On August 25, 2021, Senate Finance Committee members Wyden, Brown, and Warner released draft bill language and a section-by-section summary of their proposed International Tax Reform Framework. The legislative language is generally in line with the International Tax Overhaul proposals first released by the Senators on April 5, 2021. The draft legislation includes some provisions similar to provisions that were included in the Green Book released by Treasury on May 28, 2021, including, in particular, modifications to the Global Intangible Low-Taxed Income (GILTI) rules that were enacted as part of the 2017 Tax Cuts and Jobs Act (TCJA). But, in so doing, it makes certain departures from the “Pillar II” minimum tax proposals under consideration at the OECD. The proposed legislation also differs from the Green Book proposals in its approach to amending the Foreign Derived Intangible Income (FDII) provision and the Base Erosion Anti-Abuse Tax (BEAT), which also were enacted as part of the TCJA.
The draft legislation, which is discussed in greater detail below, is incomplete and the drafters specifically request comments on the operation of a number of significant provisions that are included in the proposed overhaul. Comments are requested on the discussion draft by September 3, 2021, which is consistent with the expressed desire of some in Congress to move swiftly on a budget reconciliation bill. The Senate passed the Budget Resolution Agreement on August 11, 2021 with the House following on August 24, 2021. The Resolution Agreement provided the Senate Finance Committee with instructions on a budget offset involving corporate and international tax reform.
Proposed modifications to the GILTI rules
Under section 951A, a US shareholder of a controlled foreign corporation (CFC) is generally required to include in its income currently the “net tested income” of such CFC to the extent such income exceeds a 10% return on the CFC’s “qualified business asset investment” (QBAI). QBAI generally is the CFC’s basis in tangible operating assets, adjusted for certain interest expense. For purposes of determining a US shareholder’s net tested income, the current rules allow tested losses of one CFC to be offset against tested income of another CFC, such that only a net amount is included under section 951A for all of a US shareholder’s CFCs.
A deduction is provided under section 250 for 50 percent of the amount of the US shareholder’s inclusion (reduced to 37.5 percent in taxable years beginning after December 31, 2025). US shareholders also are permitted to claim a foreign tax credit for 80 percent of non-US taxes paid with respect to income included under section 951A, subject to certain general foreign tax credit limitations. Under regulations, a US shareholder may elect to exclude from its GILTI calculation, net tested income of a CFC that is subject to a foreign effective tax rate (ETR) greater than 90 percent of the maximum corporate tax rate (currently 18.9 percent). The ETR is determined using a “tested unit” approach, which aggregates all CFCs and branches that are resident in a single foreign taxing jurisdiction. Also, under the regulations the election applies with respect to all qualifying tested units—it cannot be made on a tested-unit-by-tested-unit basis.
The proposed legislation materially modifies the current operation of the GILTI rules, including:
- Eliminating the permitted 10 percent return on QBAI; and making the high-tax exclusion mandatory, such that:
- The high-tax exclusion is applied on a country-by-country basis, whereby all CFCs and CFC branches in a single foreign taxing jurisdiction are treated as one tested unit.
- The high-tax threshold is changed from 90 percent of the maximum US corporate tax rate to 100 percent of the GILTI rate.
- Loss tested units are treated as high-tax (and therefore excluded).
The “tested unit” approach is similar to the approach taken in the existing GILTI high-tax exclusion regulations. Tested units include CFCs, CFC-owned foreign branches, and interests in pass-through entities held by CFCs. All tested units within one country and within one CFC are aggregated into a single tested unit. Moreover, tested units of different CFCs that are members of the same expanded affiliated group (generally based on 50 percent common ownership other than by individuals) are combined in a single tested unit for purposes of calculations related to a US shareholder that is also a member of the expanded affiliated group. For example, a US-parented multinational group would generally have a single tested unit in each country in which it operates through CFCs, leading to a combined group-wide country-by-country determination for high-tax tested income.
The net effect of the changes in the draft legislation is to cause GILTI to operate as a “top-up tax,” which is in line with the OECD Pillar II proposals. However, it departs from the OECD proposal with the elimination of the permitted return on QBAI. The current draft of the OECD’s Pillar II proposal contemplates that in applying the global minimum tax a carve out of at least 5 percent of tangible assets and payroll is applied.
|Eversheds Sutherland Observation: Given the continuing work at the OECD on the Pillar II proposals, it is arguable that making significant modifications to the GILTI rules at this time is premature. If any legislation is to be enacted, it should be in line with current OECD proposals to minimize the likelihood that additional changes are required once an OECD agreement is reached.
