Stephen Shay (Boston College; Google Scholar) presents Applying Section 265 to Address an Opaque Foreign Income Subsidy virtually at Boston College today as part of its Tax Policy Workshop Series hosted by Shu-Yi Oei, Jim Repetti, and Diane Ring:
This article considers whether gross income offset by deductions whose sole object is to exempt foreign income from U.S. tax (exemptive deductions), is a class of income wholly exempt from taxes for purposes of the deduction disallowance rule of Section 265(a)(1). The better analysis of the statute and regulation is that deductions (other than an exemptive deduction) allocable to income offset by an exemptive deduction are subject to disallowance under existing Code Section 265(a)(1). Allowing a U.S. shareholder deductions for expenses allocable to foreign income offset by an exemptive deduction would be an opaque subsidy for foreign investment. If permitted, the subsidy would advantage multinational over domestic businesses, shareholders over workers, and high income and foreign investors over other taxpayers.
There is a possible alternative interpretation of the regulation that would limit application of Section 265(a)(1). Adopting a notice and comment regulation amendment confirming the application of Section 265 to income offset by an exemptive deduction would reasonably interpret the statute, offer stakeholders the opportunity to make contrary views known, and mitigate the burdens of potential litigation on taxpayers and the Government. Because exemptive deductions are a recently adopted and novel feature of the income tax law and application of Section 265 may be underappreciated by taxpayers, the IRS may consider exercising its discretion to make a regulatory amendment prospective in application. If, contrary to the analysis in this article, a court concluded that existing Section 265 cannot apply, or, if Congress disagrees with the regulatory interpretation, legislation would remain an available tool.
It would be possible, of course, to propose a legislative clarification of Section 265. Whether the legislative proposal would have a budgetary effect would depend on how the Staff of the Joint Committee on Taxation interprets the statute and existing regulation. Under the analysis in this article, the Treasury has authority to adopt a regulation incorporating a reasonable interpretation of the statute, as proposed in this article, irrespective of whether a legislative clarification were enacted and irrespective of whether the legislative proposal were considered to have a budgetary effect.
The contributions of the article are to identify and make salient the expense disallowance issue, to illuminate its revenue importance, and to show how different legal avenues, including statutory interpretation, regulation, legislation and their combinations, are available to address the issue in a divided and partisan U.S. political environment. Although the article’s analysis is solely in relation to the U.S. tax system, the treatment of allocable expenses is relevant as well to multilateral international consideration of a global minimum tax