Corporations with significant intangible asset value in foreign subsidiaries that have both a net operating loss (NOL) limited by section 382 and a global intangible low-taxed income (GILTI) inclusion need to consider how the income inclusion and the section 382 limitation may interact. Failure to do so could lead to an increased tax liability.
While not strictly limited to certain industries, this issue is prevalent in the life sciences, technology, and consumer products industries.
Introduction
Key to the determination of available NOLs that a taxpayer may use to offset taxable income is the application of section 382. Where a corporation’s NOLs are limited by section 382, the identification of recognized built-in gains (RBIGs) to increase the annual limitation on NOL utilization is often critical.1 The addition of GILTI, codified as part of the Tax Cuts and Jobs Act of 2017 (TCJA),2 added yet another layer of complexity to the determination of RBIG.
A U.S. shareholder’s GILTI amount is intended to approximate its income from intangible assets that are held by a controlled foreign corporation (CFC) in a foreign jurisdiction.3 Specifically, GILTI is calculated as a U.S. shareholder’s pro rata share of active income from its CFCs that exceeds 10 percent of such CFCs’ investment in certain tangible property.4 Domestic corporations are permitted a (partial) offsetting deduction equal to 50 percent of the GILTI amount included in gross income for a given taxable year.5
This item discusses whether a U.S. corporation’s GILTI inclusion may be treated as RBIG so that it would increase the base section 382 limitation. Stated differently, is it possible for the portion of a loss corporation’s GILTI amount that is economically attributable to the period before a section 382 ownership change (pre-change period) to be treated as an RBIG under section 382(h) when recognized?
Background: Section 382 and built-in gains under Notice 2003-65
Section 382 imposes a limitation on a corporation’s use of its NOLs and other tax attributes after it undergoes an ownership change. If a corporation undergoes an ownership change which is an ownership shift exceeding 50 percentage points over a three-year period, annual utilization of these attributes generally is limited to the fair market value (FMV) of the corporation multiplied by the long-term tax-exempt interest rate.6
In addition, a corporation must determine if it is in a net unrealized built-in gain position (NUBIG) or a net unrealized built-in loss position (NUBIL). If a corporation has a NUBIG, then its annual base limitation is increased for the first 5 years after the ownership change (recognition period) to the extent the corporation has RBIG.7 If a corporation has a NUBIL, by contrast, then any built-in loss recognized during the recognition period (RBIL) is subject to the section 382 limitation.8
In Notice 2003-65, the Internal Revenue Service (IRS) provided two safe harbor approaches for identifying built-in items for purposes of section 382(h): the 1374 approach and the 338 approach.9 The 338 approach identifies RBIG and RBIL by comparing the corporation’s actual items of income, gain, deduction, and loss with the items that would have resulted if the corporation had made a section 338 election for a hypothetical stock purchase on the date of the ownership change. A distinguishing feature of the 338 approach is that built-in gain assets can be treated as generating RBIG even if such assets are not disposed of during the post-change recognition period. For instance, a corporation with self-created intangibles or intangibles that have appreciated since their acquisition can take into account RBIG each year equal to its (higher) hypothetical amortization deduction over its (lower) actual amortization deduction. As a result, the 338 approach is often advantageous to a corporation with a NUBIG because it permits a greater amount of RBIG to be taken into account.
On September 10, 2019, Treasury and the IRS released proposed regulations under section 382 (2019 proposed regulations) that would eliminate the long-standing 338 approach permitted by Notice 2003-65. The preamble raised concerns about the interaction of the 338 approach with various newly-enacted provisions in the TCJA, including GILTI inclusions under section 951A. In essence, Treasury and the IRS concluded that such provisions might complicate and/or compromise the intended application of the 338 approach.10 Further, the 2019 proposed regulations would expressly prohibit treating GILTI amounts as RBIG.11 Nevertheless, the 2019 proposed regulations have been roundly criticized on several fronts and it is not clear that they will be finalized, at least in their current form. In any case, corporations may still apply Notice 2003-65, including the 338 approach, for the time being.12
Treatment of GILTI amounts under the section 338 approach
As discussed above, a U.S. corporation’s GILTI is determined by calculating the amount by which its share of active income from CFCs (i.e., net CFC tested income) exceeds its share of a 10 percent return on the CFCs’ investment in tangible property (i.e., net deemed tangible income return). In addition, a U.S. corporation includes GILTI in its gross income on a hypothetical distribution date, which is typically the last day of a CFC’s taxable year.13
If a U.S. corporation includes GILTI in its gross income after undergoing a section 382 ownership change, it is possible to view some portion of the corporation’s GILTI as economically attributable to the pre-change period. First, consider how a portion of a corporation’s GILTI for the year of the ownership change could be attributed to its pre-change period under the 338 approach.
