Addressing an Opaque Foreign Income Subsidy With Expense Disallowance

I. Introduction

This report considers whether income offset by deductions whose object is to exempt foreign income from U.S. tax is a class of income wholly exempt from taxes for purposes of the deduction disallowance rule of section 265(a)(1). From a normative perspective, the disallowance of deductions for expenditures to earn untaxed income is fundamental to achieving a tax on net income that measures ability to pay. Net income representing a change in taxpayer wealth will be mismeasured if expenses allocable to exempt income are allowed to offset other income instead of being disallowed. If deductions are to be allowed, the distortion of net income should be justified.

The issue arises under current law from the adoption of two deductions in the Tax Cuts and Jobs Act whose object is to exempt specific foreign income from the federal income tax.¹ The deductions exempt 50 percent of a global intangible low-taxed income inclusion (subject to a taxable income limit) and 100 percent of the foreign-source portion of a dividend (the exemptive deductions).² These deductions are not equivalent to rate reductions applied to a category of taxable income, because they apply before other deductions and do not thereby limit the benefit of those deductions to the lower tax rate.³ Unlike other business deductions, these deductions are fundamentally exemptive in nature and do not have a measurement-of-income objective.⁴ The better analysis of the section 265(a)(1) statutory language is that deductions (other than the exemptive deduction) allocable to income offset by an exemptive deduction are subject to disallowance under existing section 265(a)(1).

Allowing U.S. shareholder deductions allocable to exempt foreign income earned through a controlled foreign corporation would be an opaque subsidy for foreign investment. That subsidy would advantage multinational over domestic businesses, shareholders over workers, and high-income and foreign investors over other taxpayers. To disable the operation of section 265(a)(1), there should be evidence in the statute or legislative history that Congress intended that its disallowance rule not apply. That evidence is lacking, while there is clear evidence that Congress intended for the income to be untaxed.

Regulations under section 265 do not directly address the treatment of income offset by exemptive deductions. The relevant regulation adopts a meaning for “class of income wholly exempt from . . . taxes” that is narrower than the statute, presenting the interpretative question whether the meaning used in the regulation is exclusive.⁵ The regulation states that “a class of income wholly exempt from . . . taxes . . . includes any class of income which is (i) Wholly excluded from gross income . . . or (ii) Wholly exempt from taxes.” (Emphasis added.) While a contrary reading is possible, as explained below, the regulation’s use of the term “includes” indicates that it is intended to be nonexclusive.

The analysis in this report demonstrates that if reg. section 1.265-1(b) were interpreted by the IRS to be the exclusive meaning, and assuming the courts either agreed with or deferred to the agency interpretation, the IRS still could validly amend its regulation to adopt an interpretation that would cause section 265 to apply to income offset by an exemptive deduction.

Adopting a notice and comment regulation applying section 265 to income offset by an exemptive deduction would reasonably interpret the statute, offer stakeholders the opportunity for criticism, and mitigate the burdens of potential litigation on taxpayers and the government. Because exemptive deductions are a novel feature of the income tax law and the proper application of section 265 may be underappreciated by taxpayers, the IRS could exercise its discretion to make a regulatory amendment prospective. Such an exercise of discretion would not be required, and the interpretation could apply from the effective dates of the exemptive deductions.

The alternative of seeking legislation clarifying the application of section 265 to income offset by exemptive deductions is available but not required. Legislation would be available, if, contrary to the analysis in this report, a court were to conclude that section 265(a)(1) cannot apply and find a confirming regulation invalid. Moreover, Congress can legislate if it disagrees with an interpretation adopted by regulation.⁶

Treasury’s fiscal 2022 revenue proposals include amending section 265 to disallow deductions allocable to a class of foreign gross income that is exempt from tax or taxed at a preferential rate through a deduction. The proposal states that no inference should be drawn regarding current law.⁷ 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 the existing regulation. If the JCT agrees with the analysis in this report, revenue from expense disallowance could be included in baseline revenue subject to adjustment for taxpayer practice and whether the IRS enforces the interpretation. If the JCT disagreed, a legislative clarification would increase revenue. Under the analysis in this report, Treasury has authority to adopt a regulation incorporating a reasonable interpretation of the statute, as proposed in this report, regardless of whether the proposed legislative clarification is adopted and whether or not the legislative proposal is considered to have a budgetary effect.

This report is intended to identify the expense disallowance issue and its structural importance in an income tax. The article illuminates the revenue significance of the expense disallowance issue and shows how different legal avenues — including statutory interpretation, regulation, legislation, and their combinations — are available to address it.

II. Exemptive Deductions and Section 265

A. Objectives of an Income Tax

The primary objective of the U.S. federal income tax is to raise revenue to fund government expenditures for public goods and services appropriated by a democratically elected Congress.⁸ Federal expenditures include those for internal and external security, for a reasonable social safety net to achieve social welfare objectives, and for any other congressionally approved purpose. The United States relies more than its peer countries on the income tax as a principal source of federal revenue.⁹

The U.S. income tax is imposed on net income as an appropriate measure of a taxpayer’s ability to pay.¹⁰ Net income is determined by reducing gross income by the deductions related to that income.¹¹ The resulting net income (or loss) reflects the taxpayer’s increased (or decreased) capacity to consume or invest.¹² If deductions in relation to gross income are understated, there is excessive income taxation. If deductions are overstated, taxable income is understated, resulting in undertaxation.¹³

When taxable income must be determined for an advantaged subset of gross income, such as foreign-source taxable income eligible for a foreign tax credit or income exempt from tax, the usual incentives are reversed. If deductions in relation to foreign-source income or exempted income are understated, U.S. tax will be understated if more foreign taxes are allowed as a credit or if deductions are allowed to offset nonexempt income. If deductions against foreign or exempt income are overstated, U.S. tax will be overstated if credits or deductions appropriately allowed are disallowed.

This report deals with the treatment of deductions allocable to income that is not taxed, in this case because of exemptive deductions. Section 265(a)(1) addresses the issue with a general rule that deductions “allocable” to a class of income “wholly exempt from . . . taxes” shall not be allowed. The reason for the general rule of section 265 is straightforward and may be seen in Example 1.

Example 1: If Corp. A has gross income of $100 and allocable business expenses of $25, its taxable income is $75, and its tax at 21 percent is $15.75. If the taxable income is exempt, the taxpayer saves the $15.75 tax otherwise due.

If the $25 of expense is allowed as a deduction and offsets other income, the taxpayer effectively is refunded the tax on income offset by the deduction, or $5.25 (21 percent * $25 = $5.25). Instead of benefiting from the exemption by $15.75, the taxpayer’s benefit is $21 ($15.75 + $5.25 = $21).

The principle underlying section 265 is that the benefit from exempting income should not exceed the tax on the income. The tax is imposed on the gross income after it is reduced by allocable deductions (in Example 1, the tax of $15.25 on net income of $75). Under this structure, exemption of income does not affect the distribution of tax burden according to level of net income.

