarding the drafting history of the totalization agreement between the United States and South Korea, information about the negotiation of that agreement, the parties' shared expectations regarding its effect, and expert testimony and/or amicus briefs.

The court's March 28 opinion, however, states that "the language of the Totalization Agreement lends strong support for the conclusion that the Contracting States' shared understanding was that a future law such as Chapter 2A [the net investment income tax] would not apply as a supplement within the meaning of the Totalization Agreement."7

Court Declines to Extend Mann's Scope

IRS guidance declaring certain trust arrangements to be "listed transactions" subject to special reporting and penalty provisions may continue to apply in most of the United States despite a Sixth Circuit ruling that the guidance violated the Administrative Procedure Act.

The U.S. District Court for the District of New Jersey on April 24 granted the government's motion to dismiss a suit seeking declaratory judgment that the Sixth Circuit's ruling applied to the New Jersey plaintiffs. The order, in Oom Inc., 8 came one month after a U.S. district court in Arizona held that the Sixth Circuit's opinion in Mann Construction, 9 and a subsequent vacatur order on remand to the trial court in the U.S. District Court for the Eastern District of Michigan did not invalidate Notice 2007-83, 2007-45 IRB 960, nationwide.10

APA Process Update

On May 1 the IRS released interim guidelines in the form of a memorandum (LB&I-04-0423- 0006) dated April 25 about the APMA program's internal review and acceptance of advance pricing agreements. These guidelines are effective immediately. Updates to Rev. Proc. 2015-41, 2015- 35 IRB 263, that detail the requirements for an APA submission, including bilateral APAs (BAPAs), are expected soon based on comments made by IRS representatives.

The memo states that its purpose is not to provide substantive changes, but to boost early identification of potential roadblocks to successfully concluding a proposed APA and potential opportunities for other paths to certainty, such as the International Compliance Assurance Program (ICAP) or a joint audit. APMA is directed to weed out earlier in the process any taxpayers that are unlikely to get an APA resolution based on the facts at issue. Therefore, the guidelines appear to be an avenue for taxpayers to be directed away from APAs/ BAPAs and to ICAP.

The memo first focuses on the optional presubmission review and states that APMA should give a preliminary opinion on whether the taxpayer should proceed with the APA process. The memo states that this is required to be done within four weeks of the prefiling memo submission or submission of additionally requested information.

The memo outlines factors that the APMA should consider during its analysis, including:

  • the significance of the transaction;
  • whether there is a high probability that transfer pricing compliance will be significantly enhanced by engaging with the treaty partner;
  • whether there is a potential for the APA to affect prior tax years; and
  • whether ICAP participation, transfer pricing practice examination, or a joint audit, are instead suitable resolutions.

Whether the proposed APA transactions are suitable for resolution through ICAP is evaluated based on factors that include:

  • the scope, materiality, and complexity of the multinational enterprise group's covered transactions in the United States and the jurisdictions participating in ICAP;
  • the MNE group's history of transparent and cooperative engagement with the IRS;
  • the MNE group's examination history regarding transfer pricing and permanent establishment issues with the IRS; and
  • the anticipated availability of third-party risk assessment resources necessary to perform the ICAP risk assessment.

The memo further provides that a similar analysis is also required once the full APA application is submitted. The additional factors to be considered during the full submission include:

  • whether there is an actual or potential transfer pricing dispute that would be most efficiently resolved through an APA based on the APMA's experience (considering the taxpayer's proposed transfer pricing method and examination history in the United States or in the foreign jurisdiction);
  • if the APA will cover prospective years;
  • country-specific strategy considerations;
  • whether the APMA can develop the facts and obtain reliable financial data; and
  • input of the treaty jurisdiction regarding the APA.

The memo provides that the full submission review and acceptance process should be completed within eight weeks of submitting the application.

IRS Releases Practice Units

New IRS practice units describe the application of the interest expense deduction limitation rules of section 163(j) as applied to controlled foreign corporations and the interest expense limitation on related foreign party loans under section 267(a)(3).

There are helpful charts in the section 163(j) practice unit; one compares the 2018 proposed regulations to the 2020 proposed regulations and the 2021 final regulations; and another compares 2020 proposed regulations to the 2021 final regulations. For example, the first chart notes that in the final regulations, there is a single limitation calculation for the CFC group. A taxpayer can calculate the limitation separately for each CFC or make a CFC group election to calculate one aggregated limitation for all members in the CFC group. The election applies to each specified group member for its entire specified tax year that ends with or within the specified period. Each designated U.S. person must file a CFC group election statement with their return detailing the CFCs included and their specified tax years. If an election is terminated, then there is a 60-month waiting period to reelect a new CFC group.

The section 163(j) practice unit also provides examples of how the CFC group election is made and how it would apply to six fact patterns.

The section 267(a)(3) practice unit includes a lengthy discussion of situations in which a circular cash flow results in no interest payment being made (and thus no interest expense deduction being available) for U.S. tax purposes.


1. Kyocera AVX Components Corp. v. United States, No. 6:22-cv-02440.

2. For prior coverage, see James P. Fuller and Larissa Neumann, "U.S. Tax Review," Tax Notes Int'l, Jan. 7, 2019, p. 35; and Fuller and Neumann, "U.S. Tax Review," Tax Notes Int'l, Aug. 19, 2019, p. 681.

3. TCJA (P.L. 115-97), section 14223(d).

4. Rawat v. Commissioner, T.C. Memo. 2023-14.

5. Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, 926 F.3d 819 (D.C. Cir. 2019) aff'g 149 T.C. 63 (2017).

6. Paul Young Kim v. United States, No. 5:22-cv-00691 (C.D. Cal. 2023).

7. For prior coverage of claims of treaty benefits with respect to the NII, see Fuller, Neumann, and Julia Ushakova-Stein, "U.S. Tax Review: International Tax Reform Proposals and FTC Guidance," Tax Notes Int'l, Oct. 4, 2021, p. 19.

8. Oom Inc. v. United States, No. 2:22-cv-02762 (D.N.J. 2023).

9. Mann Construction Inc. v. United States, 27 F.4th 1138 (6th Cir. 2022).

10. Govig & Associates Inc. v. United States, No. 2:22-cv-00579 (D. Ariz. 2023). For prior coverage, see Neumann, Ushakova-Stein, and Mike Knobler, "U.S. Tax Review: Annual APA Report; Corporate AMT; and Recent Developments in FedEx, Moore, Mann, Farhy, and Coca-Cola," Tax Notes Int'l, May 1, 2023, p. 589.

Originally published by Tax Notes International.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.