Executive summary: GILTI in a nutshell
It has been more than five years since the Tax Cuts and Jobs Act of 2017 (TCJA) introduced the concept of global intangible low-taxed income (GILTI). Broadly speaking, the GILTI rules require a 10% U.S. shareholder of a controlled foreign corporation (CFC) to include in current income their pro rata share of the GILTI income of the CFC, beginning with 2018 tax years. While the rules are applicable to C corporations, individuals and trusts, the GILTI rules affect different taxpayers in various ways. For instance, only C corporations (or individuals (including a trust or estate) that make a section 962 election) are eligible for a section 250 deduction and foreign tax credit (FTC).
While GILTI itself may no longer be considered new to many taxpayers, what is new is the ever-changing tax law and analysis. As taxpayers begin to plan for the 2022 compliance season and beyond, it's important to be cognizant of certain filing deadlines and understand which tax law changes could have an indirect impact on GILTI. Failure to plan ahead and apply the changing law could result in penalties, tax inefficiencies and lost opportunities. Here are ten important reminders for year-end planning.
Aggregate treatment for pass-through entities
On Jan. 25, 2022, Treasury and the IRS released final regulations (T.D. 9960) clarifying stock ownership under section 958. These regulations treat a domestic partnership (and S corporation) as an aggregate of its partners (shareholders) for purposes of sections 951 and 951A.
This "aggregate" treatment is a major shift from historical pre-TCJA "entity" treatment of subpart F inclusions. Pre-TCJA, partnerships (and S corporations) would compute subpart F at the partnership level and allocate the tax impact to its partners (shareholders). Post TCJA, partners (and shareholders) take into account their pro-rata share of subpart F components to compute their own tax liability.
The final regulations apply to taxable years of foreign corporations beginning on or after Jan. 25, 2022, and to taxable years of U.S. persons in which or with which such taxable years of foreign corporations end. Taxpayers may apply these regulations to tax years beginning on or after Dec. 31, 2017, subject to certain requirements (e.g., consistency).
While aggregate treatment has applied to GILTI inclusions for taxable years beginning on or after Dec. 31, 2017 (and continues to apply), aggregate treatment for general subpart F inclusions will no longer be optional. For most taxpayers, these final regulations should not impact GILTI tested income. For GILTI purposes, tested income and tested loss are determined without regard to any gross income taken into account in determining the CFC's subpart F income, and any gross income that is excluded from the CFC's subpart F income under the section 954(b)(4) high-tax exception regardless of early adoption.
Proposed changes for elections made on behalf of controlled foreign corporations
Also on Jan. 25, 2022, Treasury and the IRS released proposed regulations (REG-118250-20) regarding passive foreign investment companies (PFICs) and CFCs held by domestic partnerships and S corporations. Of importance, these proposed regulations contain guidance relating to the determination of a controlling domestic shareholder (CDS) of a foreign corporation. The CDS(s) of a CFC is defined as the U.S. shareholder(s) that, in the aggregate, own more than 50% of the total combined voting power of all classes of stock of the CFC entitled to vote and that undertake to act on the CFC's behalf. The CDS is extremely important in a GILTI context because they are responsible for making (or not making) certain elections with respect to CFC(s) (i.e., the GILTI high-tax exclusion election (HTE)).
The final section 958 regulations discussed above do not apply aggregate treatment for purposes of determining a CFC's CDS. The regulations clarify that partnerships (and S corporations), as opposed to their partners (or shareholders), would be considered a CDS, assuming the ownership requirement is met. However, Treasury and IRS state in the proposed PFIC regulations that they believe aggregate treatment should apply to domestic partnerships (and S corporations) for purposes of determining the CDS(s) of a CFC. The rationale behind the flip is that such actions should generally be taken by those persons whose tax liability is directly affected. In other words, partners (and shareholders) bear the tax liability and they should be responsible for the decision. This change in thought has been provided in the proposed PFIC regulations to give taxpayers an additional opportunity to comment.
The proposed regulations generally apply to tax years beginning on or after the date the regulations become final.
