The U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) released final regulations (T.D. 9866) (the Final Regulations) on June 14, 2019, regarding the new regime for taxing global intangible low-taxed income (GILTI) contained in the 2017 Tax Cuts and Jobs Act (TCJA). The Final Regulations are generally consistent with proposed regulations (REG-104390-18) (the 2018 Proposed Regulations) issued on Sept. 13, 2018, but there are a number of significant modifications.
Concurrent with the release of the Final Regulations, Treasury and the IRS also issued new proposed regulations (REG-101828-19) (the New Proposed Regulations) that address the treatment of domestic partnerships for purposes of determining the Subpart F income of a partner, and an elective GILTI high-tax exclusion.
This alert provides an overview of some of the key highlights from the Final Regulations and New Proposed Regulations. Broadly speaking, the Final Regulations provide relief from the GILTI rules to partners in partnerships that have a relatively small economic interest in a foreign corporation owned by the partnership. The Final Regulations also provide an election to use non-ADS depreciation for property placed in service before the first taxable year beginning after Dec. 22, 2017.
The New Proposed Regulations would provide extraordinary relief by way of an election to exclude from GILTI items of income that are subject to a high foreign tax rate. While public comments suggested Treasury adopt these rules, they were nonetheless unexpected and will have a significant impact on taxpayers who otherwise must comply with the GILTI rules.
The GILTI rules (contained in section 951A of the Internal Revenue Code of 1986) are intended to discourage U.S. shareholders from shifting highly mobile income from intangible property to low-tax jurisdictions. This is achieved by subjecting U.S. shareholders of a controlled foreign corporation (CFC) to current U.S. taxation on certain CFC earnings that exceed a 10% return on foreign tangible assets. The thinking is that a CFC’s tangible assets should yield a “routine” rate of return of 10%, so any income above that exemption amount must arise from intangible assets.
Corporate shareholders, and noncorporate shareholders (individuals and certain trusts and estates) electing under section 962 to be treated as corporations for purposes of Subpart F income, are permitted a credit for foreign taxes paid on GILTI under section 960(d), subject to an 80% limitation, separate basketing, and no carryback or carryforward. U.S. corporations (and, under proposed section 250 regulations (REG-104464-18), noncorporate shareholders that make a section 962 election), can also claim a deduction for up to 50% of the GILTI inclusion amount under section 250, resulting in a 10.5% effective tax rate for GILTI.
The Final Regulations
- Treatment of U.S. partnerships for GILTI purposes. The Final Regulations adopt an aggregate approach for purposes of determining a partner’s GILTI inclusion with respect to a CFC owned through a U.S. partnership. Under this approach, persons who are partners in a U.S. partnership will not have any income inclusions under the GILTI rules with respect to a CFC owned by such U.S. partnership unless those partners are themselves 10% U.S. shareholders of such CFC. However, a domestic partnership that owns a foreign corporation is treated as an entity for purposes of determining whether the partnership and its partners are U.S. shareholders, whether the partnership is a controlling domestic shareholder, and whether the foreign corporation is a CFC.
To illustrate these rules, the Final Regulations provide the following example: DC, a U.S. corporation, and individual A, a U.S. citizen unrelated to DC, own 95% and 5%, respectively, of PRS, a U.S. partnership. PRS owns 100% of FC, a foreign corporation. PRS is a 10% U.S. shareholder under section 951(b) and FC is a CFC under section 957(a). DC is also a U.S. shareholder of FC because it owns 95% of FC (by vote or value) under sections 958(b) and 318(a)(2)(A). Individual A, however, is not a 10% U.S. shareholder of FC because A owns only 5% of FC (by vote or value) under sections 958(b) and 318(a)(2)(A). For purposes of determining income inclusions under the GILTI rules, PRS is treated in the same manner as a foreign partnership (look-through approach). Therefore, for purposes of determining GILTI inclusions, DC is treated as owning 95% of FC and A is treated as owning 5% of FC. DC is a 10% U.S. shareholder of FC and thus determines its GILTI inclusion based on its indirect ownership of FC stock (95%). However, because A is not a 10% U.S. shareholder of FC, A does not have a GILTI inclusion with respect to FC.
