Recently released final regulations provide some relief to taxpayers that are subject to high foreign taxes on their global intangible low-taxed income (GILTI), but whether the GILTI high-tax exclusion is beneficial to any given taxpayer will require annual calculations as there are trade-offs to making the election. And, recently released proposed regulations would conform the elections for the subpart F high-tax exception to the GILTI high-tax exclusion, making them a single election applicable to all of a United States shareholder’s controlled foreign corporations (CFCs), further complicates the analysis.
Released on July 23, 2020, the
final regulations detail the GILTI high-tax exclusion and how taxpayers may elect the exclusion (the Final Regulations), providing some welcome flexibility compared to the proposed version of the regulations released in June 2019 (the 2019 Proposed Regulations), even if not going as far as many taxpayers had hoped. At the same time,
proposed regulations were released that would prospectively modify the new GILTI high-tax exclusion and the historic subpart F high-tax exception and bring them into conformity (the 2020 Proposed Regulations).
Significantly, under the Final Regulations:
- The GILTI high-tax exclusion that applies to any item of income that is subject to an effective foreign tax rate greater than 90 percent of the maximum corporate tax rate (i.e., currently 18.9 percent) is retained from the previously proposed regulations--but the final regulations adopt a “tested unit” approach in determining the effective foreign tax rate that combines all entities and branches resident in a foreign jurisdiction that are owned by a single CFC for purposes of determining the effective foreign tax rate;
- The election for the GILTI high-tax exclusion generally is required to be made with respect to all of a United States shareholder’s CFCs for the taxable year;
- The election is permitted to be made on an annual basis, eliminating the 60-month limitation on changing elections that would have applied under the proposed regulations; and
- The election can be applied retroactively to taxable years beginning after December 31, 2017 (i.e., all taxable years to which GILTI applies).
The 2020 Proposed Regulations detail changes to the subpart F high-tax exception to conform the exception to the GILTI high-tax exclusion, which would:
- Make the elections a single annual election that applies to the electing United States shareholder for all GILTI and subpart F purposes;
- Modify existing subpart F high-tax exception rules to adopt the “tested unit” approach in the Final Regulations for purposes of determining the effective foreign tax rate; and
- Base determinations of gross income for each tested unit on an “applicable financial statement,” rather than books and records.
A more comprehensive discussion of the provisions in the Final Regulations as well as the 2020 Proposed Regulations, and their impact on taxpayers, follows.
I. The GILTI rules
The GILTI rules of section 951A are a hallmark of the international tax reforms that were enacted as part of the Tax Cuts and Jobs Act (TCJA) in 2017. Under those rules, a United States shareholder generally is required to include in its US taxable income the GILTI of its CFCs.
A US shareholder computes GILTI by reference to all of its CFCs—there is not a separate GILTI inclusion for each CFC. Although the actual calculation is more involved, very simply stated GILTI is the excess of the net CFC tested income of the US shareholder’s CFCs over a 10 percent return on the CFCs’ investments in depreciable tangible property. Net tested income generally is the net income of the CFCs determined under US tax principles, except for subpart F income and certain other exempt income. For a more comprehensive discussion of the GILTI calculation, see our prior
Legal Alert.
A deduction is provided under section 250 for up to 50 percent of the amount of the GILTI inclusion (37.5 percent for tax years beginning after 2025) in calculating the US shareholder’s taxable income, resulting in an effective rate of tax as low as 10.5 percent (13.125 percent for tax years beginning after 2025). In addition, 80 percent of the foreign income taxes attributable to the GILTI inclusion can be claimed as a foreign tax credit (FTC), subject to the general FTC limitation rules. Before taking into account the potential limitation resulting from allocation of expenses at the US shareholder level, a taxpayer’s GILTI inclusion generally will not be subject to residual US income tax if the income has been subject to an average foreign effective rate of tax of at least 13.125 percent (16.40625 percent for tax years beginning after 2025). However, because of the operation of the FTC limitation rules, many US taxpayers have determined that residual US income tax results from their GILTI inclusions even when the effective foreign tax rate on their GILTI income exceeds 13.125 percent.