Taxpayers looking for additional information on the proposed PFIC regulations can view RSM's previous tax alert (Proposed PFIC regulations revise reporting by US partnerships).
Section 174 research and experimental expenditures
As the 2022 tax year-end has come and gone, taxpayers closely monitoring Capitol Hill in hopes of a fix to the impending changes coming to section 174 will be devastatingly disappointed. The now in-force changes result from a delayed provision under TCJA, effective beginning with tax years beginning after Dec. 31, 2021 (i.e., 2022 calendar year taxpayers), which requires mandatory capitalization and amortization of costs incurred under section 174.
Prior to Dec. 31, 2021, research and experimental (R&E) expenditures under section 174 (R&E expenditures) were by default deducted as incurred. As such, taxpayers following that treatment did not typically track and categorize R&E expenses based on the Code’s definition of such costs. Going forward, taxpayers will need to identify the R&E expenditures not only of their U.S. companies, but of their foreign subsidiaries as well, in order to comply with the capitalization requirement. Foreign R&E expenditures must be capitalized and recovered over 15 years, while domestic costs may be recovered over five years. A half year convention applies in year one.
Taxpayers will be faced with hardships associated with implementation (e.g., identifying R&E costs of foreign subsidiaries), and should consider that these changes could have unanticipated GILTI tax consequences. For instance, capitalization could drastically affect GILTI through increased tested income, a modified GILTI inclusion percentage, and/or altered ability to claim the HTE.
The good news is that Rev. Proc. 2023-8 provides an automatic accounting method change for taxpayers to adopt these new capitalization and amortization rules for R&E expenditures under section 174 for tax years beginning after 2021.
Taxpayers looking for additional information on section 174 R&E can view RSM's previous tax alerts (Looming required capitalization of section 174 expenditures and IRS issues method change procedures for sec. 174 R&E expenditures).
Section 163(j) interest
Similar to section 174, taxpayers will be disappointed to hear that there has been no fix implemented before year-end to the impending changes coming to section 163(j). Another delayed provision under TCJA, these changes apply to tax years beginning after Dec. 31, 2021 (i.e., 2022 calendar year taxpayers).
Beginning Jan. 1, 2022, depreciation, amortization and depletion may no longer be added back to a company's adjusted taxable income (ATI) calculation. ATI, which closely mimicked EBITDA (earnings before interest, taxes, depreciation and amortization), will now more closely resemble EBIT (earnings before interest and taxes). This update could significantly impact a taxpayer's ability to deduct interest expense beginning after Dec. 31, 2021. The application of section 163(j) is relevant when calculating tested income for GILTI purposes and/or in determining whether a CFC group election should be made, and may also impact application of the HTE for GILTI purposes.
Taxpayers looking for additional information on section 163(j) business interest expenses can view RSM's previous tax alert (With no year-end tax package, businesses face unfavorable changes).
High-tax exception election and amended returns
An annual election is available under section 951A which allows eligible taxpayers to exclude certain high-taxed income of CFCs from their GILTI computation on an elective basis (i.e., the HTE). A CFC's tested unit tested income is considered high-taxed when that income is subject to an effective tax rate (ETR) in the relevant foreign country greater than 90% of the U.S. corporate tax rate (i.e., 18.9%). In general, in order to be valid, the election must be made by the CDS, notification to non-CDS U.S. shareholders must be provided and the consistency requirement must be maintained.
The regulations generally allow taxpayers to make (or revoke) the GILTI HTE with an amended tax return to the extent the following conditions are met:
- 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 CDS's inclusion year with or within the CFC inclusion year,
- 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-month period.
Additional analysis is required when amending a tax return due to a foreign tax redetermination (i.e., a change in a taxpayer's foreign tax liability) and how this impacts the validity of the GILTI HTE.
Calendar year-end pass-through entities have until March 15, 2023, and C corporations have until April 18, 2023, to amend their 2020 tax returns. In case-by-case scenarios, the IRS may issue an extension of time to file outside the normal 24-month window. On Nov. 25, 2022, the IRS released PLR 202247008 granting such an extension.
