United States: A Deep Dive Into G.I.L.T.I. Guidance

Last Updated: December 12 2018
Article by Stanley C. Ruchelman and Rusudan Shervashidze

INTRODUCTION

The 2017 Tax Cuts and Jobs Act ("T.C.J.A.") introduced a new anti-abuse tax regime applicable to controlled foreign corporations ("C.F.C.'s"). The Treasury Department and the I.R.S. introduced Proposed Treasury Regulations on September 13, 2018, ("Proposed Regulations") that provide guidance on calculating global intangible lowtaxed income ("G.I.L.T.I."). For an introduction to the G.I.L.T.I. regime, see "A New Tax Regime for C.F.C.'s: Who Is G.I.L.T.I.?" in Insights.

At one level, the G.I.L.T.I. regime is designed to decrease the incentive for a U.S.- based multinational group to shift corporate profits to controlled subsidiaries based in low-tax jurisdictions. This treatment is particularly important because the T.C.J.A. has modified U.S. tax law to provide a dividends received deduction ("D.R.D.") for dividends received from foreign subsidiaries. Without G.I.L.T.I., a U.S.-based group could erode its U.S. tax base by shifting profit-making activities to its C.F.C.'s that could generate low-tax profits abroad and distribute them to the U.S. parent on a tax-free basis under the D.R.D.

At another level, the G.I.L.T.I. regime reflects a shift in U.S. tax policy regarding international operations. Prior to the T.C.J.A., U.S. tax policy was nominally one of global taxation, but as news articles relating to the largest of U.S. multinational companies indicated, it was effectively a territorial tax system. With a large enough budget, U.S. rules such as those embodied in Subpart F and Code §367(a) and (d) could be gamed so that U.S. tax jurisdiction was limited to income from U.S. operations. With the enactment of the T.C.J.A., the U.S. tax system nominally became a modified territorial tax system. However, the effect of provisions such as the Transition Tax, G.I.L.T.I., and F.D.I.I. is that the U.S. effectively adopted a global tax system with several effective rates. The rates are (i) 8% or 15.5% for transition tax, (ii) 21% for income from domestic operations and international operations caught by Subpart F, and (iii) 13.125% under F.D.I.I. for U.S. operations that service a foreign market and under G.I.L.T.I. for international operations that do not generate immediate tax under Subpart F (once the 80% foreign tax credit on G.I.L.T.I. is factored into the computation).

COMPUTATIONAL CAVEAT

While similarities exist as to the purpose of the G.I.L.T.I. regime and Subpart F Income – each provides for current taxation of certain income of a C.F.C. – certain fundamental differences exist in the way income is included in the tax return of a U.S. Shareholder.

Subpart F Income is determined at the level of each C.F.C. Once it is determined, a U.S. Shareholder of that C.F.C. includes in gross income its pro rata share. In this way, the amount of the U.S. Shareholder's inclusion with respect to one C.F.C. is not taken into account in determining that U.S. Shareholder's inclusion with respect to another C.F.C. Stated somewhat differently, a silo exists between each U.S. Shareholder and each separate C.F.C. that is owned. If multiple C.F.C.'s are owned, multiple silos exist.

In comparison, when a U.S. Shareholder computes its income inclusion under the G.I.L.T.I. regime, it aggregates and then nets or multiplies its pro rata share of all items into a single shareholder level amount. Consequently, no matter how many C.F.C.'s exist, only one single aggregate Tested Income amount is computed. That amount is reduced by aggregate Tested Loss of all C.F.C.'s reporting losses. The result is only one net Tested Income for the C.F.C.'s and only one aggregate qualified business asset investment ("Q.B.A.I.") that is multiplied by 10% to arrive at only one single deemed tangible income return ("D.T.I.R."). A U.S. Shareholder's G.I.L.T.I. inclusion amount for a taxable year is calculated by subtracting only one aggregate shareholder level amount from another. The U.S. Shareholder's net D.T.I.R. is the excess of the D.T.I.R. over certain interest expense. Finally, the G.I.L.T.I. inclusion amount is the excess of the net C.F.C. Tested Income over its net D.T.I.R. Because there is only one set of computations no matter how many C.F.C.'s are owned by a U.S. Shareholder, an inclusion of G.I.L.T.I. will occur.

