On September 13, the U.S. Internal Revenue Service (IRS) and Department of the Treasury (Treasury) released proposed regulations (Proposed Regulations) providing guidance on the global intangible low-taxed income (GILTI) provisions in Section 951A of the Internal Revenue Code of 1986, as amended (Code),1 enacted as part of the 2017 tax reform legislation known as the Tax Cuts and Jobs Act (Tax Act). The Proposed Regulations are largely dedicated to computational and definitional guidance with respect to calculating GILTI. They also include significant revisions to rules for calculating “subpart F income” inclusions, which now also apply for GILTI purposes. Notably, the Proposed Regulations do not provide guidance on the deduction used to reduce the effective tax rate on GILTI to 10.5 percent (through 2025) or 13.125 percent (after 2025) or foreign tax credits (FTCs) with respect to GILTI.2 Guidance on these topics is forthcoming.
Section 951A requires each 10 percent U.S. shareholder (U.S. Shareholder) of a controlled foreign corporation (CFC) to include in gross income for federal income tax purposes each year its GILTI, calculated across all of its CFCs. Section 951A applies to tax years beginning after December 31, 2017. The GILTI regime is intended to discourage taxpayers from eroding the U.S. tax base by locating profitable assets and activities in CFCs that are in low-tax jurisdictions.
GILTI generally is the excess of a U.S. Shareholder’s pro rata share of (i) the net income (or loss) of each of its CFCs, excluding income already subject to current U.S. tax and certain other amounts3 (referred to as “tested income” or “tested loss”), over (ii) an amount equal to a 10 percent return on each CFC’s investments in tangible depreciable property that produces tested income (referred to as “qualified business asset investment” (QBAI)), reduced by certain interest expense. GILTI is calculated on an aggregate basis across the shareholder’s CFCs, determined by netting the shareholder’s tested income and tested loss from each of its CFCs and aggregating QBAI and such interest expense across its CFCs. GILTI thus generally results in current taxation of extranormal profits of foreign operations conducted through CFCs. Only the deemed 10 percent return on investment in tangible depreciable property escapes current U.S. taxation and, in the case of a U.S. Shareholder that is a corporation, can be repatriated without further U.S. tax.
Under Section 250, U.S. corporations are entitled to a deduction equal to 50 percent of the GILTI inclusion through 2025, which results in a 10.5 percent effective tax rate on GILTI. The deduction percentage decreases to 37.5 percent for taxable years beginning after December 31, 2025, resulting in an effective tax rate of 13.125 percent on GILTI beginning in 2026.
Under Section 960, U.S. corporations are also permitted FTCs for 80 percent of any foreign income taxes imposed on GILTI. As a result, corporate taxpayers generally will be able to avoid U.S. tax on GILTI if they are subject to foreign tax at a rate of 13.125 percent (16.41 percent after 2025) or more. However, for FTC purposes, GILTI is in a separate basket with no carrybacks or carryforwards, and therefore circumstances may arise where additional U.S. tax is owed even if the foreign tax rate exceeds these thresholds.
Summary of Proposed Regulations
The Proposed Regulations generally focus on computational and definitional guidance with respect to calculating the GILTI inclusion, including rules in the context of domestic partnerships and consolidated groups. They also contain robust anti-avoidance provisions.
Computational and Definitional Guidance on the GILTI Inclusion. The Proposed Regulations supplement and clarify various aspects of the computational and definitional rules under Section 951A.
- High-Taxed Income. Based on its name, “global intangible low-taxed income,” there was some uncertainty as to whether all income subject to high rates of foreign tax was excluded from GILTI. The Proposed Regulations follow the literal text of the Code and clarify that the specific exclusion for high-taxed income applies only to income that would have been taxed currently as “subpart F income”4 but is not solely because it is subject to a high rate of foreign tax (>18.9 percent). Accordingly, taxpayers should be aware that other high-taxed income does not escape the GILTI rules under this exception. However, FTCs might reduce or eliminate the U.S. tax on such income.
