GILTI is a new anti-deferral provision of the U.S. tax law that results in current taxation of offshore earnings for U.S. shareholders of a controlled foreign corporation (CFC) regardless of whether the income is distributed or retained offshore.1 Recently released final regulations under GILTI have a considerably different impact on private equity and venture capital fund structures than originally anticipated.
In September 2018, the Treasury issued proposed regulations under GILTI in which the government adopted a “hybrid approach” as it relates to a U.S. partnership’s GILTI inclusion reporting requirements. Under the proposed hybrid regulations a domestic partnership would calculate the GILTI inclusion related to its CFCs and allocate that inclusion to all of its partners as part of their distributive share. If a partner of the partnership owned at least 10% vote or value of the CFCs directly, indirectly or constructively on its own, then such partner would not be required to include the allocated distributive share of GILTI inclusion with respect those CFCs but instead would do a separate GILTI determination of their own using information provided by the partnership. Separately, all of the other partners of the partnership would be required to include their distributive share of the partnership’s calculated GILTI income in their taxable income, regardless of whether or not they were deemed to own enough of the partnership’s CFC(s) to be considered a U.S. shareholder under the GILTI regulations.
In a major change from the proposed regulations, the final regulations issued in late June 2019 did not adopt this hybrid approach and instead move toward a simpler partner level approach. Specifically, the final regulations provide that for purposes of the GILTI statute and regulations, a domestic partnership does not have a GILTI inclusion amount, and thus no partner of the partnership will have a distributive share of GILTI inclusion reported to them by the partnership. Instead, the partnership will report necessary information to its partners, and they themselves must determine if they are a U.S. shareholder and therefore subject to reporting the GILTI inclusion under the final regulations. This outcome provides considerable relief from GILTI liability for those partners of a domestic partnership having small minority interests that might have otherwise been allocated partnership level GILTI under the proposed regulations. For example, a partnership that is a 100 percent owner of a foreign corporation would have calculated and allocated a GILTI inclusion amount under the proposed regulations and it is likely that partners owning less than 10% of the CFC would have been subject to tax on that amount. Under the final regulations, only partners who have a 10% interest in the foreign corporation have income inclusions.
Many questions will need to be addressed by fund managers investing in multinational operating partnerships about how these final regulations affect their fund structures:
- Do existing operating agreement provisions apply broadly enough to accommodate tax distributions related to GILTI inclusions?
- How do they account for the resulting basis related to a GILTI inclusion realized by a U.S. shareholder partners?
- Will U.S. investors become weary of GILTI inclusions so much that they, like their tax exempt and foreign co-investors, also seek assurances from the fund that it will avoid investing in operating partnership structures?
- Will they need to explore different structuring techniques designed to avoid GILTI but that possibly would change the return on investment for partners that are not impacted by GILTI?
For individual partners that are U.S. shareholders, the interposition of a corporate blocker entity between the fund and the U.S. shareholder, or a section 962 election, may be considered. In a typical multi-tier fund structure, the final regulations divert such planning decisions to the ultimate individual partner level, rather than to any intervening entities.
The final regulations are effective as of June 21, 2019, and apply as of the first tax year of a foreign corporation beginning after Dec. 31, 2017, and for tax years of U.S. shareholders in which, or with which, such tax year of a foreign corporation ends. Thus, final regulations apply retroactively to tax years beginning after Dec. 31, 2017, and may require amending returns and K-1s that have already been filed.
1 Very generally, a CFC is a foreign corporation that is more than 50% owned by vote or value by United States shareholders. For this purpose, a United States shareholder is defined as a U.S. person (including a domestic partnership) that owns at least 10% of the vote or value of the foreign corporation. Both tests are applied taking into consideration direct, indirect and constructive ownership rules.