The proposed modifications to effectively determine GILTI on a country-by-country basis are generally in line with the OECD Pillar II proposals, which target a minimum corporate tax rate in all jurisdictions of 15 percent. This means that the ability of US shareholders to reduce their tested income in one jurisdiction by the amount of tested losses in another jurisdiction is eliminated. In addition, taxpayers generally would not be able to use excess foreign tax credits on tested income earned in one jurisdiction to offset residual US tax on tested income in another jurisdiction.
If a tested unit is determined to be high-taxed (i.e., the foreign ETR is higher than the GILTI rate or it has a net tested loss), its income is nominally US tax deferred under a mandatory high-tax exclusion until repatriated into the US. As a practical matter, taking into account the section 245A dividends received deduction, in most cases this income is expected to be exempt from US federal income tax. No foreign tax credits are allowed with respect to exempt distributions, and deductions attributable to exempt distributions may be disallowed.
|Eversheds Sutherland Observation: Treasury’s Green Book would expand the application of section 265 to disallow deductions for expenses attributable to foreign gross income that is exempt from tax or taxed at a preferential rate through a deduction (e.g., a section 250 deduction or a section 245A deduction). This proposal raises the question as to what expenses may be attributed to the exempt dividend income. Any rule should be narrowly tailored such that it only impacts expenses directly related to the exempt dividends.
One of the complications of the country-by-country, top-up approach laid out by the drafters is that it exacerbates timing-of-income issues. Timing differences between US and foreign tax rules could cause a tested unit to be high-tax in one year and low-tax in a subsequent year. Even though the foreign taxes paid in the earlier year related to income that was treated as accruing for US tax purposes in a subsequent year, under the draft legislation there is no ability to carry forward the credits. This could result in taxpayers paying the GILTI top-up tax in the later year, even though the overall foreign ETR over multiple years equals or exceeds the GILTI tax rate.
|Eversheds Sutherland Observation: The change to a country-by-country system coupled with the mandatory high-tax exclusion would make it more likely than under current GILTI that taxpayers could be whipsawed as a result of timing or other differences. Solving these timing issues will be complex and raise questions as to whether the complexity of a mandatory high-tax exclusion is justified from a policy perspective. Country-by-country foreign tax credit basketing without a mandatory high-tax exclusion would generally prevent cross-crediting and the whipsaw issue could be resolved through the use of a tailored carryover provision (e.g., same country foreign tax credits could be carried forward/backward). This approach is in line with the approach outlined by the OECD.
Similar considerations arise in the case of tested units that have a net tested loss, even though they may have positive income for foreign tax purposes. If the taxes related to the loss years are not permitted to be carried forward, taxpayers may be whipsawed and subject to US tax at rates significantly higher than the GILTI rate.
|Eversheds Sutherland Observation: Creating separate country-by-country baskets for foreign tax credits with carryovers within each basket could minimize the potential for double taxation where CFCs have losses for US tax purposes in certain years, but nonetheless pay tax locally. In order for this to work efficiently, credits related to loss years would need to pool in country-by-country baskets and be able to be carried forward by the US shareholder to offset US tax on income in the same basket in future years.
The proposed GILTI rate also is not specified in the draft legislation, presumably reflecting that it is expected to be tied to the general corporate tax rate, which the Biden Administration has proposed to increase, and the ultimate Pillar II agreement at the OECD.
The draft legislation also reserves on whether the foreign tax credits with respect to any GILTI inclusion should be subject to a haircut. The current GILTI rules only permit a US shareholder to credit 80 percent of the foreign taxes paid with respect to its GILTI inclusions. The draft legislation suggests a haircut of between 0 and 20 percent, but provides no policy rationale for how this determination is to be made.
|Eversheds Sutherland Observation: In the existing GILTI rules, the 20 percent haircut on foreign tax credits incentivizes US shareholders to minimize the foreign taxes paid with respect to their CFCs’ income. Because it encourages US shareholders to operate in lower-tax jurisdictions, any haircut in the foreign tax credits with respect to GILTI inclusions runs counter to the stated desires of Congress, Treasury and the OECD in adopting minimum tax rules and avoiding a “race to the bottom.” Not providing a full foreign tax credit also would subject income to an ETR that is higher than the global minimum tax rate agreed with the OECD, putting US taxpayers at a disadvantage globally.