Taxpayers looking for additional information on the GILTI HTE can view RSM's previous tax alert (GILTI high tax kickout rules finalized).
New foreign tax credit guidance
Over the course of this past year, Treasury and the IRS have released final 2022 regulations (T.D. 9959), a set of technical corrections (2022-15867 and 2022-15868) and proposed 2022 regulations (REG-112096-22) all aimed at addressing the creditability of foreign income taxes for purposes of the FTC. In general, these new rules revised the net gain requirement, ensuring that a foreign tax is only a creditable net income tax if the determination of the foreign tax base conforms in essential respects to the determination of taxable income under the Code. This effectively shifts the definition of a creditable tax from an income tax (i.e., a tax on income) to being a tax that is sufficiently similar to the Code. Under these new rules, a foreign tax will only satisfy the net gain requirement if the tax satisfies four sub requirements: realization, gross receipts, cost recovery (i.e., formerly the net income requirement), plus a new attribution requirement.
The 2022 final regulations further stipulate that determining whether a foreign tax satisfies each component of the net gain requirement is generally based on the terms of the foreign tax law governing the computation of the tax base rather than empirical analysis. Also, the 2022 final regulations maintain the long-standing all-or-nothing rule. A foreign tax either is or is not a foreign income tax, in its entirety, for all persons subject to the foreign tax.
The technical corrections to the 2022 final regulations closed a loophole with respect to the section 901(m) haircut. The technical corrections amend the GILTI HTE regulations to now refer to "eligible current year taxes" as opposed "current year taxes" when determining foreign income taxes paid or accrued with respect to a tentative tested income item. This seemingly small revision ensures that when computing the ETR for purposes of the GILTI HTE, only creditable foreign income taxes, not those for which an FTC is unavailable, are taken into consideration. Eligible current year taxes exclude taxes for which a credit is disallowed at the level of a CFC (e.g., under sections 245A(d) or 901(j), (k), (l), or (m). In other words, taxpayers must compute the ETR after applying the section 901(m) haircut to their foreign income tax.
In terms of GILTI, these changes could have a drastic impact on a taxpayer's ability to claim the HTE and / or FTC. Under the new rules, historically creditable taxes may no longer be creditable for tax years beginning on or after Dec. 28, 2021 (i.e., 2022 calendar year taxpayers). Note that while certain foreign income taxes may no longer be creditable, non-creditable taxes are still deductible for tested income purposes.
Taxpayers looking for additional information on the 2022 final FTC regulations and 2022 proposed FTC regulations can view RSM's previous tax alerts (Treasury releases technical corrections to final FTC regulations and Treasury releases much anticipated proposed FTC regulations).
Schedule K-2 / K-3 reporting
Domestic partnerships (and S corporations) are no longer required to complete Form 8992, U.S. Shareholder Calculation of GILTI, or Schedule A (Form 8992), Schedule of CFC Information to Compute GILTI. Instead, domestic partnerships (and S corporations) must complete Schedule K-2 (Form 1065), Partners' Distributive Share Items - International, Part VI - Information on Partners' Section 951(a)(1) and Section 951A Inclusions, and Schedule K-3 (Form 1065), Partner's Share of Income, deductions, Credits, etc. - International, Part VI - Information on Partner's Section 951(a)(1) and Section 951A Inclusions (or Schedule K-2 (Form 1120S), Part VI, and Schedule K-3 (Form 1120S), Part VI).
Note that eligible taxpayers looking to make a section 962 election will likely need additional information outside of Schedule K-3. The current schedule still does not include a line to report a taxpayer's pro-rata share of tested foreign income taxes.
Taxpayers looking for additional information on Schedule K-2 / K-3 reporting and section 962 elections can view RSM's previous tax alerts (Schedules K-2 and K-3 draft instructions for tax year 2022 and Cushioning the double-tax blow: The section 962 election).