GENERAL RULES AND DEFINITIONS

The Proposed Regulations under Prop. Treas. Reg. §1.951A-1 provide general operating rules and definitions:

  • Prop. Treas. Reg. §1.951A-1(c)(3) defines D.T.I.R., which is computed at the U.S. Shareholder level based on Q.B.A.I. held by the C.F.C.'s of the shareholder and reduces the shareholder's net C.F.C. Tested Income for purposes of determining the G.I.L.T.I inclusion amount. The Proposed Regulations clarify that a Tested Loss C.F.C. is treated as not having specified tangible property. As a result, tangible property of a Tested Loss C.F.C. is not taken into account in calculating a U.S. Shareholder's aggregate pro rata share of Q.B.A.I., its D.T.I.R., or its net D.T.I.R.
  • As prescribed by the Code, the Proposed Regulations incorporate the pro rata share rules of Subpart F, with modifications to account for the differences between Subpart F Income and the components of G.I.L.T.I. (specifically, Tested Income, Tested Loss, and Q.B.A.I.):

    • The pro rata share of Tested Loss and Q.B.A.I. of a preferred shareholder must be computed (discussed below).
    • Tested Income must be allocated among U.S. Shareholders of a C.F.C., so that a C.F.C. having more than one U.S. Shareholder must allocate Tested Income to each U.S. Shareholder's in the same manner as it allocates Subpart F Income to each U.S. Shareholder under Code §951(a)(2) and Prop. Treas. Reg. §1.951-1(b) and (e). In other words, it is based on the relative amount that would be received by each U.S. Shareholder in a year-end hypothetical distribution of all the C.F.C.'s current year earnings.1
    • Q.B.A.I. deemed distributed to the U.S. Shareholder in the hypothetical distribution generally must be proportionate to the amount of the C.F.C.'s Tested Income distributed in the hypothetical distribution to the U.S. Shareholder.2
    • Tested Income between holders of preferred shares and common shares must also be allocated when, for G.I.L.T.I. purposes, a C.F.C. has a positive return on Q.B.A.I. but a loss from operations. Where a C.F.C.'s Q.B.A.I. exceeds its Tested Income by a factor of ten or more, so that the amount of Q.B.A.I. allocated to preferred stock exceeds ten times the Tested Income allocated to the preferred stock under the general proportionate allocation rule, the excess amount of Q.B.A.I. must be allocated solely to the C.F.C.'s common stock.3 This rule is meant to ensure that the notional return associated with the C.F.C.'s Q.B.A.I. generally flows to the shareholders in a manner consistent with their economic rights in the earnings of the C.F.C.
    • Tested Loss allocated among a C.F.C.'s U.S. Shareholders is generally distributed solely with respect to the holder of a C.F.C.'s common stock, based on their proportional holdings.4
  • A special rule addresses the allocation of Tested Loss when the shares of a C.F.C. are not held for an entire year by a U.S. Shareholder. Under the rule,5 the Tested Loss is treated as a dividend received by another person even if an actual dividend is not made by the Tested Loss C.F.C. The effect of this rule is to reduce a U.S. Shareholder's pro rata share of Tested Loss in proportion to the number of days the shareholder did not own the stock of the Tested Loss C.F.C. in order to allocate to each U.S. Shareholder an amount commensurate with the economic loss borne by such person with respect to the Tested Loss.

TESTED INCOME AND TESTED LOSS

Both gross Tested Income and Subpart F Income are determined at the C.F.C. level – although, as previously mentioned, gross Tested Income is computed on an aggregate basis with regard to all C.F.C.'s. Consequently, aggregate net Tested Income of all C.F.C. subsidiaries and net Subpart F Income of each particular C.F.C. are taxed to a U.S. Shareholder on a current basis.

Use of U.S. Domestic Rules

At the C.F.C. level, the determination of gross income and allowable deductions for G.I.L.T.I. is made under procedures that are similar to the determination of Subpart F Income. Accordingly, the Tested Income or Tested Loss of a C.F.C. is determined by treating the C.F.C. as a domestic corporation taxable under Code §11 and by applying the principles of Code §61.6 Only items of deduction that are allowable in determining the taxable income of a domestic corporation may be taken into account for purposes of determining a C.F.C.'s net Tested Income or Tested Loss. Nondeductible expenses, such as additions to a reserve for estimated items or notional expenses, cannot be taken into account when determining the Tested Income or Tested Loss of the C.F.C. This treatment is not altered even if the item reduces the C.F.C.'s earnings and profits ("E&P"). The I.R.S. has requested comments on the application of the rules for purposes of determining Subpart F Income, Tested Income, and Tested Loss and the interactions of Code §§163(j) and 267A with Code §951A.