To coordinate GILTI with non-US minimum taxes, the bill authorizes Treasury to give priority to “ultimate parent countries” by providing foreign tax credits for taxes paid by foreign corporate owners of the US shareholder that are attributable to relevant income of the CFC.
|Eversheds Sutherland Observation: The reference to ultimate parent countries is apparently intended to cede OECD Pillar II priority to countries where the US is not the ultimate parent jurisdiction on the theory that such approach ultimately benefits the US given the predominance of US-parented multinationals potentially subject to Pillar II. This presumably means the US top-up tax would not apply to the earnings of foreign subsidiaries of US companies with a foreign parent that applies Pillar II, but working out the details seems to be left to Treasury, causing uncertainty for taxpayers in that posture pending guidance from Treasury. Based on the draft bill, it appears that the contemplated mechanism is to provide credits for foreign taxes imposed on a foreign-group parent with respect to CFCs, rather than taking such foreign parent’s taxes into account in determining the tested unit ETR. This approach would likely lead to US tax effectively being imposed on the CFC’s income after US expense apportionment rules are taken into account, resulting in partial double taxation.
Modifications to subpart F income
The proposed legislation also would make changes to the existing subpart F high-tax exception, in line with the changes made to the GILTI high-tax exclusion. Under current rules, an item of subpart F income that is subject to an ETR of more than 90 percent of the US corporate tax rate is considered to be high-taxed, and the US shareholder may elect to exclude this income from current inclusion under subpart F.
The proposed legislation would modify the existing subpart F high-tax exception to require the determination be made on a tested unit basis, rather than on the basis of items of income, and exclusion of high-tax income would be mandatory. The proposed legislation also would modify the high-tax rules so that subpart F income is not considered to be high-taxed unless it is taxed at an ETR of greater than the US tax rate that would be applicable to the income in the hands of the US shareholder. (In determining the ETR, passive income is considered separately from general income.)
Like the proposed amendments to the GILTI rules, these proposed changes generally would prevent taxpayers from cross-crediting taxes on foreign income. The high-tax exception would be mandatory, and no foreign tax credits are permitted with respect to amounts excluded under the high-tax exception. The proposed legislation also indicates that foreign tax credits with respect to subpart F inclusions that are not exempt under the high-tax exception may be subject to a haircut of between 0 and 20 percent, which reduction would be taken into account in determining whether the income is high-tax, without offering any policy justification. To ensure consistency across withholding taxes imposed on distributed CFC earnings and net income taxes, the foreign tax credit haircut would also be applied to foreign taxes imposed on distributions of previously taxed earnings and profits (PTEP).
|Eversheds Sutherland Observation: The proposed subpart F modifications raise the same timing considerations as the proposed modifications to the GILTI rules. In order to minimize any risk of whipsaw to taxpayers, a system to basket foreign tax credits on a country-by-country basis and permit carryforwards of losses is appropriate.
|Eversheds Sutherland Observation: If the corporate tax rate were to increase to 28 percent, there is a limited number of jurisdictions the income from which would be considered to be high-taxed. So, these rules may have limited practical application in the subpart F context. According to the OECD’s database of statutory corporate tax rates, there are currently six jurisdictions that impose a corporate tax rate of at least 28 percent and eleven jurisdictions that impose a corporate tax rate of at least 25 percent. If a haircut were adopted with respect to foreign tax credits related to subpart F income, the high-tax exclusion would be even less likely to come into play. Further, if a haircut is imposed on foreign tax credits for subpart F (or foreign branch income), such income would be subject to a higher rate of tax than domestic income.
Exclusion of high-tax income of foreign branches
To create parity between income earned through CFCs or branches of CFCs and income earned in branches of US companies, the proposed legislation also includes a new section 139J. As proposed, section 139J would exempt high-tax foreign branch income earned by a US corporation from US tax. Similar to the proposed subpart F rules described above, high-tax foreign branch income for this purpose would be income subject to a tax rate greater than (1) the corporate rate, for corporations, or (2) the highest individual rate, for non-corporate taxpayers. The test is applied to tested units on a country-by-country basis, and the proposed legislation similarly suggests a haircut on foreign tax credits for income that is not exempt of between 0 and 20 percent. A foreign branch that has a loss would be considered a high-tax foreign branch.
|Eversheds Sutherland Observation: The timing of income and loss questions that exist with respect to the proposed GILTI and subpart F rules persist with the rules for high-tax foreign branches. As noted above, a system for foreign tax credit carryforwards on a country-by-country basis, that also takes into account loss carryforwards, would prevent taxpayers from being whipsawed and appears to preserve the rationale underlying the legislation, i.e., to eliminate opportunities for cross-crediting.
