Every one of us has some guilty pleasure, whether it's watching soap operas, binging on jelly donuts, attending electronic dance music parties after your 20s or whatnot. For tax aficionados, however, few pastimes can surpass perusing the 157 pages of regulations proposed on September 13, 2018, by the Internal Revenue Service ("IRS") under Section 951A of the US Internal Revenue Code of 1986, as amended (the "Code") (the "Proposed Regulations"). This Code section contains the rules applicable to the tax imposed on global intangible low-taxed income or "GILTI." The GILTI rules were intended to protect the US tax base from the shifting of profits to non-US jurisdictions, especially in light of the new participation exemption system under which offshore profits can be repatriated to US corporate shareholders with no US tax.
The introduction of the GILTI regime left taxpayers and practitioners struggling with a host of thorny questions. The Proposed Regulations provide awaited guidance on a number of these issues, such as the calculation of GILTI income inclusions for US consolidated groups and US partnerships. However, the IRS deliberately decided not to tackle in the Proposed Regulations some of the most critical questions, notably, those relating to the calculation of foreign tax credits for GILTI income and its interaction with the expense allocation rules. According to the preamble, tax aficionados will need to wait a few more months to indulge, yet again, in the guilty pleasure of unwrapping a new piece of IRS guidance to uncover the answers to those other questions.1
This Legal Update explores the Proposed Regulations, which generally are slated to be effective for tax years beginning in 2018.
Highlights of the Proposed Regulations
- Broad anti-abuse rules for certain transactions intended to reduce the GILTI inclusion.
- GILTI calculation on a consolidated basis for US consolidated groups.
- Hybrid approach for the taxation of CFCs owned by US partnerships.
- Stock basis reduction in CFCs that generate a tested loss.
- Confirmation that GILTI income is determined before Code § 956 inclusions.
- Announcement that the "Code § 78 gross up" will be included in the GILTI basket for foreign tax credit purposes.
The GILTI rules were enacted as part of the Tax Cut and Jobs Act in December 2017 and apply beginning in 2018.2 These rules were folded into the rules governing the taxation of CFCs under the subpart F regime, but operate largely independently of such rules.3 Specifically, for each year beginning in 2018 or after, a US shareholder4 must include in its gross income the excess of his "net CFC tested income" over its "net deemed tangible income return" ("net DTIR").5 The Proposed Regulations define this excess as a US shareholder's "GILTI inclusion amount."6
Broadly speaking, the US shareholder's "net CFC tested income" is the excess of (i) the aggregate of its pro rata share of its CFCs' "tested income" over (ii) the aggregate of its pro rata share of its CFCs' "tested loss."7 A CFC's "tested income" equals the excess of (x) the CFC's gross income without regard for certain items (including, but not limited to, items of subpart F income, effectively connected income and dividends received from related parties) over (y) the CFC's deductions properly allocable to such tested income—if, instead, (y) exceeds (x), the CFC will be considered to have a "tested loss."
The net DTIR equals (i) the shareholder's pro rata share of the aggregate adjusted bases of its CFCs' "specified tangible property"8 (determined by using the alternative depreciation system, regardless of when the property is acquired9) multiplied by a deemed 10 percent return, minus (ii) the amount of interest expense that reduced the CFCs' net tested income and was not included in another CFC's tested income.10 The Proposed Regulations refer to a CFC's investment in specified tangible property as "qualified business asset investment" or "QBAI."
In plain English, the CFC is deemed to earn a 10 percent return on its QBAI and all income earned by the CFC in excess of such 10 percent return is deemed to be GILTI. Thus, between the subpart F income rules and the GILTI rules, most US shareholders of CFCs do not truly enjoy a significant exemption or deferral on the income earned by their foreign subsidiaries, other than with respect to the 10 percent return on the investment in tangible property. So much for the proclaimed "territorial system."