High-Tax Exception – Limited Application

The Proposed Regulations clarify how the high-tax exception is to be applied in the case of Tested Income. Under the high-tax exception, a U.S. Shareholder of a C.F.C. does not include in income any Subpart F Income that is subject to a high tax rate abroad. Broadly speaking, the effective rate of foreign tax on an item of income must exceed 90% of the highest rate of U.S. corporate tax on that income. In computing the effective tax rate in a foreign country, the C.F.C.'s gross income is computed by applying U.S. concepts of income and expense, not foreign concepts. Once income is computed, the actual foreign tax paid is compared with the notional U.S. tax computed under U.S. concepts. At the current corporate tax rate of 21%, the actual foreign tax must exceed 18.9% in order for the high-tax exception to be applicable. Income of a C.F.C. that would be Subpart F Income but for the high-tax exemption is excluded from Tested Income. The Proposed Regulations clarify that if the item of income of a C.F.C. is not Subpart F Income for the C.F.C., the high-tax exception is not applied in determining Tested Income. In such instance, the only tax relief available is the foreign tax credit applicable to G.I.L.T.I.

E&P Limitation

Code §952(a) identifies items of Subpart F Income. For most U.S. taxpayers, the principal item of concern is Foreign Base Company Income. Included in that category of income are Foreign Personal Holding Company Income, Foreign Base Company Sales Income, and Foreign Base Company Services Income. Subpart F Income is limited to current E&P.7 Where that ceiling prevents the full inclusion of Subpart F Income, the benefit is recaptured from excess earnings of Subpart F Income in subsequent years. The proposed regulations address the interplay of the definitional rule and the ceiling for G.I.L.T.I. purposes. Simply stated, all income that is identified as Subpart F Income under Code §952(a) is included in gross Tested Income. Consequently, the recapture of Subpart F Income under Code §952(c)(2) is irrelevant – income that is recaptured as Subpart F Income in a subsequent year is not excluded from gross Tested Income in the recapture year.8

Example

A domestic corporation, USCo, owns 100% of the single class of stock of a C.F.C., C.F.C. 1. USCo and C.F.C. 1 use the calendar year as the taxable year. In Year 1, C.F.C. 1 has Foreign Base Company Income of $100, a loss in foreign oil and gas extraction income of $100, and E&P of $0. C.F.C. 1 has no other income. In Year 2, C.F.C. 1 has a gross income of $100 and E&P of $100. Without regard to Code §952(c)(2), the C.F.C. has no other income in Year 2. The C.F.C. has no allowable deductions properly allocable to gross Tested Income for Year 2.

As a result of the E&P limitation of Code §952(c)(1), C.F.C. 1 has no Subpart F Income in Year 1, and USCo has no inclusion with respect to C.F.C. 1 under Code §951(a)(1)(A). The gross Tested Income of the C.F.C. is determined without regard to Code §952(c)(1). Therefore, in determining the gross Tested Income of C.F.C. 1 in Year 1, the $100 Foreign Base Company Income of the C.F.C. in Year 1 is excluded, and C.F.C. 1 has no gross Tested Income in Year 1.

In Year 2, under Code §952(c)(2), C.F.C. 1's E&P ($100) in excess of its Subpart F Income ($0) is treated as Subpart F Income. Therefore, C.F.C. 1 has Subpart F Income of $100 in Year 2, and USCo has an inclusion of $100 with respect to C.F.C. 1 under Code §951(a)(1)(A). The gross Tested Income of C.F.C. 1 is determined without regard to Code §952(c)(2). Accordingly, C.F.C. 1's income in Year 2 is not Subpart F Income, and C.F.C. 1 has $100 of gross Tested Income.

Q.B.A.I.

The Proposed Treasury Regulations provide that the Q.B.A.I. of a tested income C.F.C. for any taxable year is the average of the C.F.C.'s aggregate adjusted bases as of the close of each quarter in specified tangible property that is used in a trade or business of the corporation and of a type with respect to which a deduction is allowable under Code §167.9 In general, specified tangible property is tangible property used in the production of Tested Income.10 Tangible property is defined as property for which the depreciation deduction provided by Code §167(a) is eligible to be determined under Code §168 (even if the C.F.C. has elected not to apply Code §168).11 The Proposed Regulations define tangible property by reference to property that can be depreciated under Code §168. A substantial amount of guidance exists regarding property that may be depreciated under Code §168.