The Final Regulations modify the approach selected in the 2018 Proposed Regulations which proposed that for purposes of determining a partner’s GILTI inclusion, a domestic partnership is treated as an entity with regard to partners that are not U.S. shareholders (partners that indirectly own less than 10% in a CFC held by a partnership), but as an aggregate of its partners with regard to partners that are U.S. shareholders (partners that indirectly own 10% or more in a CFC held by a partnership). Had the approach taken in the 2018 Proposed Regulations been adopted, then Individual A, in the above example, would have a GILTI inclusion with respect to FC.
These rules will likely be a great relief to the private equity industry because many small investors will not be subject to currect tax under the GILTI rules.
- Determining tested income and tested losses. The GILTI rules require U.S. shareholders to include an amount in income annually based in part on the tested income and tested loss earned by their CFCs. A CFC’s tested income or tested loss is gross income, subject to certain exclusions, such as income effectively connected with a U.S. trade or business and Subpart F income, less allocable deductions (including taxes).
The 2018 Proposed Regulations indicate that tested income and tested loss is to be determined by reference to the section 952 regulations, which, for Subpart F purposes, treat a CFC as a domestic corporation taxable under section 11 and applying the principles of sections 61 and 63. The Final Regulations adopt this approach without change but the preamble suggests that forthcoming guidance will be issued to address the application of particular code sections (such as the section 245A dividends received deduction), to the determination of a CFC’s tested income and tested loss under the section 952 regulations. This guidance is also expected to clarify that, in general, any provision that is expressly limited in its application to domestic corporations, such as section 250, does not apply to CFCs by reason of the section 952 regulations.
- No excess tested loss carryforward. CFCs with tested losses can offset CFCs with tested income and if the total amount is a net tested loss, there is no GILTI inclusion for the year. Comments suggesting that U.S. shareholders be allowed to carryforward excess tested losses to offset tested income in future years were rejected.
- Effect of basis adjustments under section 961(c). Sections 961(a) and (b) provide rules for adjusting the basis of shares in a CFC that correspond with the previously taxed earnings and profits (PTEP) rules under section 959. Sections 961(a) and (b) are intended to ensure that a U.S. shareholder who was previously taxed on the earnings of a CFC is not taxed again if it sells its interest in the CFC prior to receiving a distribution of PTEP. Under these rules, taxpayers increase their basis in stock of a CFC to account for Subpart F or GILTI inclusions, and decrease it to reflect distributions of PTEP. Section 961(c) provides rules for basis adjustments similar to those under sections 961(a) and (b) for the stock of lower-tier CFCs held by upper-tier CFCs – but only for purposes of determining the amount included under Subpart F. Thus, it is not clear whether section 961(c) applies for purposes of determining GILTI tested income.
The following simple example illustrates the issue. Assume that U.S. shareholder owns 100% of the stock of CFC1, and CFC1 owns 100% of the stock of CFC2. CFC1 has a $100 basis in its CFC2 shares. CFC2 has no accumulated earning and profits (E&P) or PTEP. In 2018, CFC2 earns $80 of GILTI tested income which is included in U.S. shareholder’s gross income. On Jan. 1, 2019, CFC1 sells its CFC2 stock to an unrelated party for $180. CFC1 will recognize no gain for purposes of determining its Subpart F income (basis of $100 plus $80 of GILTI tested income minus $180 of proceeds). Without guidance, however, it’s not clear whether CFC1 is required to recognize $80 of GILTI tested income from the sale of the CFC2 stock (resulting in the same economic income potentially being taxed twice). The preamble to the Final Regulations says that this issue will be addressed in a separate regulatory project under sections 959 and 961.
- Basis adjustments for used tested losses. The 2018 Proposed Regulations set forth rules providing for downward basis adjustments to the stock of a tested loss CFC to the extent its tested loss was used to offset tested income of another CFC. The Final Regulations do not adopt this rule with the preamble instead providing that such rules will be addressed in a future regulatory project.