If deductions allocable to exempt income are allowed such that exemption applies to gross income, the benefit of exemption ($15.25 in Example 1) will be increased to $21. In a business income context, exemption of gross instead of net income will be more beneficial for businesses with more deductions and lower margins than for businesses with fewer deductions and higher margins. It is difficult to reconcile this discrimination among taxpayers with rational policy.

Another way to describe the principle of section 265 is that a deduction should not give rise to a double benefit.¹⁴ A deduction for an expenditure to generate income that is exempted should not also be allowed to offset other income. That would be using the deduction twice. If this is allowed as a general matter, a taxpayer could increase its expenditures to earn the exempted income and thereby erode the nonexempt tax base. Accordingly, a limit is necessary to protect the income tax base.¹⁵

In the TCJA, Congress adopted a form of partial territorial taxation known as foreign dividend exemption. The section 245A deduction eliminates the U.S. tax on the foreign portion of a dividend from a foreign corporation. Similarly, a GILTI deduction offsets 50 percent (declining to 37.5 percent in 2026) of a GILTI inclusion.¹⁶ Both exemptive deductions apply without regard to whether the underlying earnings have been previously taxed by the United States or, indeed, taxed — or even subject to tax — by any foreign country. The deductions are not based on an expenditure by the taxpayer and serve no separate measurement-of-income purpose. To the extent of the exemptive deduction, the United States is declining to assert its taxing jurisdiction over the foreign earnings.¹⁷

There has been little discussion whether U.S. shareholder expenses (other than the exemptive deduction) allocable to a foreign dividend or the portion of a GILTI inclusion offset by an exemptive deduction should be allowed to the shareholder as a deduction. Allowing a U.S. shareholder’s deductions allocable to the income offset by an exemptive deduction would be inconsistent with the basic principle that deductions allocable to exempted income should not be allowed.¹⁸ It has been widely accepted that deductions allocable to exempt income in an exemption regime should be disallowed (or an equivalent adjustment should be made to limit the exemption).¹⁹ While this normative conclusion is clear, this report focuses on the analysis of section 265 and the exemptive deductions under the code.

Before turning to the relevant statutory background and considering whether section 265 applies to gross income offset by exemptive deductions, to motivate analysis of the disallowance issue, the next section considers the revenue implications of not disallowing deductions allocable to a U.S. shareholder’s income offset by an exemptive deduction.

B. Scale of the Exemptive Deduction Issue

The effect of not disallowing under section 265 U.S. shareholder deductions allocable to a U.S. shareholder’s income offset by an exemptive deduction may be seen in Example 2.

Example 2: Assume that USP, a U.S. corporation, owns all the stock of CFC, its only foreign subsidiary. CFC has $500 of taxable income for the year that is not subpart F income and is not GILTI (for example, because USP’s net deemed tangible income return for the year exceeds $500, so there is no GILTI inclusion). CFC pays a dividend of $250 at the end of the year. USP has $750 of U.S.-source gross income; $250 of foreign-source dividend income eligible for a section 245A exemptive deduction; and $450 of expense, of which $50 would be stewardship expense allocable to a dividend on CFC stock.²⁰

USP’s gross income is $1,000, and its deductions are a section 245A deduction of $250 and other deductions of $450, including $50 allocable to the foreign dividend. USP’s taxable income is $300 ($1,000 - $250 - $450 = $300), and USP pays U.S. tax of $63 (21 percent * $300 = $63).

The 245A deduction of $250 reduces U.S. tax by $52.50 ($250 * 21 percent = $52.50). But the foreign-source taxable income is $200 ($250 - $50 = $200). The U.S. tax saved by exempting the net income of $200 would be $42 ($200 * 21 percent = $42). The additional $10.50 of tax saved is attributable to allowing the deduction of $50 to reduce U.S. tax on other income, which is more than the tax that would be saved by exempting the gross income net of deductions. From a U.S. perspective, the effective marginal tax rate on the investment giving rise to the deemed tangible income return is negative.²¹

Some simple metrics suggest the scale of the issue from a revenue perspective. If 10 percent of CFC earnings is subpart F income²² and 25 percent of CFC earnings is equal to a 10 percent return on net deemed tangible investment return (NDTIR), the remaining 65 percent of CFC earnings and profits would be GILTI. The total earnings offset by exemptive deductions would be 57.5 percent of total earnings (half of GILTI or 32.5 percent of earnings plus 25 percent of earnings that are NDTIR). If it is assumed that expenses allocable to income from CFCs are equal to approximately 20 percent of total CFC earnings, disallowed expenses would be 10.4 percent of total CFC earnings.²³ At 21 percent, the marginal tax rate benefit to taxpayers of not disallowing allocable deductions would be approximately 2.17 percent of total CFC earnings.

Table 1

Inputs
Row	Description
1	CFC total earnings less deficits	100%
2	Subpart F and other exceptions	-10%
3	CFC net tested earnings	90%
4	NDTIR 10% return less CFC interest expense	-25%
5	GILTI	65%
6	U.S. shareholder expenses allocable to total CFC earnings	20%
Marginal Tax Rate Benefit of Allowing Expenses Allocable to Exempted Income
7	50% * GILTI	32.5%
8	NDTIR 10% return less CFC interest expense	-25%
9	Exempt income	57.5%
10	U.S. expenses allocable to exempt income	10.4%
11	U.S. pre-credit tax rate on CFC net tested earnings without section 265	3.05%
12	U.S. pre-credit tax rate of CFC net tested earnings applying section 265	5.22%
13	Marginal tax rate benefit of not applying section 265	2.17%

This table is reproduced at Appendix A with explanatory comments.²⁴

Under this model’s assumptions, the U.S. pre-credit effective tax rate on CFC net tested earnings without applying section 265 would be 3.05 percent. (In other words, the effective U.S. tax on the CFC net tested earnings assuming the level of exemptive deductions in the facts would be 3.05 percent absent the application of section 265.) After applying section 265, the effective tax rate on CFC net tested earnings would be 5.22 percent. The tax rate effect of applying section 265 is 2.17 percent of net tested income. This rate would approximate an average for all CFCs and would, of course, vary for each company depending on its facts. Under a range of reasonable assumptions, however, the amounts at stake would be material, possibly in the range of $5 billion to $10 billion a year, or $50 billion to $100 billion over a 10-year budget period.

The application of section 265 to income offset by exemptive deductions would prevent the overstatement of allowable deductions that would result from failing to disallow expenses allocable to income that bears no U.S. tax because of the exemptive deductions. Allowing deductions allocable to untaxed income essentially refunds U.S. tax on other income, which subsidizes the investment made to earn the exempted income. There is no indication in the TCJA’s legislative history that this subsidy (from allowing deductions allocable to exempt income) is intended.²⁵

The next section provides relevant statutory background on the exemptive deductions before analyzing in Section III whether section 265 applies to income offset by exemptive deductions.