Once a non-corporate US shareholder has determined his GILTI inclusion amount, he simply includes such amount in his gross income. If, however, the US shareholder is a domestic C-corporation, the US shareholder is entitled to a deduction equal to 50 percent of such amount (and of the Code § 78 gross-up).11 This deduction generally results in an effective rate of 10.5 percent for GILTI taxed to a C corporation, compared to the 37 percent top rate for GILTI taxed to a non-corporate shareholder. In addition, a US corporate shareholder is entitled to a foreign tax credit for up to 80 percent of the foreign taxes of a CFC that are properly attributable to the tested income.12 No foreign tax credits are available to non-corporate US shareholders. These disparities incentivize non-corporate US shareholders of CFCs to contribute their CFC stock to a C corporation or, alternatively, to consider making elections under Code § 962 to be subject to tax at the corporate rate and benefit from the foreign tax credits.
The Proposed Regulations
DETERMINATION OF TESTED INCOME AND TESTED LOSS
The Proposed Regulations flesh out how tested income and tested loss are calculated. The Proposed Regulations start the calculation with gross income excluding certain items (e.g., subpart F income) and then deduct CFC expenses that are allowable as deductions under the existing subpart F rules.13
On the income side of the calculation, subpart F income is excluded from tested income even if it is not taxed to a US shareholder because the CFC lacks sufficient earnings and profits. Conversely, no amount is excluded when subpart F income is recaptured in a later year under Code §952(c)(2).14 Further, the Proposed Regulations clarify that tested income does not include foreign base company income or insurance income that is excluded from subpart F income by reason of the high tax exception or kick-out. Importantly, this exclusion applies only to income that is excluded from subpart F income solely by reason of the high tax kick-out and not to income that would not otherwise be subpart F income.15
As for the deductible expenses, following the subpart F rules, the Proposed Regulations generally allow a CFC to deduct expenses that would be deductible if the CFC was a domestic corporation, subject to certain exceptions.16 Among these exceptions, notably, a CFC is not allowed a net operating loss ("NOL") carryforward deduction under Code § 172 and, therefore, a CFC's tested loss in one year cannot be used to offset that CFC's tested income in a later year.17
The IRS has requested comments on other applications of the general rule that allows CFCs to deduct expenses that would be allowable to a domestic corporation. For example, comments are requested on whether this fiction should allow a CFC to claim a dividend received deduction under Code §245A. In addition, the IRS announced that forthcoming guidance will address whether and how the interest deduction limitation rules of Code § 163(j) and the antihybrid rule of Code §267A should apply to the calculation of a CFC's tested income.
1 As a preview, the preamble to the Proposed Regulations announces that "it is anticipated" that the Code §78 grossup will be included in the "GILTI basket" for foreign tax credit purposes.
2 See Section 14201(a) of P.L. 115-97.
3 One particular distinction is that subpart F income inclusions are limited by the CFC's earnings and profits. GILTI, on the other hand, is included in the income of a US shareholder without regard to the CFC's earnings and profits. Additionally, while subpart F income is determined at the level of the CFC, the GILTI inclusion amount is determined at the shareholder level.
4 A US shareholder is a US person who owns, actually or through the application of certain attribution rules, 10 percent or more of the voting stock or value of all stock of the CFC. Code § 951(b).
5 Code § 951A(b)(1).
6 Prop. Treas. Reg. § 1.951A-1(c).
7 Code § 951A(c).
8 "Specified tangible property" is defined as tangible property used in the production of gross tested income. Prop. Treas. Reg. § 1.951A-3(c)(1). Tangible property is defined as property eligible for depreciation under Code § 168 determined without regard to Code §§168(f)(12), (2) or (5). Prop. Treas. Reg. § 1.951A-3(c)(2).
9 Prop. Treas. Reg. § 1.951A-3(e)(3).
10 Code § 951A(b)(2).
11 Code § 250(a)(1). The Code § 78 gross-up increases the amount taxable to certain US shareholders to account for taxes imposed on the CFC which may be claimed as a foreign tax credit by the US shareholder.
12 Code § 960(d).
13 Prop. Treas. Reg. § 1.951A-2(c)(2).
14 Prop. Treas. Reg. § 1.951A-2(c)(4).
15 Prop. Treas. Reg. § 1.951A-2(c)(iii).
16 Treas. Reg. § 1.952-2.
17 Treas. Reg. § 1.952-2(c)(5). See also Lewis-Velarde, Proposed GILTI Regs Could Result in Taxable Phantom Income, Worldwide Tax Daily (September 17, 2018). 18 Prop. Treas. Reg. § 1.951A-3(c)(2).
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