Section 250 deduction limitation
The TCJA and the 2020 Coronavirus Aid, Relief and Economic Security Act (CARES Act) significantly reformed the use of net operating losses (NOLs) for corporate taxpayers. In general, NOLs generated in tax years beginning in 2018 and later (i.e., post-TCJA) can no longer offset 100% of taxable income and can reduce no more than 80% of modified taxable income. With respect to these NOLs, taxpayers no longer have the option for NOL carryback, but will be able to carryforward NOLs indefinitely. The CARES Act did provide some relief to the 2018, 2019 and 2020 tax years. However, this relief is not available for tax years beginning in 2021. It's important to note that pre-2018 (i.e., pre-TCJA) NOL carryforwards can still offset 100% of taxable income for tax years beginning in 2021 and later.
Corporate taxpayers (or those that make a valid section 962 election) have the ability to claim a section 250 deduction against their GILTI inclusion. The deduction is typically equal to 50% of the GILTI inclusion and associated section 78 gross-up, subject to a taxable income limitation which includes complex interplay with NOLs. At a high level, it is important to remember that the section 250 deduction is computed after the application of NOLs. For instance, to the extent a taxpayer has a pre-2018 (i.e., pre-TCJA) NOL carryforward that brings 2021 taxable income, including GILTI, down to zero, there is no ability to utilize a section 250 deduction.
When dealing with post-2017 (i.e., post-TCJA) NOLs that do not bring taxable income, including GILTI, down to zero, the section 250 deduction is limited to the lesser of 50% of the GILTI inclusion and associated section 78 gross-up or 50% of modified taxable income. Given the expiration of the CARES Act, taxpayers with NOL carryforwards may begin claiming some section 250 deduction against residual taxable income after NOL.
The section 250 deduction is set to reduce to 37.5% starting in 2026. This will result in an ETR of 13.125% for GILTI inclusions.
Election to close the controlled foreign corporation's taxable year
When entering into mergers and acquisitions (M&A) like transactions, taxpayers should be cognizant of the fairly recent final regulations (T.D. 9909) under sections 245A and 954(c)(6). Of importance, in terms of GILTI, the regulations purport to close certain loopholes that, according to the IRS, use the section 245A dividends received deduction (DRD) contrary to legislative intent.
Particularly, the IRS is concerned with planning based on the interaction of section 951(a)(2)(B). This code section effectively reduces a U.S. shareholder’s pro rata share of CFC subpart F income or GILTI tested income for dividends a different taxpayer receives in respect of the same CFC stock, and the section 245A DRD. This situation arises when a CFC issues a dividend before the date of sale. In this transaction, the seller receives the dividend while the buyer receives the subpart F / tested income reduction with no corresponding income pick-up. To restrict such planning, the regulations treat dividends (or deemed dividends) that occur in the same tax year as an “extraordinary reduction” ineligible for the DRD to the extent of the U.S. shareholder’s pre-reduction, pro rata share of the CFC’s subpart F income or GILTI tested income. An extraordinary reduction occurs when:
- A controlling section 245A shareholder (generally, a U.S. corporate shareholder that owns more than 50% (by vote or value) of the stock of the CFC) transfers more than 10% of its stock in a CFC, or
- There is a greater than 10% dilution in the controlling section 245A shareholder's overall ownership of the CFC.
Absent an exception, an extraordinary reduction can lead to some harsh results. In other words, the controlling section 245A shareholder (e.g., the seller) must include the dividend in income without the availability of an offsetting section 245A deduction.
Once such exception for preserving the section 245A DRD is the "elective exception to close CFC's taxable year" (the election). The controlling section 245A shareholder affirmatively elects to close the tax year of the CFC at the time of the sale and recognize its pro rata share of subpart F income or GILTI for the short year. In general, for the election to be considered valid, the following requirements must be met:
- Before the filing of the election, each controlling section 245A shareholder must enter into a written, binding agreement with each U.S. tax resident that on the end of the date on which the extraordinary reduction occurs owns directly or indirectly, stock of the CFC and is a U.S. shareholder with respect to the CFC, and
- The written, binding agreement must state that each controlling section 245A shareholder will elect to close the taxable year of the CFC.
