The U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) released final regulations (T.D. 9902) (the Final Regulations) on July 20, 2020, regarding the global intangible low-taxed income (GILTI) high-tax exclusion. The Final Regulations are generally consistent with proposed regulations (REG-101828-19) (the 2019 Proposed Regulations) issued on June 14, 2019, but there are a number of significant modifications.
Broadly speaking, the Final Regulations allow taxpayers to exclude certain high-taxed income of a controlled foreign corporation (CFC) from their GILTI computation on an elective basis. When coupled with the new section 245A dividends received deduction (DRD), the election effectively results in the elimination of U.S. tax on high-taxed amounts for corporate U.S. shareholders. The election also permits individual U.S. shareholders of CFCs to defer U.S. taxation of high-taxed amounts until repatriated.
RSM Comment: While the Final Regulations provide some welcome relief and significant opportunities, they contain very complex rules that will require taxpayers to model outcomes very carefully in order to assess the impact of a potential election.
Concurrent with the release of the Final Regulations, Treasury and the IRS also issued new proposed regulations (REG-127732-19) (the New Proposed Regulations) that would conform the Subpart F income high-tax exception to the finalized GILTI high-tax exclusion. The IRS is asking for comments and hearing requests to be received by Sept. 21, 2020.
This alert provides an overview of some of the key highlights from the Final Regulations and New Proposed Regulations. We expect to publish an in-depth white paper in the coming weeks with further analysis and observations.
Section 245A, added to the Internal Revenue Code (IRC) by the 2017 Tax Cuts and Jobs Act (TCJA), allows a U.S. corporation a 100% DRD for the foreign source portion of a dividend received from a specified 10% owned foreign corporation provided that certain requirements are met (e.g., shareholder must satisfy a holding period and the dividend may not be a “hybrid dividend” as defined in section 245A(e)). In the TCJA’s legislative history, Congress expressed concern that section 245A may create an incentive for U.S. corporations to shift income to foreign affiliates operating in low-or zero-tax jurisdictions, and that low-or zero-taxed income could potentially be distributed back to the U.S. corporation without the imposition of any U.S. tax. To prevent this type of base erosion, the TCJA retained the Subpart F regime and enacted the GILTI regime.
The Subpart F regime subjects U.S. shareholders of CFCs to current taxation on their pro rata shares of the CFC’s Subpart F income. Subpart F income includes passive income and income earned outside the CFC’s country of incorporation from certain sales and service transactions involving related parties. A U.S. corporation may claim an indirect foreign tax credit for its proportionate share of the foreign income taxes paid or accrued by the CFC on its Subpart F income. In addition, if an item of Subpart F income is subject to an effective foreign income tax rate that is greater than 90% of the U.S. corporate tax rate (i.e., 18.9% based on the current U.S. corporate rate of 21%), an election may be made to exclude the item from the gross income of the U.S. shareholder.
The remaining amount of a CFC’s gross income generally is “tested income” that is taken into account in calculating the amount included in the income of the U.S. shareholder as GILTI. The amount of a U.S. shareholder’s tested income is reduced by the shareholder’s portion of a 10% ‘routine’ return on the CFC’s foreign tangible assets. In addition, U.S. shareholders that are C corporations are allowed a deduction up to 50%, subject to limitations, of their GILTI inclusion, reducing the effective rate on GILTI income to 10.5% instead of the normal 21%. U.S. corporate shareholders may also claim an indirect foreign tax credit for 80% of the foreign tax paid by the shareholder’s CFCs that is allocable to GILTI income. The TCJA’s legislative history suggests that foreign income subject to a rate of 13.125% or higher would be effectively exempt from the GILTI tax (because 10.5 is 80% of 13.125). In practice, however, the U.S. expense allocation rules (which can reduce the amount of foreign taxes that can actually be credited) may have the effect of causing foreign income subject to foreign taxes greater than 13.125% to still be taxed in the U.S. as GILTI.