II. The proposed GILTI high-tax exclusion
Under section 951A(c)(2)(A)(i)(III), a gross item of income that is excluded from the foreign base company income of a corporation under section 954(b)(4) (the subpart F high-tax exception) also is excluded in determining net tested income for GILTI purposes. The IRS and Treasury determined that the statute is ambiguous as to whether this exception is intended to apply only to income that otherwise constitutes subpart F income and, in the 2019 Proposed Regulations, resolved the ambiguity by providing a separate high-tax exclusion from GILTI that is based on the subpart F high-tax exception.
The 2019 Proposed Regulations would have permitted taxpayers to elect to exclude all of a CFCs income from “tested income” if such income was considered to be “high taxed.” More specifically, if a taxpayer made the election under the proposed regulations, a tentative gross tested income item would be excluded from the calculation of net tested income if it was subject to an effective rate of foreign tax greater than 90 percent of the US statutory tax rate applicable to corporations (18.9 percent based on the current rate of 21 percent). A tentative gross tested income item was the aggregate of all items of gross tested income attributable to a qualified business unit (QBU) of the CFC within a single category of income as determined for FTC purposes. In other words, the GILTI high-tax exclusion applied to items of income within a single section 904 FTC basket at the level of each QBU of a CFC. The election, once made, could not be rescinded for 60 months.
A taxpayer electing the GILTI high-tax exclusion for an item of tested income would not be permitted to claim FTCs with respect to such income. In addition, an electing taxpayer would not be permitted to include in the determination of its QBAI the basis in any assets that generated income for which the election was made. For a complete discussion of the 2019 proposed regulations, see our prior
Article.
II. Details of the Final Regulations
The Final Regulations retain the basic structure of the GILTI high-tax exclusion as proposed in the 2019 Proposed Regulations, with certain revisions as outlined below, which respond to comments received on the proposed regulations.
| Eversheds Sutherland Observation: The fundamental trade-off in evaluating whether to elect the GILTI high-tax exclusion is (x) the benefit of reducing the portion of CFC stock held by the US taxpayer that is treated as a GILTI asset and therefore causes additional expenses to be apportioned to the GILTI basket, reducing the FTC limitation in that basket versus (y) forgoing the excess FTCs that are associated with the high-taxed GILTI that could offset the US tax imposed on the inclusion of low-taxed GILTI and the tested losses treated as high-taxed and the tangible assets related to the high-taxed GILTI for purposes of the QBAI computation, which could reduce the total GILTI inclusion. |
Tested unit standard for determining effective foreign tax rate
The Final Regulations adopt a “tested unit” standard for purposes of determining the effective rate of foreign tax, in lieu of the qualified business unit (QBU) approach of the 2019 Proposed Regulations. The tested unit construct generally combines entities or activities of a CFC that are actually subject to tax under a single foreign country’s tax law (i.e., as a tax resident, permanent establishment (PE), or similar taxable presence). The tested unit approach bears some similarity to the separate unit approach in the dual consolidated loss rules of section 1503(d), although they are not identical.
There are three types of tested units:
- CFCs;
- interests in pass-through entities held, directly or indirectly, by a CFC, provided
- the pass-through entity is a tax resident of a foreign country, or
- the pass-through entity is not subject to tax as a resident, but is treated as a corporation (or another non-fiscally transparent entity) for purposes of the CFC’s tax law; and
- branches (or a portion thereof), the activities of which are carried on, directly or indirectly, by a CFC, provided
- the branch gives rise to a taxable presence in the country in which it is located, or
- the branch gives rise to a taxable presence under the owner’s tax law, and this law provides an exclusion, exemption, or other similar relief (e.g., a preferential rate) for income attributable to the branch.
Significantly, under a tested unit combination rule, all tested units of a US shareholder that are tax resident or located in the same foreign country are treated as a single tested unit. This is true even if the tested units are not subject to the same foreign tax rate or have different functional currencies. The preamble explains that the tested unit combination rule mitigates the potential for mismatches of income and deductions in a single jurisdiction that lead to a high effective tax rate in one tested unit, but a low effective tax rate in another.