- Rules Relating to the Exclusion of a Deemed 10 Percent Return on Investment in Tangible Depreciable Property. As mentioned above, GILTI is reduced by an amount equal to a deemed 10 percent return on the shareholder’s share of each of its CFC’s QBAI, reduced by certain interest expense.
- Dual Use Properties. QBAI is calculated by reference to the tax basis of a CFC’s property that produces tested income. Where property produces both tested income and other income, the Proposed Regulations require a U.S. Shareholder to take into account only a ratable share of the tax basis in the property. The ratable share depends on whether the property produces directly identifiable income (e.g., production equipment producing widgets) or does not (e.g., a general purpose office building). If the property produces directly identifiable income, the ratable share corresponds to the share of income from that property that is tested income. If the property does not produce directly identifiable income, the ratable share corresponds to the share of the income of the CFC (not that specific property) that is tested income.
- Depreciation Method. The tax basis used for purposes of determining a CFC’s QBAI is determined by calculating depreciation on a straight-line basis (rather than applying accelerated depreciation rules). This depreciation method applies from the date that the property was placed in service, even if that property was placed in service before the enactment of the Tax Act. This is generally favorable to taxpayers, as it increases QBAI and thus the deemed 10 percent return that can escape taxation under the GILTI rules.
- Tangible Property of CFCs with Losses. The Proposed Regulations clarify that tangible property of a CFC with a tested loss is not taken into account in determining QBAI. Accordingly, the tangible property of tested loss CFCs does not reduce the GILTI inclusion. Taxpayers may therefore want to transfer depreciable tangible assets to those CFCs that are projected to have tested income to maximize their QBAI.5
- Determining the Shareholder’s Pro-Rata Share of a CFC’s QBAI. A shareholder’s pro rata share of a CFC’s QBAI generally is determined by multiplying the CFC’s QBAI by the percentage of the CFC’s tested income that is allocable to the shareholder. However, the share of QBAI allocated to preferred stock is capped at 10 times the amount of tested income attributable to the preferred stock.
- Tangible Property of Partnerships. Where a CFC is a partner in a partnership that owns tangible depreciable property, the CFC’s share of tax basis is determined based on the percentage of the income generated by such property that is allocable to the CFC. This could lead to unexpected results when partnership income is not shared pro rata. For example, if a partnership issues both common and preferred interests, partnership income (and thus tax basis for QBAI purposes) might be allocated solely to the preferred partners in a year, which would result in no tax basis being allocated to the common partners.
- Specified Interest Expense. As noted, the deemed 10 percent return on QBAI (which reduces GILTI) is itself reduced by certain interest expense (specified interest expense). Accordingly, GILTI is increased by such interest expense on a dollar-for-dollar basis, effectively disallowing the benefit of such interest expense. The Code describes the interest expense subject to this rule as any interest expense taken into account in computing GILTI if the corresponding interest income is not taken into account in computing GILTI. This suggests a burdensome, tracing approach. The Proposed Regulations, however, rejected a tracing approach and instead calculate such interest expense as a shareholder’s aggregate pro rata share of CFC interest expense taken into account in calculating GILTI over CFC interest income taken into account in calculating GILTI. Under special provisions, certain interest expense and certain interest income related to a CFC’s active financing or insurance business is excluded for this purpose.
- Reliance on Existing Subpart F Rules. The Proposed Regulations rely heavily on the existing subpart F rules. For instance, a U.S. Shareholder’s pro rata share of a CFC’s tested income is generally based on the relative amount that the U.S. Shareholder would receive in a year-end hypothetical distribution of all the CFC’s current year earnings, as determined under the existing subpart F rules (as modified by the Proposed Regulations; see discussion below).
- Currency Translations. GILTI is computed at the U.S. Shareholder level. Accordingly, the various items of the CFC that are required to calculate GILTI need to be translated into U.S. dollars. The Proposed Regulations provide that the translation is to be made using the average exchange rate during the taxable year.