C. Statutory and Regulatory Background

1. The GILTI exemptive deduction.

Section 951A requires a U.S. shareholder of a CFC to currently include GILTI in income.²⁶ A U.S. shareholder that is a domestic corporation is allowed a deduction for 50 percent of the sum of the GILTI amount and the section 78 dividend attributable to it.²⁷ This report refers to this 50 percent deduction against GILTI as the GILTI exemptive deduction. The section 250 GILTI deduction combined with the section 250 foreign-derived intangible income deduction is subject to a taxable income limit. If the GILTI and FDII exceed the U.S. shareholder’s taxable income, GILTI and FDII deductions are reduced pro rata.²⁸ The section 250 deduction as so limited is subject to the limitation of section 246(b).²⁹ The section 250 deduction is not allowed in determining the amount of an NOL.³⁰

2. The section 245A exemptive deduction.

Section 245A provides a 100 percent deduction for the foreign-source portion of a dividend (that is not a hybrid dividend) received by a 10 percent corporate U.S. shareholder on stock in a foreign corporation satisfying a holding period condition (a section 245A dividend).³¹ The foreign-source portion of a dividend is based on the ratio of undistributed foreign earnings to total undistributed earnings of the foreign corporation, each determined at the end of the year without reducing earnings for the dividends distributed during the year. This report refers to the 100 percent deduction as the section 245A exemptive deduction.

It is possible that a dividend from a CFC is in whole or in part from earnings effectively connected with a U.S. business or from dividends from an 80 percent owned domestic corporation (that is not a regulated investment company or a real estate investment conduit). The portion of the dividend that is attributable to those earnings would be subject to 50 percent section 245 dividends received deduction (DRD).³² The apportionment of the dividend between the foreign earnings and the rest of the earnings directs section 245A at foreign dividend income. No FTC or deduction is allowed for any foreign income taxes paid or accrued on a dividend for which the section 245A exemptive deduction is allowed.³³

3. Section 265(a)(1).

Section 265(a)(1) disallows deductions allocable to “one or more classes of gross income” (other than interest to which section 265(a)(2) applies) “wholly exempt from the taxes imposed by this subtitle.” Under section 261, the disallowance of deductions under section 265 takes precedence over code provisions allowing deductions, including sections 245A and 250. Before turning to interpretation of section 265, the next subsection describes statutory provisions that intersect with the exemptive deductions to assess their potential import for the interpretation of section 265 in relation to gross income offset by the exemptive deductions.

4. Exemptive deductions and the FTC.

a. The FTC.

It may reasonably be asked, what is the relevance of the FTC to the disallowance under section 265 of deductions attributable to gross income offset by exemptive deductions:

• First, some code provisions described in this subsection of the report prescribe rules for allocating and apportioning deductions attributable to exempt income for purposes of the FTC limitation. Consequently, they are a potentially relevant context for interpreting section 265’s disallowance rules.

• Second, the regulatory implementation of these rules shows that the IRS appears to consider gross income offset by exemptive deductions as exempt income for purposes of sections 864(e)(3) and 904(b)(4), described below.

• Third, the approach taken in regulations under sections 864(e)(3) and 904(b)(4), particularly in conjunction, is quite distortive if the section 265(a)(1) deduction disallowance does not apply.

Because of the technical nature of this part of the argument, a more generalist reader may prefer to skim this section and retain their focus on the section 265 discussion.

The FTC mitigates the effects of income being subjected to taxation by two countries. In this case, the two countries are the United States and the country where the CFC earns its income. The U.S. tax on the taxable portion of the CFC’s earnings may be reduced by a credit for corporate-level foreign income tax.³⁴ As previously noted, a section 245A dividend is not allowed to be offset by an FTC.³⁵

The FTC broadly involves two steps. The first is to determine whether the foreign tax is an income tax for purposes of the FTC, and how much tax is paid.³⁶ In this discussion, it is assumed that the foreign taxes are income taxes and that the amount of the foreign tax is not in question. The second step is to determine the limit on the amount of the foreign tax allowed to offset the U.S. tax. The purpose of the FTC limitation is to prevent foreign taxes from being allowed as a credit against U.S. tax on U.S.-source taxable income.³⁷

The FTC limitation is applied separately to categories of foreign-source income, including passive income,³⁸ GILTI (that is not passive income),³⁹ and general category income (including subpart F income that is not passive category income).⁴⁰ The FTC limitation for a limitation category is determined by multiplying the U.S. taxpayer’s total U.S. taxes (before reduction by the FTC) by a fraction. The numerator is foreign-source taxable income in the relevant income category, and the denominator is the taxpayer’s worldwide taxable income.⁴¹ Accordingly, the allocation of deductions between U.S.-source and foreign-source income in a limitation category determines the relative size of the numerator of the fraction. The more deductions allocated to a category in the numerator, the smaller the numerator and the limitation for that category. As this makes clear, the allocation of deductions to or away from foreign-source income in a category is an essential part of the FTC regime.⁴²

b. GILTI, the section 960 indirect credit, and section 864(e)(3).

The portion of GILTI that is not offset by the GILTI exemptive deduction is foreign-source income taxed by the United States. If a domestic corporate U.S. shareholder elects the FTC for a year, the shareholder is treated as paying 80 percent of its share of the foreign taxes associated with a GILTI inclusion (before reduction by the GILTI exemptive deduction).⁴³ The U.S. shareholder also must include in income a “section 78 dividend” for 100 percent of the CFC-level foreign income taxes associated with the net tested income that is included in GILTI.⁴⁴ The U.S. corporate shareholder’s deemed paid foreign taxes assigned to the GILTI FTC limitation category may be used for cross-crediting against other GILTI but may not be used against income in other limitation categories.⁴⁵

The final FTC limitation regulations make it clear that U.S. shareholder deductions must be allocable to GILTI in determining the numerator of the FTC limitation.⁴⁶ Section 864(e)(3), adopted in the Tax Reform Act of 1986,⁴⁷ provides that a tax-exempt asset (and income from the asset) is not taken into account in the allocation and apportionment of deductions.⁴⁸ This rule applies only to deductions that are allowed as expenses, and not to expenses disallowed under section 265.⁴⁹

In applying section 864(e)(3), post-TCJA regulations treat GILTI offset by a GILTI exemptive deduction as exempt income, and they treat stock in the CFC as an exempt asset in proportion to the exempt income.⁵⁰ Accordingly, GILTI (and stock from which it is derived) is excluded from the numerator and denominator of the FTC limitation fraction based on the ratio of the GILTI exemptive deduction to the amount of the GILTI inclusion.⁵¹ The effect of this rule is illustrated in Example 3, which is drawn from the example at reg. section 1.904(b)-3(e).

