IRS, Reversing Course, Tees Up Potential Tax Fight With Multinational Companies

WASHINGTON — The IRS is bracing for a protracted battle over the withholding created in the 2017 tax law that could pit the government against some of the largest U.S.-based multinationals.

The Internal Revenue Service is examining the first batch of tax returns that include the deduction for foreign-sourced intangible income (FDII), and the government earlier this month published a legal argument suggesting it could potentially oppose the claims of many companies.

In a memo sent to the attorneys representing them, Peter Blessing, the lead international tax attorney at the IRS, outlined how the government intends to calculate deductions for companies that fit two criteria: They profits in the United States they make from foreign sales and a deduction for deferred payments. equity-based compensation plans, such as limited stock units issued in previous years, granted after 2017.

In the memo, Mr. Blessing said the IRS is reversing a position it took on a similar issue in 2009. That change means the companies have calculated the deduction based on the information. Former IRS rates may find themselves facing unexpected tax bills.

“It’s an important step and not one they’re going to take lightly,” said Michael Mollerus, partner at the New York-based law firm Davis, Polk & Wardwell LLP, which represents large firms.

The IRS memo was publicly posted but did not disclose which companies were involved in any potential disputes. However, any US-based company that claims an FDII and reports deductions for stock compensation plans, including aircraft maker Boeing Co.

sports shoe giant Nike Inc.,

manufacturer 3M Co., and technology companies Microsoft Corp.

and Texas Instruments Inc.,

according to securities records. None of those companies commented on the recent reversal in IRS views.

Congress created the FDII in tax law in 2017, part of a process to restructure international tax rules. The idea is to give an incentive for companies to locate intellectual property in the US and serve foreign markets from the US rather than abroad. Effectively, the FDII creates a system in which companies pay a 13,125% tax rate on domestic income from foreign sales, instead of the 21% tax rate they pay on pure income in the country and the minimum tax rate on youth’s foreign income is low.

The agency’s relocation has attracted the attention of tax attorneys, who often represent multinational companies. They said they are taking the memo as a sign that the IRS is preparing to include this revised stance in audits and litigation against multiple companies.

“It looks like the IRS is trying to strengthen its litigation stance or warn taxpayers that they are fighting a war,” said Layla Asali, an international tax attorney at Miller & Chevalier. International tax attorney at Miller & Chevalier.

To some extent, the tax breaks have worked as intended, as companies including Microsoft and tech giant Alphabet Inc.

and the Meta . Platform Inc.

According to the Congressional Joint Committee on Taxation, FDII has restructured its operations to account for a larger share of global income in the US than it did before 2017. FDII is expected to cost the government $26.3 billion in revenue this fiscal year, according to the Congressional Joint Committee on Taxation.

The FDII has to be calculated by figuring out how much income comes from foreign sales, and that’s where the disputes start.

Companies first claim a tax break on their 2018 tax returns, which are usually filed in late 2019. Those filings are largely in the audit stage and it can take years before those audits are done. that audit leads to internal appeals, US Tax Court cases and subsequently any kind of binding precedent.

The technical legal question surrounds how deductions for equity-based compensation are considered when calculating FDII. In general, for employee compensation, such as limited stock units, companies will deduct the expense from their taxable income when the underlying equity is recognized or become an all-employee keep or sell, even if the money was earned several years before the 2017 tax law took effect.

According to the IRS, companies are arguing that those compensation deductions should not be fully included in their income from years after 2017 when calculating FDII, as it actually relates to previous years. That way, their compensation deductions in years with the FDII appear smaller, their foreign sales income larger, and so does the FDII deduction they receive for that.

The IRS agreed to that approach in 2009 on a similar domestic production deduction that was repealed. Now, it is taking the opposite view.

“Nothing has really changed since 2009,” said Gary Scanlon, a principal at the Washington National Tax Group’s KPMG LLP accounting firm. “It’s a bit of a surprise that they’ve reversed course, but it’s not surprising that they’ll re-examine the issue.”

In Mr Blessing’s memo, the government said that all compensation deductions should be allocated to the current year’s income, to better align income and deductions. The result is a reduction in a company’s income from foreign sales, a reduction in FDII deductions, and an increase in its tax bill. The IRS declined to comment beyond its memo.

Over time, as companies deduct less compensation earned before 2018, the specific dispute will fade.

For now, the memo is just a statement of the IRS’s position. Colleen O’Neill, a partner at accounting firm EY LLP, said: Ms O’Neill said companies would use the old guidance.

Write letter for Richard Rubin at richard.rubin@wsj.com

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Edmund DeMarche

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