- U.S. Tax Accounting Principles. The Proposed Regulations provide that a CFC’s tested income or loss generally is determined by applying U.S. tax accounting rules, treating the CFC as if it were a domestic corporation. However, the preamble requests comments as to whether a CFC should be allowed a deduction for, or required to include in income, amounts that are expressly limited to domestic corporations under the Code, such as the Section 245A dividends received deduction added by the Tax Act for certain dividends received by domestic corporations from 10 percent owned foreign corporations. The preamble notes that issues related to Section 245A, as well as Sections 163(j) (limiting the deductibility of business interest) and 267A (denying deductions for certain amounts paid in hybrid transactions or by (or to) hybrid entities), will be addressed in future guidance.
- Interaction with Subpart F Income. The Proposed Regulations clarify that the earnings and profits cap on subpart F income is disregarded for purposes of determining what income is subpart F income and thus excluded when calculating tested income or loss.
CFCs Held by Domestic Partnerships. The Proposed Regulations adopt a blended “aggregate” and “entity” approach in applying the GILTI rules to CFCs owned by domestic partnerships, treating the partnership as an entity with respect to partners that are not U.S. Shareholders of CFCs owned by the partnership and as an aggregate with respect to partners that are themselves U.S. Shareholders with respect to one or more CFCs owned by the partnership. This blended approach results in (i) each non-U.S. Shareholder partner including its distributive share of the partnership’s GILTI inclusion in its income and (ii) each U.S. Shareholder partner determining a single GILTI inclusion by reference to all of the CFCs with respect to which it is a U.S. Shareholder, even if owned through domestic partnerships.
Under the blended approach, a domestic partnership that is a U.S. Shareholder of a CFC computes its GILTI in the same manner as any other U.S. Shareholder, and each partner generally takes into account its distributive share of the domestic partnership’s GILTI inclusion. However, if a partner is itself a U.S. Shareholder of one or more CFCs owned by the partnership, that partner instead computes its GILTI by taking into account its proportionate share of the partnership’s pro rata share of each of the relevant items (i.e., tested income, tested loss, QBAI and certain interest income and expense) for each such CFC. Such a partner must also include in income its distributive share of the partnership’s GILTI attributable to any CFCs with respect to which the partner is not a U.S. Shareholder.
Thus, a U.S. Shareholder partnership is required to provide to its partners information regarding their distributive share of the partnership’s GILTI and, for each U.S. Shareholder partner, the partner’s proportionate share of the partnership’s pro rata share (if any) of each relevant item.
Consolidated Groups. The Proposed Regulations also provide guidance for calculating GILTI for members of a consolidated group. The preamble to the Proposed Regulations states that the IRS and Treasury “determined that a member’s GILTI inclusion amount should be determined by reference to the relevant items of each CFC owned by members of the same consolidated group” (i.e., GILTI is calculated on a consolidated group basis). Accordingly, to determine a group member’s GILTI inclusion, the pro rata shares of the relevant CFC items of each member are aggregated across the group, and then a portion of each aggregate CFC item is allocated to each member of the group that is a U.S. Shareholder of a tested income CFC based on the proportion of such member’s aggregate pro rata share of tested income to the total tested income of the consolidated group. This brings much-sought relief for consolidated groups that do not need to determine the GILTI inclusions separately with respect to each U.S. Shareholder that is a member of the consolidated group and generally prevents abuse by limiting the potential manipulation that would have been available under the GILTI aggregation and FTC rules if different members of the group held shares in different CFCs. For example, if one member of the group holds stock in CFCs with tested income, and another member holds stock in CFCs with tested loss, the tested loss would not be available to offset the tested income if GILTI was calculated separately for each member, resulting in artificially high GILTI inclusions for the group as a whole.
GILTI Inclusions by Tax-Exempt Shareholders. The Proposed Regulations do not contain guidance on whether the GILTI inclusion is characterized as unrelated business taxable income (UBTI) for tax-exempt entities. However, IRS Notice 2018-67 provides that a GILTI inclusion is to be treated as a dividend for this purpose, and thus would generally be excluded from UBTI so long as the CFC stock was not acquired with borrowed money.