Example 3: USP, a domestic corporation, owns a domestic factory with a tax book value of $27,000x. USP owns three CFCs and has a tax book value of $10,000x in the shares of each CFC, $8,000x of which is assigned to the section 951A (GILTI) category and $2,000x of which is assigned to the general category in the section 245A subgroup. USP has U.S.-source gross income of $1,600x and a GILTI inclusion amount of $2,200x.⁵² USP has a GILTI exemptive deduction of $1,100x (50 percent * $2,200x) and interest expense of $1,500x.⁵³ Half of each CFC’s stock assigned to the section 951A category, or $4,000x, is treated as exempt under section 864(e)(3), so $12,000x of stock basis is excluded from the apportionment fraction (and $12,000x stock basis remains).

The $1,500x of interest expense is apportioned based on assets after being adjusted for section 864(e)(3) as follows:

Description	Asset Basis	Allocation
Section 951A assets	$12,000x	$400x
General section 245A assets	$6,000x	$200x
Residual U.S. grouping	$27,000x	$900x
Totals	$45,000x	$1,500x

The effect of the regulation is to shift interest expense away from section 951A and to the other categories. If section 864(e)(3) did not apply, then absent any disallowance under section 265(a)(1), the allocation would be:

Description	Asset Basis	Allocation
Section 951A assets	$24,000x	$632x
General section 245A assets	$6,000x	$158x
Residual U.S. grouping	$27,000x	$711x
Totals	$57,000x	$1,500x

Specifically, the effect of the rule in Example 3 is to shift $232x of interest away from reducing the FTC limitation on foreign taxes imposed on GILTI to exempt foreign dividends and U.S. income instead. This will expand the GILTI FTC limitation and thereby allow more FTCs.⁵⁴ This does not reach the correct answer. The correct answer is to disallow the interest expense allocable to half the GILTI ($315x = 50 percent * $632 (rounded)) and allocate the remaining $1,185x according to the assets after the application of section 864(e)(3):

Description	Asset Basis	Allocation
Section 951A assets	$12,000x	$315x
General section 245A assets	$6,000x	$158x
Residual U.S. grouping	$27,000x	$711x
Totals	$45,000x	$1,185x

In other words, the operation of section 863(e)(3) is more coherent when section 265 applies to disallow deductions allocable to income offset by exemptive deductions.

c. Sections 245A and 904(b)(4).

Section 904(b)(4) provides that a 245A dividend and deductions allocable to a 245A dividend (and the portion of stock giving rise to a section 245A dividend) are not taken into account for purposes of the FTC limitation (numerator and denominator).⁵⁵ This rule parallels the rule of section 864(e)(3), except that it applies only for purposes of subsection (a) of section 904.

With the preceding as background, we turn to statutory interpretation of section 265 in relation to income offset by an exemptive deduction.

III. Section 265 and Exemptive Deductions

This Section III considers the following: Does section 265(a)(1) disallow deductions allocable to gross income offset by the GILTI or the section 245 exemptive deduction? The discussion in this part of the report is broken into separate elements to allow the pieces to be assembled according to the reader’s interpretative proclivities.⁵⁶ The order of questions addressed is:

• Does the statutory language support applying section 265(a)(1) to gross income offset by exemptive deductions?⁵⁷

• Does the context support applying section 265(a)(1) to gross income offset by exemptive deductions?

• Does the legislative history support applying section 265(a)(1) to gross income offset by exemptive deductions?

A. Section 265 Statutory Language

The first clause of section 265(a)(1) identifies circumstances in which a deduction will be disallowed.⁵⁸ The provision has three elements:

• it potentially applies to “any amount otherwise allowable as a deduction”;

• the amount must be “allocable to one or more classes of income other than interest”; and

• the “class of income” must be “wholly exempt from the taxes imposed by this subtitle.”

From the earliest days of the income tax, it was recognized that “expenses incurred in earning income which is not subject to tax under the income tax law do not constitute allowable deductions in computing net income from other sources which are taxable under the law.”⁵⁹ This is the principle adopted in 1934 in the predecessor to section 265(a)(1) in relation to income other than interest.⁶⁰

The question here is whether the language of the first clause of section 265(a)(1) admits of an interpretation that would apply the disallowance rule to expenses (otherwise allowable as deductions) allocable to income that is exempted by the mechanism of an exemptive deduction. Sections 250(a)(1)(B) and 245A each describe an amount that otherwise would be deductible. The gross income that is offset by these exemptive deductions is not exempt, so section 265 does not apply to the exemptive deductions themselves. Once an exemptive deduction is applied, however, the gross income that is offset by the exemptive deduction is readily described in the words “wholly exempt from the taxes imposed by this subtitle.” In other words, for purposes of section 265, exempting gross income is equivalent to including gross income and offsetting it with an exemptive deduction. In both cases, any deductions allocable to the resulting exempt income should be disallowed.

But wait. Would that reading cause section 265(a)(1) to potentially apply whenever any deduction was allocable to gross income? This clearly is not contemplated by section 265(a)(1).⁶¹ What is it about exemptive deductions that would justify marrying the exemptive deduction to gross income so as to treat the gross income as exempt and not similarly treating all other corporate deductions?

1. Attributes of exemptive deductions.

Exemptive deductions have the following attributes that when combined, single out exemptive deductions from other deductions for corporations (found in parts VI and VIII of subchapter A):

• the exemptive deductions are not the result of any expenditure of amounts for property or services relating to the corporation’s business;⁶²

• the “amount” of each exemptive deduction is determined before the allocation of other deductions (here U.S. shareholder deductions that are not taken into account in determining tested income);⁶³

• in contrast to other non-expenditure deductions, such as the section 243 and section 245 DRDs, the exemptive deductions do not serve a purpose to avoid double U.S. corporate taxation;⁶⁴ and

• the exemptive deductions declare that the United States declines to assert its taxing jurisdiction over the foreign portion of a dividend from a foreign corporation and the requisite percentage of GILTI (50 percent until 2026).⁶⁵

Deductions that share some of the features of the exemptive deductions are the percentage depletion deduction⁶⁶ and the qualified business income (QBI) deduction.⁶⁷ The percentage depletion deduction, which is calculated as a percentage of gross income from the property (reduced by rents and royalties paid regarding the property and limited to 50 percent of taxable income from property), is the closest to the exemptive deductions.⁶⁸ Percentage depletion, which substitutes for cost depletion when it is more generous, is best understood as a taxpayer-favorable instrument to measure income (much like accelerated depreciation) and as an incentive for resource extraction.⁶⁹ The history of percentage depletion demonstrates that Congress thought it was enacting an administrable substitute for the discovery depletion deduction, which had proven incapable of being administered with any consistency or fairness but nonetheless was designed to allow recovery of costs of unsuccessful wells.⁷⁰ Percentage depletion may be distinguished from the exemptive deductions, which are untethered from measurement-of-income objectives.