Special rules apply to ensure no double counting of items attributable to tested units, generally attributing any item to the lowest-tier tested unit in the chain.
| Eversheds Sutherland Observation: As a result of the tested unit combination rule, effective tax rate for purposes of applying the GILTI high-tax exclusion is determined on a country-by-country basis. This approach could have broader relevance under the OECD’s Pillar Two approach, which has similar objectives to the GILTI rules. |
The tested unit standard responds to criticisms of the QBU-by-QBU approach of the 2019 Proposed Regulations, which some commentators suggested would result in restructuring of CFC groups. It also eliminates uncertainty as to whether activities constitute a “trade or business” for US tax purposes, the basis on which the existence of a QBU is determined.
The Final Regulations do not materially change the manner in which the effective rate of tax is determined from the 2019 Proposed Regulations. Thus, the effective rate at which taxes are imposed on a tested unit for a taxable year is the US dollar amount of foreign income taxes paid or accrued with respect to a “tentative tested income item,” over the sum of that amount and the US dollar amount of the tentative tested income item. A tentative tested income item is generally determined by taking into account a “tentative gross tested income item,” less certain deductions allocated and apportioned to such gross income for the CFC inclusion year. A tentative gross tested income item is generally determined by taking into account the aggregate of all items of a CFC’s gross income attributable to its tested unit in the CFC inclusion year that would otherwise qualify as gross tested income and be in a single FTC category.
Gross income is generally attributable to a tested unit to the extent it is properly reflected on the tested unit’s separate set of books and records and must be determined applying US federal income tax principles (i.e., disregarding its determination for foreign income tax purposes), as adjusted for disregarded payments. Under the Final Regulations and consistent with the treatment of regarded payments, if a tested unit makes a disregarded payment to another tested unit, the relevant gross income must generally be reallocated among the tested units to appropriately associate the income with the tested unit corresponding to the country in which the income is subject to foreign tax.
Under the Final Regulations the threshold rate of tax is set, consistent with the subpart F high-tax exception, at 90 percent of the rate that would apply if the income were subject to the maximum corporate tax rate (i.e., currently 18.9 percent). Comments that advocated for a lower threshold of 13.125 percent based on a different interpretation of the statute’s legislative history were specifically rejected.
Manner of electing the GILTI high-tax exclusion
The Final Regulations maintain the consistency requirement from the 2019 Proposed Regulations, requiring that the GILTI high-tax exclusion generally be elected with respect to all of a taxpayer’s controlled CFCs (i.e., the CFC group). And, under the 2020 Proposed Regulations as discussed below, this consistency requirement also would apply for purposes of the subpart F high-tax exception. Although many taxpayers commented that the election should be made on a CFC-by-CFC basis, the IRS and Treasury concluded that consistency is required to minimize the risk that taxpayers would manipulate the FTC limitation.
The Final Regulations revise the proposed CFC group definition and instead adopt the affiliated group definition of the consolidated return rules with certain modifications intended to broaden the scope, such as incorporating a more-than-50-percent-vote-or-value threshold and including foreign corporations and other corporations that would otherwise be excluded from the definition of includible corporation.
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Eversheds Sutherland Observation: The definition of CFC group seems to encompass all of the CFCs that are members of a multinational group with a foreign parent and US subsidiaries. When such a multinational group has a 10% US shareholder and CFCs owned by the US members of the group, the intended operation and scope of the election is unclear. A literal application of the rules would seem to require the CFCs controlled by the US group members to be subject to the election made (or not made) by the US shareholders of the foreign parent.
Although the IRS and Treasury declined to permit the election to be made on a CFC-by-CFC basis, the Final Regulations relax the rules with respect to the timing of making the election. Under the Final Regulations, the GILTI high-tax exclusion may be elected annually. Under the 2020 Proposed Regulations, a US shareholder making the election would not have been permitted to change the election for 60 months. This provides greater flexibility to taxpayers in determining whether to make the election.
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Eversheds Sutherland Observation: The practical impact of making the GILTI high-tax exclusion election an annual election that must be applied consistently across the CFC group is that taxpayers will be required annually to prepare two calculations in filing their US federal income tax returns, one with the application of the election and one without. Taxpayers also will need to consider the impact of potential future adjustments to US and foreign tax liability in making the election, and potentially file amended returns with respect to prior elections to take into account such adjustments.
Although the regulations permit the GILTI high-tax exclusion election to be made or revoked on an amended return (with certain limitations, including a requirement that amended returns be filed within 24-months of the unextended due date for the relevant original returns), the rules require all US shareholders of any CFC for which an election is made to file amended returns reflecting the change. For CFCs with multiple US shareholders, this could serve as a practical limitation on the ability to make or revoke the GILTI high-tax exclusion election.