The proposed legislation is notable in that it defines foreign branch, which previously has not been defined. Foreign branch would be defined to mean “any branch (or portion thereof) (i) the activities of which are carried on directly or indirectly by the taxpayer, (ii) which is not a tested unit (as defined in section 951A(e)(3)) of a controlled foreign corporation of the taxpayer, and (iii) which gives rise to a taxable presence under the tax law of the foreign country in which the branch is located.”
Apportionment of R&D and stewardship expenses
For purposes of computing foreign-source income, the tax on which may be offset by foreign tax credits, the discussion draft provides that expenses for research and experimentation and for stewardship would be treated as 100 percent allocated to a taxpayer’s US-source income if those activities are conducted within the United States. Current law would remain unchanged with respect to the foregoing activities when performed outside of the United States.
|Eversheds Sutherland Observation: The changes are intended to benefit R&D and stewardship expenses incurred in the US by avoiding the potential loss of foreign tax credits attributable to such expenses. It is not clear how beneficial such changes would be in light of the proposed increases in US tax rates and the exclusion of high-tax income that would seem to reduce the likelihood of excess foreign tax credits for many taxpayers without regard to this change.
Modification of foreign derived intangible income deduction
The Code currently permits domestic corporations a deduction equal to 37.5 percent of its foreign-derived intangible income (FDII) for the taxable year. The amount of a taxpayer’s FDII is determined generally by reference to “foreign-derived deduction eligible income,” (FDDEI) which in very general terms is income from sales of property or foreign services to foreign persons for a foreign use.
The proposed legislation would retain the general FDII framework (repurposing the acronym to stand for foreign-derived innovation income), but modify the rules so that the amount of a taxpayer’s deduction is based on a currently unspecified percentage of the taxpayer’s US research and experimentation expenditures and qualified worker training expenses, as well as its FDDEI. In other words, the proposed legislation would convert the current FDII deduction into a super deduction for US R&E expenditures and worker training expenses for US corporations with income from foreign sales and services. The proposed legislation refers to this as “domestic innovation income,” retaining the acronym from the existing rules. While the amount of the deduction for FDII is to-be-determined, the draft legislation notes that the amount will be conformed to the GILTI deduction.
|Eversheds Sutherland Observation: The OECD recently noted that the US has indicated that it intends to repeal the existing FDII rules, and a repeal of FDII was included in the Green Book. In light of the expressed intent to repeal FDII, the rationale for retaining the general framework is unclear. Retaining the existing framework also would be burdensome on taxpayers, who in some cases are required to maintain substantial documentation supporting foreign sales and services under existing rules.
Base erosion and anti-abuse tax
Section 59A currently imposes, in addition to any other tax, the BEAT, which is a tax equal to the base erosion minimum tax amount for each tax year. The BEAT is currently generally equal to the excess of (i) 10 percent of the taxpayer’s modified taxable income for the year over (ii) the taxpayer’s regular tax liability for the taxable year. Modified taxable income is generally taxable income with certain deductions added back for related-party payments. The applicable rate increases to 12.5 percent for taxable years beginning after 2025. A portion of certain general domestic business tax credits are currently excluded from computing regular tax liability for BEAT purposes, and all such credits are excluded for taxable years beginning after 2025, meaning that taxpayers subject to the BEAT would receive no (or a reduced) benefit from such credits.
Responding to criticisms that the BEAT rules discourage taxpayers from taking advantage of certain investment and energy credits, the discussion draft would no longer reduce a taxpayer’s regular tax liability by the amount of any section 38 credits. In effect, general business credits would be available to reduce a taxpayers’ BEAT liability. The proposed legislation also would introduce a new, higher BEAT tax rate for deductions attributable to related-party payments.
|Eversheds Sutherland Observation: The Biden Administration has recommended a repeal of BEAT, and replacement with an alternative “stopping harmful inversions and ending low-tax developments” (SHIELD) rule. The OECD has criticized the BEAT rules and argues that they are inconsistent with the objectives of Pillar II. To that end, the SHIELD rule contemplated by the Administration is more in line with the undertaxed payment rules contemplated by the OECD. While the draft bill proposal includes a placeholder for the incorporation of SHIELD-like concepts, it is unclear what any inclusion of SHIELD would look like in practice.