The QBI deduction is based on a percentage of taxable income from a business. There are no deductions allocable to pretax income offset by the QBI deduction, and consequently, application of section 265 would have no effect.⁷¹ A non-expenditure deduction calculated in relation to taxable income is a proxy for a modification of the tax rate. A non-expenditure deduction calculated in relation to gross income has an effect equivalent to a reduced tax rate only if other expenses allocable to the gross income reduce the gross income before the deduction is taken or, if not, are disallowed. Those who would argue that Congress intended for the exemptive deductions to serve as an effective rate reduction implicitly are arguing for section 265(a)(1) to apply.

There is no evidence in the statute enacting the exemptive deductions that Congress did not intend for section 265 to apply.⁷² As demonstrated in Section III.B below, the affected provisions operate as intended when section 265 is applied. As discussed in Section III.C below, the legislative history supports the conclusion that section 265 should apply.

2. Scope of ‘class of income.’

What is meant by the statute’s use of the term “class of income”? For example, is it limited to the items of gross income listed in section 61? Clearly, the answer is no. First, the list of income items in section 61 is by its own terms nonexclusive, because gross income is defined to be “all income from whatever source derived, including (but not limited to) the following items.”⁷³ (Emphasis added.)

Can the term “class of income” refer to gross income that is offset by an exemptive deduction? The infamous (to tax lawyers) Gitlitz decision is instructive in interpreting “item of income” to include cancellation of debt income excluded from gross income of a corporation to the extent it remained insolvent after the forgiveness.⁷⁴ If Gitlitz remains good law, despite the evident failure of its interpretative method to discern what Congress appears to have intended,⁷⁵ the same interpretative approach applied here (hopefully more appropriately) supports allowing “class of income” to include income identified by its being offset by an exemptive deduction. Importantly, this reading of the term “class of income” comports with the use of the term elsewhere in the code.

Sections 652(b) and 662(b), which provide for flow-through to a trust beneficiary of character of amounts distributed by a trust, use “class of income” to refer to the possibility that the trust instrument specifically allocates income to different beneficiaries. A class of income for this purpose can be income under trust accounting rules that differ from tax accounting and can include net income amounts. Thus, the code’s use of the term “class of income” is consistent with an understanding that it refers to an inherently flexible concept and is not limited to categories of gross income. Accordingly, a class of income can include gross income identified by its being offset by an exemptive deduction.

3. Income wholly exempt from tax.

Does the class of income described in section 265(a)(1) have to be excluded “gross income,” for example, of the kind found among exclusions from gross income in Part III of subchapter B?⁷⁶ The regulations under section 265(a) consider a class of income wholly exempt from taxes to include income “wholly excluded from gross income under any provision of Subtitle A.”⁷⁷ (Emphasis added.) This interpretation would restrict the scope of what is considered income wholly exempt from taxes to an extent not required by the text of the statute.

Gross income offset by an exemptive deduction is in fact “wholly exempt from the taxes imposed by this subtitle.”⁷⁸ As stated in Curtis, the earliest reported case applying the predecessor to section 265(a)(1), in 1944: “The language of section 24(a)(5), including therein the phrase [‘income wholly exempt from . . . taxes’], is susceptible of only one sensible interpretation, namely, that a taxpayer is allowed no deduction for expenditures which are allocable to income that is nontaxable for whatever reason.”⁷⁹ (Emphasis added.)

Importantly, the section 265 regulation’s meaning for income wholly exempt from taxes is prefaced by the term “includes,” which can either be used to indicate an exclusive list or a nonexclusive list of items. The term “includes” in legal usage is more commonly used to leave open the possibility of additional items,⁸⁰ although it is possible for it to describe a closed group of items. The interpretation of the regulation as providing a nonexclusive definition of exempt income encompasses a statutory interpretation that includes gross income offset by an exemptive deduction within the scope of section 265(a)(1).

The term “income” is used throughout the code and is preceded by numerous modifiers (“gross,” “adjusted gross,” “taxable,” etc.). Section 265(a)(1) uses the term “class of income” and not, as used for example in section 862(b), “class of gross income.” There is no presumption that when the word “income” is preceded by “class of,” it means “gross income,” particularly where “wholly exempt from the taxes imposed by this subtitle” can refer to taxable income and exemption can be achieved by deduction as well as exclusion. As observed in Curtis, the target of section 265 is income “that is nontaxable for any reason.”

4. Section 265 case law.

There are relatively few cases that address section 265 (or its predecessor) generally and even fewer that raise interpretative questions. There is no Supreme Court case interpreting section 265(a)(1).⁸¹

Cases interpreting section 265(a) generally involve excluded gross income, as expected in light of the regulation’s approach to defining income wholly exempt from taxes. With one arguable exception, the cases do not consider exemption situations paralleling those involving exemptive deductions. This may be because there are few precedents for deductions having the configuration of attributes of exemptive deductions. The cases do not foreclose the application of section 265(a)(1) to income offset by exemptive deductions.

Perhaps the most significant interpretative issue addressed in the section 265 case law is whether specific nonrecognition provisions should be considered to give rise to gross income “wholly exempt from the taxes imposed by this subtitle.” This line of cases has concluded that income subject to nonrecognition under sections 332 and 337 is not considered wholly exempt.⁸² The decisions’ rationales are largely based on the view that the carryover of tax attributes preserves future taxation so that exemption may be considered temporary. In contrast, the exemptive deductions result in permanent, not temporary, exemption from tax.⁸³

In Petschek, the Second Circuit overruled a district court decision and held that the exclusion of a war loss recovery to the extent a prior deduction for the loss had not been used would not be treated as wholly exempt gross income, and deductions incurred to win the recovery were allowed.⁸⁴ The class of income tested by the court under section 265 was the war loss recovery and not solely the excluded portion, and therefore the gross income should not be considered wholly exempt. This conclusion may raise the question whether the exempt income analysis can be based on a portion of underlying gross income. The Second Circuit placed weight on the fact that had the taxpayer not been required by the code’s war loss provision to claim a deduction for the year of the loss, the recovery likely would have constituted recovery of basis and not gross income in the first place (in which case section 265 would not apply, and deductions to win the recovery would be allowed).⁸⁵

The facts and context of Petschek are distinguishable from treating as exempt gross income offset by an exemptive deduction. Petschek seeks to measure net income correctly over the affected periods. In contrast, the amount of the GILTI exemptive deduction is determined based on a fixed percentage of a category of income — GILTI as defined in section 951A — and the 245A exemptive deduction is 100 percent of the foreign-source portion of a dividend from a foreign corporation. The income offset by the exemptive deductions will be “untaxed” without regard to tax attributes of the taxpayer.