Dual-Use Property

Dual-use property is treated as specified tangible property on a proportional basis12 based on the relative amount of gross Tested Income to other gross Tested Income that the property generates for the taxable year.13 A special rule is provided for determining the proportion of the property treated as specified tangible property if the property generates no directly identifiable income.14

Example

A tested income C.F.C., C.F.C. 1, owns a machine that only packages Product A, which is acquired from a related party based in the U.S. In Year 1, C.F.C. 1 sells Product A to related and unrelated resellers for use and consumption in a third country and earns $1,000 of gross income. For Year 1, sales of Product A produce gross Tested Income of $750 and Foreign Base Company Sales Income of $250. Packaging does not meet the definition of manufacturing for purposes of Subpart F. The average adjusted basis of the machine for Year 1 in the hands of C.F.C. 1 is $4,000. C.F.C. 1 also owns an office building for its administrative functions, with an average adjusted basis for Year 1 of $10,000. The office building does not produce directly identifiable income. C.F.C. 1 has no other specified tangible property. For Year 1, C.F.C. 1 also earns $1,250 of gross Tested Income and $2,750 of Foreign Base Company Sales Income from sales of Product B. Neither the machine nor the office building is used in the production of income related to Product B. For Year 1, C.F.C. 1's gross Tested Income is $2,000 and its total gross income is $5,000.

The machine and office building are both properties for which depreciation deductions under Code §167(a) may be claimed and qualify as tangible property under Code §168. The basis in the machine allocated to specified tangible property is equal to C.F.C. 1's average basis in the machine for the year ($4,000), multiplied by the percentage that gross Tested Income produced by the property ($750) bears to the total gross income produced by the property ($1,000), or 75%. Accordingly, $3,000 ($4,000 x .75) of C.F.C. 1's adjusted basis in the machine is taken into account in determining the average of C.F.C. 1's aggregate adjusted bases. The portion of the basis in the office building treated as basis in specified tangible property is equal to C.F.C. 1's average basis in the office building for the year ($10,000), multiplied by the percentage that gross Tested Income produced by the property ($2,000) bears to the total gross income produced by the property ($5,000), or 40%. Accordingly, $4,000 ($10,000 x .40) of C.F.C. 1's adjusted basis in the office building is taken into account in determining the average of C.F.C. 1's aggregate adjusted bases in specified tangible property.

Computing Adjusted Basis

The Proposed Regulations provide that the adjusted basis in any property is determined by using the alternative depreciation system under Code §168(g) ("A.D.S.") and allocating the depreciation deduction with respect to the property ratably to each day during the period in the taxable year to which the depreciation relates. A.D.S. applies for purposes of determining Q.B.A.I. even if another depreciation method is used for other purposes of the Code. In circumstances where specified tangible property was acquired before December 22, 2017, the adjusted basis in the property is determined using A.D.S. as if this system applied from the date that the property was placed in service.15

tax rate abroad. Broadly speaking, the effective rate of foreign tax on an item of income must exceed 90% of the highest rate of U.S. corporate tax on that income. In computing the effective tax rate in a foreign country, the C.F.C.'s gross income is computed by applying U.S. concepts of income and expense, not foreign concepts. Once income is computed, the actual foreign tax paid is compared with the notional U.S. tax computed under U.S. concepts. At the current corporate tax rate of 21%, the actual foreign tax must exceed 18.9% in order for the high-tax exception to be applicable. Income of a C.F.C. that would be Subpart F Income but for the high-tax exemption is excluded from Tested Income. The Proposed Regulations clarify that if the item of income of a C.F.C. is not Subpart F Income for the C.F.C., the high-tax exception is not applied in determining Tested Income. In such instance, the only tax relief available is the foreign tax credit applicable to G.I.L.T.I.

E&P Limitation

Code §952(a) identifies items of Subpart F Income. For most U.S. taxpayers, the principal item of concern is Foreign Base Company Income. Included in that category of income are Foreign Personal Holding Company Income, Foreign Base Company Sales Income, and Foreign Base Company Services Income. Subpart F Income is limited to current E&P.7 Where that ceiling prevents the full inclusion of Subpart F Income, the benefit is recaptured from excess earnings of Subpart F Income in subsequent years. The proposed regulations address the interplay of the definitional rule and the ceiling for G.I.L.T.I. purposes. Simply stated, all income that is identified as Subpart F Income under Code §952(a) is included in gross Tested Income. Consequently, the recapture of Subpart F Income under Code §952(c)(2) is irrelevant – income that is recaptured as Subpart F Income in a subsequent year is not excluded from gross Tested Income in the recapture year.8