It is worth noting that U.S. shareholders that are individuals are also subject to the Subpart F and GILTI regimes (at federal rates of up to 37%) even though individuals may not claim the section 245A DRD. Further, individual taxpayers are not entitled to the 50% deduction from GILTI or indirect foreign tax credits available to corporations unless the taxpayer makes a section 962 election to be treated as a corporation solely for purposes of Subpart F and GILTI. However, individual taxpayers are entitled to the Subpart F income high-tax exception and may now claim the benefit of the new GILTI high-tax exclusion discussed below.
The Final Regulations
- Foreign effective tax rate. The 2019 Proposed Regulations apply the same 18.9% threshold used for the Subpart F high-taxed exception noted above to the GILTI high-tax exclusion. Several commenters called for a lower threshold of 13.125%. These commenters maintained that a 13.125% tax rate is consistent with legislative history and the spirit of the GILTI regime. The Final Regulations decline to adopt the lower threshold and a footnote to the Preamble contends that the commenters reading of the TCJA’s legislative history is incorrect.
RSM Comment: Taxpayers must measure the effective tax rate on the income of each “tested unit” (further described below) of a CFC. To do this, the taxpayer must not only identify the income associated with the tested unit but it must also determine the amount of taxes associated with such income using complex rules that apply for U.S. foreign tax credit purposes. This could result in allocations of taxes paid in one country to operational income earned in another which could be substantially different from the nominal effective tax rate on a stream of operational income.
- Tested unit standard. The 2019 Proposed Regulations require a qualified business unit (QBU)-by-QBU approach to identifying whether income is eligible for the GILTI high-tax exclusion. Commenters requested that the QBU-by-QBU approach be replaced with a CFC-by-CFC approach. The Final Regulations reject the CFC-by-CFC approach, but also scrap the QBU-by-QBU approach. Instead, under the Final Regulations, whether income is eligible for the GILTI high-tax exclusion is determined on a “tested unit” basis. This new standard is meant to more accurately match foreign taxes to items of income and prevent taxpayers from inappropriately “blending” high-taxed and low-taxed income. A tested unit may include (if certain conditions are met):
- A CFC,
- An interest in a pass-through entity (i.e., a partnership or a disregarded entity) held by a CFC, or
- A branch of a CFC.
The Final Regulations provide that tested units are determined independently of other tested units. In other words, a CFC can itself be a tested unit and that CFC may have an interest in other tested units (such as partnerships or disregarded entities). Each of these tested units are analyzed separately. Tested units that are residents of, or located in, the same foreign country, however, may to be combined for purposes of determining whether the combined income is eligible for the GILTI high-tax exclusion.
RSM Comment: In determining the income of a tested unit, the taxpayer generally must look to the items of income and expense that are properly reflected on the books and records of a tested unit. However, the Final Regulations require that taxpayers make complex adjustments to account for interbranch transactions that are not generally recognized for federal income tax purposes. These adjustments may create additional complexity in assessing the impact of making a high tax election.
- Consistency requirement. The Final Regulations provide that the election, if made, applies to all “related” CFCs that meet the effective tax rate threshold. The Final Regulations adopt new “CFC Group” rules for purposes of determining the CFCs subject to this requirement. A CFC Group is defined by cross-reference to the definition of affiliated group in section 1504(a) (with certain modifications). The constructive ownership rules in section 318(a) (with certain modifications) are also applied in making this determination.
- Annual election. The 2019 Proposed Regulations provide that the election, once made, applies for all subsequent tax years until revoked. If revoked, the election cannot be made again for five years. Under the Final Regulations, the GILTI high-tax exclusion may be made annually instead of once every five years.
- Effective date. The Final Regulations generally apply to tax years of foreign corporations that begin on or after July 23, 2020. However, taxpayers may retroactively apply the GILTI high-tax exclusion to taxable years of foreign corporations that began after Dec. 31, 2017, and before July 23, 2020, and to taxable years of U.S. shareholders in which or with which such taxable years of the foreign corporations end.