It might be argued that the taxable income limitation on the section 250 deductions in section 250(a)(2) is a taxpayer attribute. This limitation effectively restricts the income exclusion to the GILTI and FDII that would be taxed, if, for example, there were a domestic loss. It is unclear why this limit should be given significance. Gross income exclusions are subject to comparable limitations. For example, the section 104 exclusion from gross income of a recovery for damages physical injuries or sickness is not applicable to the extent of prior section 213 medical deductions (which in turn must exceed a percentage, currently 7.5 percent, of adjusted gross income). The taxable income limit is a similar mechanic to prevent the effective reduction in tax rate from applying to income not intended to be within its scope. The limit is consistent with treating the deduction as equivalent to an exclusion and does not align with a tax base measurement rationale.

Nonetheless, an argument against an interpretation applying section 265 to exemptive deductions could be that under section 265, the “class of income” should be all dividends from a foreign corporation or all GILTI, not just the portion eligible to be offset by the GILTI exemptive deduction, and that the income therefore should not be considered “wholly exempt from . . . taxes.” This would be at odds with the position recently taken by the IRS in Notice 2020-32, 2020-21 IRB 837, and Rev. Rul. 2020-27, 2020-50 IRB 1552, which would have disallowed certain expenses to the extent they give rise to forgiveness of a covered PPP loan (when forgiveness of the loan is based on the amount of those expenses).⁸⁶ Although the notice was overridden by legislation, the reason was not that the analysis in the notice was incorrect, but that Congress intended to provide the double benefit.⁸⁷ The interpretation in the notice also is consistent with the approach to interpreting section 265(a)(1) manifest in Curtis that section 265(a)(1) should apply to income “that is nontaxable for whatever reason.”⁸⁸

What may be concluded so far is that the text of section 265(a)(1) permits an interpretation that would apply it to gross income offset by an exemptive deduction.

B. Context: Section 265, Exemptive Deductions

Section 265 prevents a double benefit from the exemption of gross income.⁸⁹ Section 261 provides that deduction disallowances in Part IX of subchapter B take precedence over income tax deductions. As commonly stated, deductions are a matter of legislative grace, and the burden is on the taxpayer to establish eligibility for a deduction.⁹⁰ There should be a basis in the statute or in the legislative record (discussed in the next section) to show that Congress intended that deductions be allowed against gross income offset by the exemptive deductions despite section 265.

There is nothing in the statute to indicate that section 265 does not apply to gross income offset by a section 245A exemptive deduction. As previously observed, those dividends are readily encompassed by the words class of “income other than interest . . . wholly exempt from the taxes imposed by this subtitle.” The statute is silent on the treatment of expenses allocated under section 862(b) to the untaxed foreign dividend income.⁹¹ Section 904(b)(4) operates appropriately regarding the section 245A dividend, the section 245A exemptive deduction, and any other deduction not disallowed because of section 265(a)(1).⁹²

Section 265(a)(1) also operates coherently to disallow deductions allocable to an inclusion in gross income under section 951A that is offset by the GILTI exemptive deduction. The disallowance does not change the amount of the taxable and untaxed amount of the GILTI inclusion. The CFC earnings attributable to the taxable amount are assigned to CFCs in the same way as previously to become previously taxed E&P.

There is further statutory evidence that Congress intended for section 265(a)(1) to apply to income exempted by the GILTI exemptive deduction. The second sentence of section 864(e)(3), which addresses the treatment of income exempted by intercorporate dividend deductions under section 243 and section 245, was not amended to include section 245A, leaving it to be addressed under the first sentence as the regulations do. The regulations have applied section 864(e)(3) to treat GILTI offset by the GILTI exemptive deduction as exempt gross income for allocation purposes. Section 864(e)(3) should apply after the application of section 265.⁹³

In summary, the statutory context of section 265 in relation to the exemptive deductions supports the application of section 265 to gross income exempted because of the exemptive deductions. Indeed, applying section 265 to this exempt income maintains the coherence of the U.S. international tax rules.

C. Extrinsic Evidence: Legislative History

1. Section 265.

The predecessor of section 265(a)(1) was section 24(a)(5) of the 1939 code, adopted in 1934.⁹⁴ The legislative history refers to income “wholly exempt” from the taxes imposed by then Title I and does not otherwise refer to gross income except in relation to affected deductions from gross income.⁹⁵ The discussion of the amendment by Samuel Hill in the House referred to disallowing expenses incurred in earning “nontaxable” income.⁹⁶

Fifty years ago, an IRS general counsel memorandum reviewing the legislative history of section 265 found:

Although expenses incurred for the purpose of producing exempt income (interest on state securities, salaries received by state employees, and income from leases of state school lands) comprised the specific situations that Congress had before it when considering the predecessor of section 265(1), we conclude that they enacted a broader statute.⁹⁷

The legislative history as understood close to the adoption of the statute and by the IRS in 1971 supports an interpretation of section 265 that restricts double tax benefits.⁹⁸

2. Sections 250 and 245A.

The legislative history to section 250 makes explicit the congressional intent that the section 250 deduction be treated as exempting the offset income from tax.⁹⁹ The legislative history to section 245A also makes explicit that its purpose is to exempt the foreign portion of a dividend.¹⁰⁰

In the legislative history, Congress did not consider allocable U.S. shareholder deductions.¹⁰¹ Taxpayers have argued as a result that Congress did not intend to allocate any U.S. shareholder deductions to GILTI. The IRS has rejected the argument for purposes of determining the FTC, observing: “The TCJA did not provide for any changes to how the generally applicable rules for computing taxable income within each separate category should apply with respect to the new section 951A category.”¹⁰²

An electronic scan of the conference report finds that there is no reference to section 265 other than those pertaining to interest, which is covered by section 265(a)(2), not section 265(a)(1). There is no discussion of section 265 in relation to section 245A or 250.

In summary, nothing in the TCJA legislative history suggests that Congress did not intend that section 265(a)(1) apply by its terms. Moreover, there is strong support for the view that Congress did understand and intended that the exemptive deductions be treated as exempting the gross income offset by the deductions.

D. Summary

The preceding analysis shows that the statute, its context, and the legislative history allow and indeed support interpreting section 265(a)(1) to apply to gross income offset by an exemptive deduction under current law. Under the U.S. self-assessment system, this interpretation of the statute would require that taxpayers forgo deductions allocable to gross income offset by an exemptive deduction.

Based on the analysis in this report, if the government asserted this position on audit before expiration of relevant statutes of limitation, it would have a material chance of success on the merits.¹⁰³ This raises important practical issues regarding whether a corporation should book a reserve in financial statements for years for which the TCJA has been effective for claiming deductions allocable to income offset by an exemptive deduction on a tax return.¹⁰⁴ As described in Section II.B, billions of dollars likely are at stake.

The next part discusses possible use of a regulation amendment to confirm and publicize the interpretation.