Example 1. LossCo, a U.S. corporation, owns all of the stock of FSub, its sole CFC. Both LossCo and FSub are calendar year taxpayers. On December 15, 2020, LossCo’s shareholders sold all of their stock to an unrelated third party, causing LossCo to undergo a section 382 ownership change. On December 31, 2020 (hypothetical distribution date), LossCo included $200 of GILTI in its gross income with respect to FSub. LossCo was in a NUBIG position at the time of the ownership change and decides to calculate its RBIG using the 338 approach.
LossCo’s includes its $200 of GILTI in gross income on December 31, 2020, the hypothetical distribution date and last day of FSub’s taxable year. Had LossCo and FSub made section 338 elections on the change date, however, FSub’s taxable year would end on December 15, 2020. As a result:
- First, FSub would have a hypothetical distribution date on December 15, 2020, and LossCo includes in gross income GILTI related to the pre-change period (assume a calculation of $190).
- Further, FSub would have a second hypothetical distribution date on December 31, 2020 and LossCo includes in gross income GILTI related to the post-change period (assume a calculation of $10).
Under the 338 approach, therefore, LossCo potentially has $190 of RBIG, reflecting the difference between its actual GILTI amount of $200 included in gross income on December 31, and the hypothetical GILTI amount of $10.14 Note that the $10 hypothetical GILTI amount reflects FSub’s items from the shorter, post-change period, which is not treated as RBIG. By contrast, the remaining $190 of LossCo’s GILTI is arguably RBIG because it is attributable to the pre-change period before December 15.15
Next, consider how the 338 approach applies to LossCo’s GILTI amount for 2021, the first full calendar year following the year of change:
Example 2. Assume the same facts as Example 1, except that LossCo wants to determine if a portion of its GILTI for calendar year 2021 could be an RBIG. As of the change date, FSub had a patent with a FMV of $300 and an adjusted basis of $50. The patent was a section 197 intangible that had 10 remaining years or amortization. Further, FSub’s specified tangible property had aggregate adjusted bases of $80 and a total FMV of $100. On December 31, 2021, LossCo had actual tested income with respect to FSub (its only CFC) of $150.
LossCo’s actual GILTI amount for 2021 is $142, calculated as follows: equal to the excess of FSub’s tested income over 10 percent of FSub’s total adjusted basis in its tangible property:
- The excess of $150 (tested income) over $8 (10 percent of FSub’s $80 total tangible property adjusted basis).
- The $150 in tested income takes into account $5 of amortization from FSub’s patent (adjusted basis of $50 divided by 10 remaining years of amortization).16
A section 338 election would cause FSub to have a stepped-up basis in its assets. Under the 338 approach, this potentially causes LossCo to have a lower hypothetical GILTI amount. First, tested income associated with the post-change period is reduced by the additional amortization deduction on the patent. Further, the stepped-up basis in specified tangible property increases FSub’s deemed investment in tangible property.17 LossCo’s hypothetical GILTI amount in 2021 is $125, calculated as follows:
- LossCo’s tested income would be $135 instead of $150. This $15 difference reflects $20 of amortization (instead of $5) had LossCo stepped up its basis in the patent to $300.
- LossCo’s adjusted basis in its specified tangible property would be stepped up to $100. Thus, 10 percent of FSub’s investment in specified tangible property is $10 (instead of $8).
- As a result, LossCo’s hypothetical GILTI amount of $125 reflects the excess of $135 of tested income over $10.
Under the 338 approach, therefore, LossCo could have an RBIG of $17, reflecting the difference between its actual GILTI amount of $142 and its hypothetical GILTI amount of $125.
Concluding thoughts
Currently, there is a lack of clarity whether a loss corporation may treat any portion of its GILTI amount as RBIG under section 382(h) using the 338 approach. There is no clear indication in Notice 2003-65 whether the hypothetical 338 election extends to lower-tier corporations of the loss corporation (in this case, CFCs). That said, there is no indication that it does not, and the “wasting asset” concept seems to fit the GILTI regime quite nicely.
Still, it is noted that the 2019 proposed regulations would expressly prohibit treating GILTI as RBIG for purposes of section 382(h), as well as do away with the beneficial 338 approach overall.18 But these are proposed regulations and it is far from clear that they will ever be finalized in their current form. Taxpayers should consult a tax adviser prior to taking a position on GILTI and the section 382 limitation.