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Implications on the FTC calculation
In response to a comment, the preamble to the Final Regulations confirms that US shareholder deductions properly allocated and apportioned to income excluded under the GILTI high-tax exclusion are not allocated to the GILTI basket for purposes of the FTC limitation.
With respect to annual accounting periods and foreign tax accruals, Treasury and the IRS rejected several comments requesting special rules that would permit taxpayers to deviate from established principles for determining when income and foreign taxes are taken into account (e.g., an election allowing allocation of foreign taxes accrued in one US taxable year across multiple US taxable years or an election to use the foreign taxable year to determine the effective foreign tax rate). Despite the potential for distortions arising from adherence to general US tax rules, Treasury and the IRS determined that foreign taxes should be associated with US income consistently for all US federal income tax purposes.
Applicability dates
The Final Regulations are effective for taxable years of foreign corporations beginning on or after July 23, 2020, and to taxable years of United States shareholders in or with which such taxable years end. Taxpayers may, however, elect to apply the regulations retroactively to taxable years of foreign corporations that begin after December 31, 2017, provided taxpayers consistently apply the provisions of the Final Regulations to each taxable year in which the taxpayer retroactively applies the GILTI high-tax exclusion.
| Eversheds Sutherland Observation: Eligible taxpayers that consider making a GILTI high-tax exclusion election for one or multiple CFCs/CFC groups in a CFC inclusion year need to be aware of the potential downsides of making the election, including lost FTCs and reduced QBAI. This will require detailed modelling of the effects of making the election versus forgoing it. |
| Eversheds Sutherland Observation: For calendar-year taxpayers, a GILTI high-tax exclusion election for 2018 must be made by filing an amended 2018 return by April 15, 2021. |
III. Details of the 2020 Proposed Regulations
The 2020 Proposed Regulations respond to commenters’ calls for consistency between the GILTI high-tax exclusion and the subpart F high-tax exception, although perhaps not in the manner in which taxpayers anticipated. The 2020 Proposed Regulations would conform the election for the subpart F high-tax exception to the GILTI high-tax exclusion election described above (with certain adjustments), making it a single election for both purposes.
| Eversheds Sutherland Observation: The proposed combination of the GILTI high-tax exclusion election with the subpart F high-tax exception election on an all-or-nothing basis would further complicate the determination of whether to make the election. Taxpayers that would benefit from the GILTI high-tax exclusion election on a standalone basis must consider whether there are offsetting costs of making the combined election from losing excess FTCs that might otherwise be associated with inclusions of high-tax subpart F income where those excess FTCs are able to be used to offset US tax on low-tax income in the same FTC category. Conversely, some taxpayers that historically have excluded subpart F income under the subpart F high-tax exception may be compelled to recognize such income as subpart F income, in order to avoid a greater GILTI cost that would arise from making the combined election (for example, as a result in the reduction of available QBAI). |
| Eversheds Sutherland Observation: The GILTI rules and the subpart F rules serve different purposes, meaning that there naturally are disparate considerations in whether to elect the GILTI high-tax exclusion or subpart F high-tax exception. In light of these disparate considerations, it is arguable that the elections should remain separate. The desired conformity could be achieved in the manner in which the effective foreign tax rate is calculated, without requiring a single election with respect to both provisions. |
Tested unit standard for determining effective foreign tax rate
Perhaps the most significant change under the 2020 Proposed Regulations is the manner in which the effective tax rate would be determined for items of foreign base company income (FBCI) otherwise eligible for the subpart F high-tax exception of section 954(b)(4). Currently, the subpart F regulations determine the effective tax rates for purposes of the subpart F high-tax exception on the basis of a CFC’s items of net FBCI, determined by aggregating certain types of income under those rules. The 2020 Proposed Regulations alter this approach, adopting instead the tested unit determination described above (subject to adoption of applicable financial statements as the basis for the determination, as described below). Effective rates of tax would no longer be determined on the basis of items of income.