The regulations make clear that this is a bilateral election. The controlling section 245A shareholder that has the extraordinary reduction amount is responsible for filing the election with their tax return. Special rules apply if the extraordinary reduction amount occurs by reason of multiple transactions and / or when consolidated groups/partnerships are involved.
The election to close the CFC's tax year will be treated as a change in accounting period.
Taxpayers looking for additional information on the final section 245A regulations can view RSM's previous tax alert (Final regulations close section 245A loopholes).
Accounting method review
For purposes of GILTI, a CFC’s tested income generally is calculated using the same tax principles that apply to domestic corporations, including, for example, revenue recognition standards under section 451, rules regarding the timing of deductions under sections 461, capitalization rules under section 263(a), and the requirement to account for inventories. Further, once a method of accounting is established with respect to calculating the CFC’s tested income, such method must continue to be used until the CFC obtains consent to change the method.
U.S. shareholders need to assess each tax year whether they have GILTI inclusions. A U.S. shareholder may be able to reduce their GILTI inclusion through an accounting method review that optimizes the CFC’s methods of accounting. Alternatively, if an improper method of accounting has been established (e.g., merely following book for immaterial items), proactively requesting an accounting method change could provide the U.S. shareholder with audit protection for the prior-year improper treatment.
An accounting method review for a CFC involves the identification of one or more specific technical accounting areas where the U.S. shareholder may be applying an improper or unfavorable method of accounting to determine the CFC’s tested income, the related research into permissible methods, and the selection/implementation of the ideal accounting method given the facts, circumstances and tax strategy of the CFC’s U.S. shareholders.
ASC 740 considerations
For most taxpayers, GILTI represents a permanent adjustment item and is therefore a key rate driver for ASC 740 purposes. It will be critical to consider all of the above for 2022 income tax provisions. In particular, increased CFC tested income from R&E capitalization and interest expense limitations may drastically increase GILTI inclusions over prior periods, especially if these items drive ETRs downward enough to put the HTE out of reach.
If legislative relief does not come until 2023, 2022 income tax provisions will still need to reflect the enacted law for the period. Thus, tax provision and ETR impacts of R&E capitalization and section 163(j) changes may be felt through GILTI for 2022 even if Congress acts on these items in 2023.
Single entity treatment
On Dec. 9, 2022, the IRS and Treasury released proposed regulations (REG-113839-22) treating consolidated group (the group) members as a single entity for purposes of determining income inclusions from CFCs under the subpart F and GILTI regimes. The proposed regulations are aimed at combating a narrow fact pattern, which involves distributions of previously taxed earnings and profits (PTEP) coupled with a CFC re-organization (i.e., changing the location of the ownership of stock of CFC) within the group. In such scenarios, the group's aggregate subpart F and GILTI inclusions could be significantly reduced via the application of section 951(a)(2)(B). The proposed regulations would preclude taxpayers from taking advantage of this narrow exception.
If regulations are finalized by April 15, 2023, the rules would be applicable for the 2022 tax year for calendar-year taxpayers.
New Pillar Two global minimum tax guidance
On Feb. 2, 2023, the Organisation for Economic Co-operation and Development (OECD) released highly anticipated guidance under the new global minimum taxation framework. The new guidance addresses many key issues and, of special importance for U.S. taxpayers, includes an allocation formula for GILTI.
The Pillar Two initiative, referred to as Global Anti-Base Erosion (GloBE), aims to impose a global minimum corporate tax of 15% on adjusted net income on large international businesses (i.e., companies with consolidated revenues above 750 million euros or equivalent) regardless of the location of the business’ headquarters or jurisdictions in which the business operates. In essence, the GloBE rules will “top up” the tax burden on a jurisdiction-by-jurisdiction basis to ensure that each jurisdiction is at a 15% tax rate.
There are a few major differences between GILTI and the new GloBE rules, including: