A 10 percent U.S. shareholder (by vote or value) of a non-U.S. corporation that is a “controlled foreign corporation” (CFC) must include each year (irrespective of any distributions) in its taxable income (i) its share of such CFC’s passive investment income (i.e., its subpart F income) and (ii) its share of such CFC’s active business income (i.e., its GILTI inclusion), in each case subject to a set of complex rules. For this purpose, a partnership formed under U.S. law (e.g., a Delaware limited partnership) could be treated as a 10 percent U.S. shareholder because it is a U.S. person within the meaning of the Internal Revenue Code of 1986, as amended (the Code). Thus, for instance, if U.S. and non-U.S. investors hold all the stock of a non-U.S. corporation through a U.S. partnership, then such non-U.S. corporation would be a CFC, and the U.S. investors would have phantom income inclusions (i.e., taxable income without corresponding cash receipts) with respect to such CFC under the subpart F income and/or GILTI rules even if each investor owns only, for example, 1 percent of the interests of such U.S. partnership. 2017 U.S. tax reform has resulted in a significant increase in the number of CFCs due to a dramatic expansion of the “downward attribution” rules.1 In addition, the GILTI rules are particularly adverse to U.S. individuals (no indirect foreign tax credit, no 50 percent deduction under Section 250, conversion of what otherwise could be long-term capital gains into ordinary income, administrative complexity and potentially large and difficult-to-predict amounts of phantom income depending on the operational success of a venture). Thus, prior to the Proposed Regulations, this new state of the U.S. tax rules has created a host of practical issues for private equity funds and their sponsors with respect to fund vehicles organized as U.S. partnerships.
The GILTI rules were enacted as an anti-abuse backstop in connection with 2017 U.S. tax reform’s move toward a more territorial regime (i.e., the U.S. would not tax foreign profits by way of the new 100 percent deduction for dividends from certain non-U.S. corporations, including CFCs, paid to domestic corporations). The GILTI rules are generally intended to ensure a combined minimum worldwide tax burden on most non-U.S. business profits of at least 10.5 percent. However, as a technical matter, the GILTI rules apply even to those CFCs that operate in traditionally high-tax jurisdictions such as France, Sweden, Brazil, Germany and Japan. This odd and surprising statutory construct is in sharp contrast to the Code’s subpart F income rules, which are in many circumstances expressly turned off by way of a high-tax kick-out (i.e., foreign passive investment income will not constitute subpart F income if it is subject to an effective foreign tax rate greater than 90 percent of the U.S. corporate tax rate (currently 18.9 percent in light of a 21 percent U.S. corporate tax rate)).
Summary of the Regulations
- No Inclusions for Partners of U.S. Partnerships Who Are Not Themselves 10 Percent U.S. Shareholders. The Proposed Regulations provide that persons who are partners in a U.S. partnership will not have any income inclusions under the subpart F income and/or GILTI rules in respect of stock of a CFC owned by such U.S. partnership if those partners are not themselves 10 percent U.S. shareholders of such CFC. This new “domestic partnership rule” would become effective after the publication of final regulations. However, a U.S. partnership may rely on this new rule with respect to taxable years beginning after December 31, 2017, and before the date that the Proposed Regulations are published as final regulations provided that the partnership, domestic partnerships that are related (within the meaning of section 267 or 707) to the partnership and certain partners consistently apply it.
Example 1: A domestic corporation (US Corp) and individual A, a U.S. citizen unrelated to US Corp, own 95 percent and 5 percent, respectively, of a Delaware partnership (US Partnership). US Partnership owns all of the single class of stock of a foreign corporation (Foreign Corp). Foreign Corp is a CFC, and US Partnership is a 10 percent U.S. shareholder for purposes of determining CFC status. In this regard, the law remains as it was. US Corp is also a United States shareholder of Foreign Corp because it owns 95 percent of Foreign Corp (by vote or value) under sections 958(b) and 318(a)(2)(A). Individual A, however, is not a 10 percent U.S. shareholder of Foreign Corp because A owns only 5 percent of Foreign Corp (by vote or value) under sections 958(b) and 318(a)(2)(A). As a result of the new domestic partnership rule, solely for purposes of determining income inclusions under the subpart F income and GILTI rules, US Partnership is treated in the same manner as a foreign partnership (i.e., a pure look-through approach). Therefore, solely for purposes of determining subpart F income and GILTI inclusions, US Corp is treated as owning 95 percent of Foreign Corp, and A is treated as owning 5 percent of Foreign Corp. US Corp is a 10 percent US shareholder of Foreign Corp and thus determines its subpart F income and GILTI inclusions based on its indirect ownership of Foreign Corp stock (95 percent). However, because A is not a 10 percent U.S. shareholder of Foreign Corp, A does not have subpart F income or GILTI inclusions with respect to Foreign Corp.
- High-Tax Kick-Out for Active Business Income Under GILTI Rules. A new high-tax kick-out rule for purposes of the GILTI rules applies to income that otherwise would constitute GILTI if such income is subject to tax at a rate greater than 90 percent of the U.S. corporate tax rate (i.e., greater than 18.9 percent, in light of the current U.S. tax rate of 21 percent). This new high-tax kick-out is a major shift toward simplifying the application of the GILTI rules. This high-tax kick-out, however, will become effective only after the publication of final regulations. If adopted in its current form, it would exempt from GILTI most of the active income of foreign corporations that is earned in developed countries.
- Private Equity Funds May Not Need to Restructure as Foreign Partnerships. After 2017 U.S. tax reform, numerous private equity funds needed to restructure their affairs to limit the adverse impact of the new GILTI rules. This was primarily achieved by restructuring existing U.S. partnerships as foreign (typically Cayman or Luxembourg) partnerships. Because this new domestic partnership rule applies to both single U.S. partnerships as well as tiered U.S. partnerships (e.g., a Delaware fund limited partnership and its general partner entity, which, in turn, is typically owned by U.S. individuals), such restructurings may, in certain cases, no longer be needed. While the private equity industry has been waiting for a technical fix to the GILTI rules and the extremely broad “downward attribution” rules, the Proposed Regulations take a different route that nonetheless limits some of the adverse impacts of the GILTI rules.
Example 2: Private equity fund X is structured as a Delaware limited partnership treated as a partnership for U.S. tax purposes. Since 2015, X has held 40 percent of the stock of Dubai corporation Y, a foreign corporation for U.S. tax purposes. The remaining 60 percent of the stock of Y has been held by co-investor Z, a non-U.S. sovereign wealth fund. Z owns numerous 100 percent U.S. corporate subsidiaries unrelated to the investment in Y. Y operates a highly profitable widget business, generating a substantial amount of GILTI. All investors in X are U.S. investors, and no investor in X owns more than 8 percent of X. The general partner of X (structured as a Delaware limited liability company treated as a partnership for U.S. tax purposes) has a 20 percent carried interest and, in turn, is owned in equal shares by 11 unrelated U.S. individuals. Prior to U.S. tax reform, Y was not a CFC. Since the enactment of tax reform, Y has been a CFC due to the downward attribution of Y stock from Z to its U.S. corporate subsidiaries. Prior to the Proposed Regulations, all of the U.S. investors would have GILTI inclusions in respect of Y. Under the Proposed Regulations, while Y is still a CFC, no U.S. investor, including no U.S. partner in the general partner (with respect to the carried interest), should have any GILTI inclusions. In the absence of the Proposed Regulations, X and its general partner might have wanted to restructure as Cayman entities to prevent future GILTI inclusions for the investors and owners of the general partner.
Example 3: Private equity fund X is structured as a Cayman limited partnership. Since 2016, X has held 100 percent of the stock of Japanese corporation Y, a foreign corporation for U.S. tax purposes. Y operates a highly profitable widget business, resulting in a large amount of GILTI. Y is subject to a 30 percent Japanese corporate tax rate. X also owns 100 percent of U.S. corporation Z. One U.S. investor, individual A, owns 11 percent of X, and all the other investors in X are non-U.S. persons. The general partner is structured as a foreign corporation held by numerous foreign entities. Whether or not the Proposed Regulations are relied on, A may have a GILTI inclusion because A is a 10 percent U.S. shareholder of Y, and Y is a CFC due to the downward attribution of Y stock from X to Z.2 This example shows that the Proposed Regulations concerning the new domestic partnership rule are far from a complete fix to the downward attribution problem. However, note that here the new high-tax kick-out rule could likely eliminate any GILTI inclusion for A.
- Consider 2018 Schedule K-1 Tax Reporting Positions. Private equity funds that have reported (or are about to report) on their 2018 Schedules K-1 significant amounts of GILTI to their U.S. taxable investors based on prior law may want to consider with their tax advisers their best course of action (e.g., amend K-1s, delay issuing K-1s).
- Private Equity Funds and Real Estate Investment Trusts (REITs) Will Benefit from the High-Tax Kick-Out Once Enacted. Because private equity funds and REITs often invest in highly developed, high-tax jurisdictions, the high-tax kick-out, once enacted, should reduce administrative burdens for private equity funds and REITs and the tax drag for their U.S. taxable investors. For REITs, this development will be particularly attractive because it should often allow them to ignore GILTI inclusions for purposes of determining their annual minimum distribution requirement. Private equity funds should be aware that solely for purposes of applying the high-tax kick-out, they could not blend low-taxed income from one country and high-taxed income from another country in a single “umbrella CFC” because the high-tax kick-out would be calculated on a business-unit–by–business-unit basis.
For more information, please see our previous GILTI Update here.
12017 U.S. tax reform repealed section 958(b)(4), which had prohibited the downward attribution of stock from a foreign person to a related U.S. person for determining, inter alia, CFC status. As a result, foreign corporations with little or no direct or indirect U.S. ownership may now be considered CFCs under a variety of fact patterns.
2Certain statements in the legislative history of the 2017 U.S. tax reform indicate that the changes to downward attribution were not intended to operate so broadly, but it is not clear whether such statements can be relied on in the absence of favorable guidance from the IRS.
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