| Eversheds Sutherland Observation: The elimination of pooling as part of the TCJA had impacted the manner in which the effective tax rate for items of subpart F income is determined under subpart F. The changes in the proposed regulations are explained in part as bringing the subpart F high-tax exception in line with the other changes made under the TCJA. |
Additionally, to obviate the need for analysis of whether an item of income subject to a high effective tax rate is subpart F income or not, the 2020 Proposed Regulations group general category items attributable to a tested unit that would otherwise be tested income, FBCI or insurance income. Certain items related to equity transactions (e.g., dividends and stock gain or loss) are also grouped separately if the income is subject to a preferential rate or exemption under the applicable foreign tax law. If the election is made and the item of income is subject to a high rate of foreign tax, it is not included in the determination of either subpart F income or tested income. However, the 2020 Proposed Regulations continue to group passive foreign personal holding company income in the same manner as under the current regulations, based on the type of income and the degree to which it is subject to foreign tax.
While the Final Regulations look to a separate set of books and records in determining gross income attributable to a tested unit, the 2020 Proposed Regulations substitute “books and records” with an “applicable financial statement” of the tested unit. The definition of an applicable financial statement for this purpose is a financial statement with respect to a separate entity, or separate branch, financial statement that is readily available, such as financial statements prepared under GAAP, IFRS, or generally accepted accounting principles in the tested unit’s jurisdiction. The 2020 Proposed Regulations provide a prioritized list of types of statements or information, and taxpayers are required to use the highest-listed item available with respect to a tested unit.
| Eversheds Sutherland Observation: Although the definitions vary in meaningful ways, the reference to an “applicable financial statement” in the 2020 Proposed Regulations is consistent with other changes made by the TCJA and post-TJCA guidance to more closely follow financial statements in applying US federal income tax rules. See section 451(b); Treas. Reg. § 1.59A-3(b)(4)(i)(D) (referring to the definition of an “applicable financial statement” in section 451(b)); Treas. Reg. § 1.1400Z2(d)-1(b)(2) (referring to the definition of an “applicable financial statement in Treas. Reg. § 1.475(a)-4(h)). |
Rather than adhering to the generally applicable rules for allocation and apportionment of deductions to gross income of a CFC, for purposes of the combined high-tax exception under the 2020 Proposed Regulations, CFC deductions generally are only allocated and apportioned to items of gross income properly reflected on the same applicable financial statement as the item giving rise to the deduction.
Although not included in the Final Regulations, the 2020 Proposed Regulations include a de minimis rule under which taxpayers are permitted to aggregate tested units located in different foreign jurisdictions that are attributed the lesser of 1 percent of the gross income of the CFC or $250,000. This de minimis rule applies after the application of the same country combination rule.
Additionally, an anti-abuse rule provides adjustments if an item is included or is not included on an applicable financial statement with a significant purpose of avoiding the purposes of sections 951, 951A or 954(b)(4).
Mechanics of the election
Currently, the subpart F high-tax exception is made with respect to each CFC. Under the 2020 Proposed Regulations, a single, combined election applies for both the subpart F high-tax exception and the GILTI high-tax exclusion, consistent with the rules applicable to the GILTI high-tax exclusion election described above.
The 2020 Proposed Regulations also require a taxpayer to maintain contemporaneous documentation to substantiate its calculations with respect to the combined high-tax exception. It is contemplated that this information also would be included on Form 5471.
Coordination rules
The 2020 Proposed Regulations also provide guidance on various coordination rules. These include:
- The combined high-tax exception applies without regard to the earnings and profits limitation in section 952(c)(1).
- The combined high-tax exception applies before the full inclusion rule. Generally, under the full inclusion rule, if the sum of gross FBCI and gross insurance income for a taxable year exceeds 70 percent of gross income, adjusted gross FBCI consists of all gross income of a CFC and adjusted gross insurance income consists of all gross insurance income.
The 2020 Proposed Regulations also clarify that amounts recaptured under the earnings and profits limitation carry over to an acquiring corporation in a distribution or transfer under section 381(a). Treasury and the IRS viewed this provision as a clarification of existing law.
Applicability dates
The 2020 Proposed Regulations are generally proposed to apply to taxable years beginning on or after the date the regulations are published as final, except that the provisions clarifying the treatment of recapture amounts under 381(a) is proposed to apply to taxable years of a foreign corporation ending on or after July 20, 2020.
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