RSM Comment: This may benefit taxpayers who paid tax on GILTI income in prior years in a variety of facts patterns. In the simplest case, taxpayers may be able to amend previously filed tax returns to claim a refund. But the election may also be helpful to taxpayers that used net operating losses (NOLs) (including NOLs authorized under the recent CARES Act) to eliminate GILTI income because the taxpayer may now be able to use such NOLs against higher taxed non-GILTI income.
- Filing Amended returns. The 2019 Proposed Regulations generally allow taxpayers to make or revoke the GILTI high-tax exclusion election with an amended income tax return. Concerns were raised related to the interaction of this rule and the statute of limitations. The Final Regulations clarify that the election may be made on an amended federal income tax return if all U.S. shareholders of the CFC(s) file amended federal income tax returns within 24 months of the unextended due date of the original federal income tax return of the controlling domestic shareholder’s inclusion year with or within the CFC inclusion year. Additionally, the amended federal income tax returns of all U.S. shareholders must be filed within a single six-month period and any tax due as a result of such adjustments must be paid within such six months period.
New Proposed Regulations
- Conforming the different high-tax exceptions. Treasury and the IRS received numerous comments recommending that the GILTI high-tax exclusion be modified to conform to the Subpart F income high-tax exception. While Treasury and the IRS agreed that the GILTI high-tax exclusion and the Subpart F high-tax exception should be conformed, it was determined, instead, that the final GILTI high-tax exclusion rules better reflect the policies underlying the TCJA than the existing Subpart F high-tax exception. Accordingly, to reduce complexity resulting from different high-tax exceptions and to prevent uneconomic tax planning (and the incentive for taxpayers to structure into the Subpart F high-tax exception) the New Proposed Regulations:
- Modify the existing Subpart F income high-tax exception to conform to the GILTI high-tax exclusion, and
- Provide for a single unified high-tax exception election to be applied for purposes of both the GILTI regime and the Subpart F income regime.
- Applicable financial statement. The Final Regulations generally use items properly reflected on the books and records (as defined in Regulation 1.989(a)-1(d)) of a given tested unit as the starting point for determining gross income attributable to such tested unit. The New Proposed Regulations would replace the use of “books and records” with “applicable financial statement,” with the most preferred applicable financial statement being an audited separate-entity financial statement that is prepared in accordance with U.S. GAAP.
- Undefined or negative foreign tax rates. In certain cases, items may be subject to a negative or undefined effective foreign tax rate. This may occur where net income is negative or zero. Under the New Proposed Regulations, such items would be deemed to be high-taxed.
- Combination of de minimis tested units. The New Proposed Regulations add a rule that would combine tested units with gross income that is less than the lesser of 1% of the CFC’s gross income or $250,000. This rule would apply only after the same country aggregation rule.
- Contemporaneous documentation. The New Proposed Regulations provide that (i) U.S. shareholders must maintain specific contemporaneous documentation to substantiate their high-tax exception computations, and (ii) such information must be included on Form 5471.
- Effective date. The New Proposed Regulations are generally effective for tax years beginning on or after the date that the New Proposed Regulations are finalized.
Although the final GILTI high-tax exclusion rules are generally more complex than the 2019 Proposed Regulations, the ability to elect to apply the exclusion retroactively is welcome news. Taxpayers may be able to amend a prior year return to obtain refunds. However, taxpayers should carefully analyze and model the impact of making a high tax exception election for prior years as it may have an impact on the taxpayer’s foreign tax credit, NOL and other positions.
In addition, Taxpayers, especially those that regularly apply the current Subpart F high-tax exception, should consult with their tax advisors to determine whether the election would be available, and beneficial, going forward under the Final Regulations and New Proposed Regulations.