Short Taxable Year

The Proposed Regulations provide a methodology to reduce the Q.B.A.I. of a C.F.C. with a short taxable year to an amount that would produce an amount equal to the Q.B.A.I. if annualized for a full 12-month taxable year.16

In determining the Q.B.A.I. of a tested income C.F.C. for a short taxable year, the quarters are the full three-month quarters beginning and ending within the short taxable year plus one or more short quarters that exist. The Q.B.A.I. is the sum of the following two amounts:

  • The C.F.C.'s aggregate adjusted bases in specified tangible property as of the close of each full quarter divided by four
  • The aggregate adjusted bases in specified tangible property as of the close of each short quarter, multiplied by the sum of the number of days in each short quarter, and divided by 365

Operation Through Partnerships

If a C.F.C. holds an interest in a partnership at the close of the C.F.C.'s taxable year, the C.F.C. takes into account its distributive share of the aggregate of the partnership's adjusted bases.17 Because the term "distributive share" is used in Subchapter K of the Code only with respect to income, gain, loss, and credits of a partnership, the Proposed Regulations use the term "share" when referring to the inside basis of a partnership asset that a partner may include in its Q.B.A.I.

A C.F.C.'s share of the partnership's adjusted basis in specified tangible property is computed by reference to the partnership's average adjusted basis in the property as of the close of each quarter of the partnership's taxable year that ends with or within the C.F.C.'s taxable year.18 Consistent with the general rule for Q.B.A.I., only a C.F.C. with Tested Income can increase its Q.B.A.I. by reason of specified tangible property owned by a partnership.19

A C.F.C. determines its share of a partnership's average adjusted basis in specified tangible property by reference to its distributive share of the gross income produced by the property that is included in Tested Income of the C.F.C. as a percentage relative to the total amount of gross income produced by the property.20 If the partnership has dual-use property, similar rules to those discussed above are applied for addressing specified tangible property that does not produce any directly identifiable income. The calculation is performed separately for each item of specified tangible property held by the partnership, taking into account the C.F.C. partner's distributive share of income with respect to such property.

Anti-Abuse Provisions

Specified tangible property of a C.F.C. is disregarded for purposes of determining the average aggregate basis in specified tangible property if the property is acquired on a temporary basis at quarter-end with a principal purpose of reducing the G.I.L.T.I. inclusion amount of a U.S. Shareholder.21 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 C.F.C. is treated as temporarily held and acquired with a principal purpose of reducing the G.I.L.T.I. inclusion amount of a U.S. Shareholder.22 This eliminates any opportunity for one C.F.C. to acquire tangible property from another C.F.C. to provide the transferee C.F.C. with a stepped-up basis in the transferred property, thereby increasing Prop. Treas. Reg. Q.B.A.I.23

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Footnotes

1 Prop. Treas. Reg. §1.951A-1(d)(2)(i).

2 Prop. Treas. Reg. §1.951A-1(d)(3)(i).

3 Prop. Treas. Reg. §1.951A-1(d)(3)(ii).

4 Prop. Treas. Reg. §1.951A-1(d)(4).

5 Prop. Treas. Reg. §1.951A-1(d)(4)(i)(D).

6 Prop. Treas. Reg. §1.952-2(a)(1); Prop. Treas. Reg. §1.951A-2(c)(2), subject to the special rules in Prop. Treas. Reg. §1.952-2(c).

7 Code §952(c)(1).

8 Prop. Treas. Reg. §1.951A-2(c)(4).

9 Prop. Treas. Reg. §1.951A-3(b).

10 Prop. Treas. Reg. §1.951A-3(c)(1).

11 Prop. Treas. Reg. §1.951A-3(c)(2).

12 Prop. Treas. Reg. §1.951A-3(d)(1).

13 Prop. Treas. Reg. §1.951A-3(d)(2)(i).

14 Prop. Treas. Reg. §1.951A-3(d)(2)(ii).

15 Prop. Treas. Reg. §1.951A-3(e)(3).

16 Prop. Treas. Reg. §1.951A-3(f).

17 Code §951A(d)(1).

18 Prop. Treas. Reg. §1.951A-3(g)(3).

19 Prop. Treas. Reg. §1.951A-3(g)(1).

20 Prop. Treas. Reg. §1.951A-3(g)(2).

21 Prop. Treas. Reg. §1.951A-3(h)(1).

22 Id.

23 Prop. Treas. Reg. §1.951A-3(h)(2).

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Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

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