IV. A Regulatory Clarification

A. Reasons for an Amending Regulation

Reasons to favor adopting an amendment to reg. section 1.265-1(b) include to announce the scope of application of section 265(a)(1), to allow stakeholders an opportunity to comment on the interpretation, to mitigate the burdens of potential litigation on taxpayers and the government, and, in the discretion of the IRS, to make the interpretation prospective.¹⁰⁵ One approach to amending the existing section 265 regulation is set out in Appendix B.¹⁰⁶

This report has argued that the current regulation left open the interpretation of the scope of application of section 265(a)(1). Under this analysis, an amendment to the regulation is an exercise of regulatory authority under section 7805 and not a change of agency position.¹⁰⁷ Even if construed as a change in position, an appropriately executed notice and comment regulation should support Chevron deference.¹⁰⁸ Whichever deference results, the use of a regulation should reduce the practical scope of controversy and litigation.

In light of the novel nature and context of the exemptive deductions, a tax administration argument could be made for using a notice and comment regulation to implement the application of section 265(a)(1) to the exemptive deductions. There will be specific situations identified by taxpayers in written comments that might not be anticipated by statute and regulation writers and warrant consideration as to whether and how section 265 should apply. Ideally, this would reduce the burden on tax and generalist courts.

To the extent the application of section 265 to gross income offset by an exemptive deduction has been underappreciated as a tax exposure, there likely would be taxpayer pressure for prospective application of such a regulation. While the IRS would not be required to apply that regulatory interpretation prospectively, it would be within its discretion to do so.¹⁰⁹

B. Prioritizing Regulatory Guidance

The Treasury tax regulatory agenda in recent years has been dominated by the demands for guidance on how to apply provisions adopted in the TCJA.¹¹⁰ Tax regulatory priorities and resources now should be redirected. First, resources should be used to ensure that regulatory interpretations take account of all Americans, including those of underrepresented communities, to further previously underweighted or disregarded social and racial justice objectives.¹¹¹ Second, Treasury and the IRS should favor interpretations that determine taxable income in accordance with measurement-of-income and ability-to-pay principles, and reconsider interpretations that are not required by the statute and in many cases give rise to unfair and inefficient distortions. Third, resources should be devoted to improving administration of the tax law. The regulation suggested here satisfies these criteria and should be given priority for guidance.

There should be a corresponding adjustment to executive branch legislative priorities. In general, Treasury should propose a regulatory change in preference to a legislative proposal in cases in which statutory authority already exists and the goals of a proposal can be accomplished by regulation. Whether a delegation of authority is general or specific, exercising rather than disregarding existing congressional delegations under the code respects separation of powers. A preference for a notice and comment regulation also serves transparency and democratic objectives when the alternative is to pass complex legislation hurriedly, without hearings and without public input (other than from interested lobbyists).

C. Policy

Whether in the form of a dividend exclusion or a 100 percent dividends deduction, the effect is the same: The dividend income is wholly exempted from U.S. tax. It has long been understood that as a normative matter, a territorial or dividend exemption should not allow deductions allocable to the exempt income to be deducted.¹¹² This is consistent with the apparent objective of section 265, which should be applied to reach this result for income offset by the section 245A and section 250(a)(1)(B) exemptive deductions.

The failure to disallow deductions allocable to exempt income goes beyond exempting the net income tax on the income. It provides an additional subsidy that is, irrationally, based on the ratio of allocated expenses to the exempted income. Income with a lower operating margin receives a greater subsidy than income with a higher operating margin. This can be seen in Example 4.

Example 4: Assume a U.S. corporation (USCorp) has a section 245A dividend of $100 and allocable deductions of $25. USCorp will have taxable income of $75 before section 245A, and U.S. tax at 21 percent of $15.75. The benefit of exemption should be the tax saved of $15.75. If the $25 of deductions are nonetheless allowed, the benefit will be increased by 21 percent * 25 = $5.25.

If, instead, USCorp had allocable deductions of $60, it will have taxable income of $40 before section 245A, and U.S. tax at 21 percent of $8.40. Again, the benefit of exemption should be the tax saved of $8.40. If the $60 of deductions are nonetheless allowed, the benefit will be increased by 21 percent * 60 = $12.60.

It makes no sense as a matter of tax or economic policy to design a general subsidy for foreign investment that varies according to the level of the U.S. shareholder’s allocable deductions. Section 265 is designed to limit the benefit of exemption to the income tax saved. Failure to apply section 265, particularly in the international context, results in an excessive incentive to engage in foreign rather than domestic economic activity.

As described above, the amount of deductions involved and the potential subsidy for foreign investment are material. It is reasonable to expect that the revenue impact of allowing deductions allocable to gross income offset by exemptive deductions would be billions of dollars annually. This hidden subsidy favors multinational over domestic businesses and shareholders over workers.¹¹³ The distribution of burden of the corporate tax among individuals is heavily skewed toward those within the highest income categories.¹¹⁴ Moreover, an increasing share of owners of U.S. corporations are foreign investors.¹¹⁵

There is no coherent policy reason to favor allowing deductions allocable to exempt foreign income. If it is urged that the tax burden on foreign income is too high, alternative policy instruments would be far superior.

D. Validity

The proposed amendment to reg. section 1.265-1(b) at Appendix B is a permissible interpretation of the statute.¹¹⁶ The preceding analysis in this report demonstrates that it is a reasonable interpretation of section 265(a)(1) to cover income that is not taxed because of an exemptive deduction. If an alternative interpretation of the statute is preferred, at a minimum the preceding analysis demonstrates that the language of the statute is susceptible to more than one interpretation, thereby satisfying an essential element of Chevron analysis.¹¹⁷

There is no meaningful distinction for the language or objective of section 265 between excluding the gross income and offsetting it by exemptive deductions. When, as here, the exemptive deductions eliminate tax on the income, involve no expenditure of taxpayer assets, and serve no measurement-of-income purpose — or indeed any purpose other than to exempt the income — it is reasonable to apply section 265(a)(1) to this untaxed income.

An argument might be made that section 911(d)(6), which disallows deductions (and FTCs) allocable to the portion of wages and housing allowance that is exempt under section 911, shows that Congress understood that income only partially exempt would not be subject to section 265 and knew how to disallow deductions for that income. Congress made no such disallowance for the exemptive deductions.¹¹⁸ However, the predecessor to section 911 including the expense disallowance was adopted in 1926, before adoption of the predecessor to section 265(a)(1) in 1934.¹¹⁹ The application of section 265 does not interfere with section 911(d)(6) if the usual canon applies that the more specific provision takes precedence. The presence of section 911(d)(6) is unpersuasive as a basis for arguing that the proposed regulation is an impermissible interpretation of section 265.

What about a reenactment concern that Congress has had many opportunities to modify section 265? The reenactment doctrine is inapposite in a context in which the interpretation complements and does not supplant the prior interpretation and can be readily reconciled with the prior interpretation. For some, the acknowledgment in the TCJA legislative history that the exemptive deductions are intended to exempt the income further supports application of section 265(a)(1).