- Accounting methods and ADS. As noted, the amount of a taxpayer’s potential GILTI inclusion is reduced by an artificial deemed return on certain of its CFCs’ tangible assets equal to 10% of the CFC’s basis in tangible depreciable assets that give rise to GILTI tested income (referred to as qualified business asset investment or QBAI). For purposes of determining QBAI, a CFC is required to use the alternative depreciation system (ADS) under section 168(g) to compute its adjusted basis in tangible depreciable assets and to allocate such depreciation deduction of the property ratably to each day in the taxable year. The Final Regulations clarify that the use of ADS to compute QBAI is not a method of accounting and, therefore, a CFC does not need a method change to use ADS to determine the adjusted basis in tangible depreciable assets for this purpose.
The Final Regulations also provide transition relief for taxpayers who did not use ADS depreciation for assets acquired prior to Dec. 22, 2017. Under this election, taxpayers may elect for purposes of calculating QBAI to use a non-ADS depreciation method to determine the adjusted basis in specified tangible property placed in service before the first taxable year beginning after Dec. 22, 2017.
A CFC is also generally required to use ADS in computing income (for Subpart F and GILTI purposes) and E&P. The Final Regulations confirm that a change to ADS from another depreciation method for purposes of computing tested income will be treated as a change in method of accounting. The preamble says that most changes should be subject to automatic consent under Rev. Proc. 2015-13, but notes that the Treasury and the IRS intend to publish additional guidance to further expand the availability of automatic consent for depreciation changes.
The New Proposed Regulations
- High-tax exclusion. The New Proposed Regulations would allow taxpayers to elect to exclude high-taxed tested income from the computation of the taxpayer’s GILTI. Similar to the Subpart F high-taxed exception under section 954(b)(4), tested income must be subject to an effective tax rate in the relevant foreign country greater than 90% of the U.S. corporate tax rate, determined at the qualified business unit (QBU) level (rather than at the CFC level). With the current U.S. corporate tax rate at 21%, such foreign income must be taxed at a rate of 18.9% or higher in the foreign country to be eligible for the exclusion. If made, the election applies to every CFC that is a member of a controlling domestic shareholder group (U.S. shareholders that collectively own, directly or indirectly, more than 50% of the CFC's stock) and is binding on all U.S. shareholders of the CFC.
The New Proposed Regulations provide that the election is made by the controlling domestic shareholders of a CFC and remains effective for all subsequent years unless revoked by the controlling domestic shareholders. Once revoked, it may not be made again for 60 months (subject to an exception for changes in control).
- Treatment of U.S. partnerships for Subpart F purposes. Like the rules described above in the Final Regulations, a U.S. partnership is treated as an aggregate of its partners for purposes of determining a partner’s Subpart F inclusion with respect to a CFC owned through a U.S. partnership. But, a domestic partnership that owns a foreign corporation is treated as an entity for purposes of determining whether the partnership and its partners are U.S. shareholders, whether the partnership is a controlling domestic shareholder, and whether the foreign corporation is a CFC.
The Final Regulations under section 951A (GILTI rules) apply retroactively to tax years of foreign corporations beginning after Dec. 31, 2017, although other effective dates apply to other provisions (non-GILTI rules) addressed in the Final Regulations.
The GILTI high-tax rules in the New Proposed Regulations are proposed to apply to taxable years of foreign corporations beginning on or after the date of publication of these rules as final regulations. As such, the GILTI high-tax rules would not be effective until at least 2020 for calendar-year taxpayers.
The New Proposed Regulations addressing the treatment of U.S. partnerships for Subpart F purposes are also proposed to apply to taxable years of foreign corporations beginning on or after the date of publication of these rules as final regulations. However, U.S. partnerships may rely on the New Proposed Regulations with respect to taxable years beginning after Dec. 31, 2017, provided that the New Proposed Regulations are consistently applied by certain related persons. But, before electing to rely on the New Proposed Regulations for Subpart F purposes, be sure to consider the potential application of the passive foreign investment company (PFIC) rules under sections 1291-1297 (less than 10% shareholders that own stock in a CFC through a U.S. partnership may be required to treat such CFCs as PFIC stock).
Taxpayers should carefully review the Final Regulations to determine the implications, if any, on their prior GILTI calculations for both tax return and financial statement purposes.