Adjustment to Tax Basis to Prevent Loss Duplication. Even though the Code did not require any adjustment to the tax basis of CFCs whose tested losses were used to reduce the tested income of other CFCs, the Proposed Regulations include a set of rules that would reduce the tax basis in such tested loss CFCs immediately prior to a disposition of their stock to prevent the duplicative use of such losses (i.e., once to reduce GILTI inclusions and again to reduce gain (or increase loss) on the disposition of stock).
Anti-Abuse Rules. The Proposed Regulations contain two anti-abuse rules targeting certain transfers of property that could reduce GILTI inclusions.
- One rule would disregard items of tangible property for purposes of calculating a CFC’s QBAI if the CFC (1) acquires the property with a principal purpose of reducing a GILTI inclusion and (2) holds the property temporarily but over at least one quarter-end measuring date for computing QBAI. For this purpose, property held for less than a 12-month period that includes at least one quarter-end during the taxable year of a tested income CFC is treated as meeting these requirements if it would reduce any U.S. Shareholder’s GILTI inclusion.
- The other rule would disallow the benefit of a stepped-up tax basis in property transferred between related CFCs after January 1, 2018, and before the GILTI rules became effective with respect to the transferring CFC (as a result of having a tax year that is not a calendar year). This anti-abuse rule, however, does not apply to the extent the gain on the transfer was subject to U.S. tax. Some taxpayers have been engaging in such transfers to increase the tax basis of their property to fair market value by recognizing built-in gain before the GILTI rules would subject it to current taxation (thus hoping to increase the transferee CFC’s QBAI or depreciation or amortization deductions, any of which could reduce GILTI inclusions).
Revisions to Subpart F “Pro Rata Share” Rules. The Proposed Regulations would replace existing (largely mechanical) rules for determining a U.S. Shareholder’s pro rata share of a CFC’s subpart F income (and now also its relevant items for GILTI purposes) when the CFC has multiple classes of stock with a test that is based “on all relevant facts and circumstances.” The change targets, for example, structures involving shares with preferred liquidation and distribution rights or cumulative preferred stock with dividends that compound less frequently than annually. Moreover, the Proposed Regulations would add an anti-abuse rule that would disregard any transaction or arrangement that is part of a plan a principal purpose of which is the avoidance of U.S. federal income tax when determining a U.S. Shareholder’s pro rata share of subpart F income or relevant items for GILTI purposes.
The Proposed Regulations provide much-needed computational and definitional guidance with respect to calculating GILTI, especially in the context of domestic partnerships and consolidated groups. However, many questions remain. Most notably, the Proposed Regulations do not address FTCs with respect to GILTI or the corporate deduction resulting in lower effective tax rates on GILTI (both of which are forthcoming). Moreover, the IRS and Treasury requested comments on a number of issues, including matters covered in the Proposed Regulations, which suggests that the final rules could look materially different in some respects from the rules in the Proposed Regulations.
1 All “Section” references herein are to the Code.
2 Except to note that it is anticipated that the FTC proposed regulations will provide rules for assigning the Section 78 gross-up attributable to GILTI FTCs to the GILTI basket under Section 904.
3 The excluded items are income that is subject to U.S. net income tax in the hands of the CFC, “subpart F income” (which is already subject to current taxation for U.S. Shareholders), certain categories of high-taxed income, dividends received from related parties, and foreign oil and gas extraction income.
4 Subpart F income includes certain passive-type income (e.g., dividends, interest, royalties, rents, net capital gains); certain income from sales to, from, or on behalf of a related person; income from certain services performed for or on behalf of a related party; and certain insurance or reinsurance income.
5 The benefit of any stepped-up tax basis resulting from such a transfer may be disallowed if the transfer is covered by one of the anti-abuse rules discussed below. Nevertheless, at least the pretransfer tax basis of the tangible property transferred to a CFC that is projected to have tested income should still increase QBAI, resulting in a lower GILTI inclusion.
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