It is impossible to discern from silence that Congress viewed section 265 as inapplicable. Congressional silence regarding the application of section 265 is the arena within which section 265 operates. Nothing prohibits Treasury from exercising its authority under section 7805(a) to address exemptive deductions. As the Supreme Court said, “‘It is a fundamental principle of statutory interpretation that absent provision[s] cannot be supplied by the courts.’ This principle applies not only to adding terms not found in the statute, but also to imposing limits on an agency’s discretion that are not supported by the text.”¹²⁰

Another question that could be raised is why disallow deductions allocable to income exempted by section 245A and not by sections 243 and 245? The corporate income targeted by the exemptive deductions has not previously been subject to U.S. corporate tax, which distinguishes section 245A’s exemption from intercorporate tax relief under sections 243 and 245.¹²¹ There is no U.S. double corporate taxation justification for section 245A or 250.

The long-standing view is that the U.S. tax base is determined independently of the foreign base on which foreign taxes are applied.¹²² Under sections 245A and 960, the foreign tax base is disregarded.¹²³ Insofar as foreign income taxes are taken into account, an FTC subject to the section 904 limitation is allowed. If U.S. income is not taxed, the fact that it may have been subject to foreign tax is not a justification for allowing a U.S. deduction allocable to the exempt income. The effect would be for the United States to make a refund to the U.S. taxpayer (with allocable deductions) to pay the foreign tax on the exempted income.

If a notice and comment regulation is executed properly, a regulation applying section 265 to the exemptive deductions would be a valid exercise of regulatory authority. If, contrary to the analysis in this report, a court concluded that existing section 265 cannot apply even by regulation, or if Congress disagrees with a regulatory interpretation, legislation would remain an available tool.

V. Legislation as an Alternative to a Regulation

Treasury’s fiscal 2022 revenue proposals would amend section 265 to disallow deductions allocable to a class of foreign gross income that is exempt from tax or taxed at a preferential rate through a deduction.¹²⁴ (A possible draft is set out in Appendix C.) President Biden also has proposed significant modifications to GILTI, including eliminating the exclusion from GILTI of a deemed return on certain tangible business investment, which would reduce the scope for the section 245A exemptive deduction; and decreasing the percentage of the GILTI exemptive deduction. Under the draft revision to section 250 at Appendix C, there would be no need to apply section 265 to the GILTI exemptive deduction because, just as for the FDII section 250 deduction, there would be no deductions allocable to the exempt income.¹²⁵ Because the Biden proposals do not repeal section 245A, the revision to section 265(a)(1) would remain relevant.

There are trade-offs between the use of a regulation and seeking legislation to achieve the same objective.¹²⁶ When the regulation is interpreting the law and not exercising a specific grant of authority, the rationale for seeking legislation would appear to be quite weak. The objective of using legislation may be based on a concern that a different administration may change a regulatory interpretation, although even that step would be subject to reversal by Congress. Factors favoring a regulation include the ability to use the expertise of the agency outside the constraints of the legislative process; the opportunity for notice and comment; the availability of the preamble for reasoned responses to comments; and the greater flexibility to adjust regulations in the future. In a highly technical area like the one discussed in this report, the regulatory process affords greater opportunity to avoid or mitigate errors.

A reported rationale to prefer a legislative proposal is to benefit from a budgetary “score” counting the revenue to be raised from a proposal.¹²⁷ This would seem to be a weak argument other than as a matter of assigning political credit for the revenue. If revenue is indeed increased materially enough to warrant a budget score (that is, it exceeds $50 million in the relevant period), it should also show up in collections if a regulation is implemented. Those revenues should be included in the budget baseline for future legislation. In a political environment hostile to tax increases, using a regulation could allow easier passage of associated or other tax legislation. Of course, in a political environment in which pay-fors are needed to meet political or procedural budgetary objectives, a positive budget score for legislation often is motivation for a legislative change in lieu of a regulatory change.

VI. Conclusion

This report considers whether gross income offset by exemptive deductions is covered by the deduction disallowance rule of section 265(a)(1). The better analysis is that section 265 should apply to income offset by exemptive deductions such that deductions (other than the exemptive deduction) allocable to that income should be disallowed.

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 for criticism, and mitigate the burdens of potential litigation on taxpayers and the government. Support for such a regulatory amendment would advance good tax policy while not implying agreement with the TCJA’s reduced taxation of foreign dividend income or GILTI. If, contrary to the analysis in this report, a court concluded that existing section 265 cannot apply, or if Congress disagrees with the regulatory interpretation, legislation would remain an available tool.

The Biden green book proposes a legislative clarification of section 265. Whether the legislative proposal would have a budgetary effect would depend on how the JCT staff interprets the statute and existing regulation and whether the income should be considered as already in the budget baseline. Under the analysis in this report, Treasury has authority to adopt a regulation incorporating a reasonable interpretation of the statute, as proposed in this report, regardless of whether a legislative clarification were enacted and regardless of whether the legislative proposal were considered to have a budgetary effect.

Irrespective of the outcome of the immediate legislative proposals, the use of exemptive deductions should trigger the application of section 265.

VII. Appendix A: Marginal Tax Rate Benefit

Table 1

Inputs
Row	Description		Source
1	CFC total earnings less deficits	100%	See IRS Statistics of Income, “U.S. Corporations and Their CFCs: Tax Year 2016” Table 1, Col. 10, Row All Industries
2	Subpart F and other exceptions	-10%	Rough estimate based on 2016 data
3	CFC net tested earnings	90%	Row 1 - Row 2
4	NDTIR 10% return less CFC interest expense	-25%	Rough estimate
5	GILTI	65%	Row 3 - Row 4
6	U.S. shareholder expenses allocable to total CFC earnings	20%	Rough estimate based on 2016 data
Marginal Tax Rate Benefit of Allowing Expenses Allocable to Exempted Income
7	50% * GILTI	32.5%	50% * Row 5
8	NDTIR 10% return less CFC interest expense	-25%	Row 4
9	Exempt income	57.5%	Row 7 + Row 8
10	U.S. expenses allocable to exempt income	10.4%	Row 3 * Row 6 * Row 9
11	U.S. pre-credit tax rate on CFC net tested earnings without section 265	3.05%	21% * (Row 3 - Row 9 - (Row 3 * Row 6))
12	U.S. pre-credit tax rate of CFC net tested earnings applying section 265	5.22%	21% * (Row 3 - Row 9 - (Row 3 * Row 6 - Row 10))
13	Marginal tax rate benefit of not applying section 265	2.17%	Row 12 - Row 11 [alternatively, 21% * Row 10]

VIII. Appendix B: Regulatory Amendment

The proposal is to amend reg. section 1.265-1(b) and (c):

IX. Appendix C: Legislative Amendments

Amendment to Section 250(a)(1)(B):

Section 250

(a) Allowance of deduction

Amendment to Section 265(a)(1):

Section 265

(a) General rule - No deduction shall be allowed for —