On July 20, 2020, the US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued final section 951A regulations (“Final Regulations”) on an election to exclude high-tax global intangible low-taxed income (GILTI) from a US shareholder’s gross income. The Final Regulations carry over similar features of the proposed regulations with some modifications intended to make the election more administrable and accessible. Like most Tax Cuts and Jobs Act (TCJA) provisions, it is necessary to model the impact of the election to evaluate whether it is beneficial to apply the GILTI high-tax exclusion.
The Final Regulations permit a US shareholder to exclude certain high-taxed income from a controlled foreign corporation’s (CFC) tested income and, in turn, from the scope of section 951A. Section 951A requires a US shareholder of a CFC to include in gross income the GILTI inclusion amount, arising (in part) from the US shareholder’s pro rata share of a CFC’s tested income that exceeds a deemed 10% return on the CFC’s tangible assets less certain interest expense. The GILTI rules are intended to address concerns that intangible property income could be allocated to no-tax or low-tax jurisdictions and then the earnings could be repatriated tax-free under section 245A. Section 951A discourages profit shifting offshore by imposing a minimum level of current taxation (10.5% with a potential foreign tax credit) on the tested income derived by a CFC.
Generally speaking, post-TCJA, there are three classes of foreign income derived by a CFC: (1) Subpart F; (2) GILTI; and (3) exempt income. High-taxed passive Subpart F income may be exempt if the election for high-tax Subpart F income is made under section 954(b)(4) and the underlying regulations. Section 951A does not provide for a statutory exception for high-taxed GILTI. However, the Final Regulations establish an elective exclusion for high-taxed CFC income that does not otherwise qualify for the Subpart F high-tax exclusion. By making the GILTI high-taxed election, active income of a CFC taxed at a minimum effective rate is excluded from the scope of tested income and, in turn, the income generally is exempt from US taxation permanently by virtue of the participation exemption regime.
GILTI High-Tax Election
The Final Regulations implement the GILTI high-tax exclusion through an election. A summary of the key aspects of the GILTI high-tax election is as follows:
- By making the GILTI high-taxed election, gross tested income does not include gross income subject to foreign income tax at an effective rate that is greater than 90% of the maximum tax rate specified in section 11 (18.9% based on the current maximum tax rate of 21%).
- The proposed regulations contained a 5-year lock-in and lock-out period once the election was made or revoked, respectively, that made it difficult to evaluate the election’s impact over the 5-year period. In a significant departure, the Final Regulations provide that the GILTI high-taxed election can be made annually.
- Moreover, taxpayers may choose to apply the GILTI high-tax exclusion retroactively to taxable years of foreign corporation that begin after December 31, 2017, and before July 23, 2020, and to taxable years of US shareholders in which or with which such taxable years of the foreign corporations end.
There are several steps involved in computing the effective foreign tax rate. Like the proposed regulations, the Final Regulations do not allow the effective foreign tax rate to be tested at the CFC level. However, instead of the QBU-by-QBU test as provided by the proposed regulations, the Final Regulations provide that the effective tax rate test is applied on the basis of gross tested income that is attributable to a “tested unit.” The “tested unit” approach applies to the extent an entity, or the activities of an entity, are actually subject to tax, as either a tax resident or a permanent establishment under the tax law of a foreign country. Generally, a CFC’s tested units may consist of the CFC itself, interests in pass-through entities (including disregarded entities) that are tax resident of any foreign country (or are not fiscally transparent under the law of the CFC’s country of tax residence) and branches of the CFC. Tested units of a CFC that are tax residents of, or located in, the same country are generally treated as a single tested unit. For more information on the implications of the “tested unit” standard, see our On the Subject.
Generally, the computation of the effective foreign tax rate operates as follows:
- The “tentative tested income item” with respect to the “tentative gross tested income item” has to be subject to an effective rate of foreign tax greater than 18.9%.
- A CFC’s gross tested income first is assigned to a tested unit of the CFC to determine a “tentative gross tested income item.”
- The CFC’s deductions are then allocated and apportioned to the tentative gross tested income item to compute a “tentative tested income item.”
- Current year taxes are allocated and apportioned to the related tentative gross tested income item to determine the foreign income taxes connected to a tentative tested income item.
- The effective rate of foreign income tax with respect to the tentative tested income item is computed by dividing the US dollar amount of the foreign income taxes paid or accrued with respect to the tentative tested income item by the sum of the US dollar amount of the tentative tested income item and the related foreign income taxes.
1. Impact of GILTI High-Tax Election to Foreign Tax Credit (FTC) Position
The impact of the GILTI high-tax election should be measured by modeling the interactions of the exclusion with myriad rules. A few of the considerations to take into account include the following if the exclusion applies:
- The US shareholder would not have a GILTI inclusion with respect to excluded income.
- A US shareholder with net operating losses would not be required to apply those losses to offset income otherwise eligible for the GILTI deduction and could potentially offset more pre-TCJA income taxed at the top marginal rate of 35% by virtue of the new carryback rules.
- The US shareholder would lose the foreign taxes and qualified business asset investment (QBAI) associated with the excluded income.
- Part (or all) of the CFC stock would become an asset that produces exempt income, rather than an asset that produces GILTI income, for expense allocation and apportionment purposes, which by itself could be favorable.
- The US shareholder would have to satisfy the requirements of section 245A to receive the exempt income tax free because the income is not treated as previously taxed earnings and profits.
- The Treasury also issued proposed regulations (REG-127732-19) that would conform the historical Subpart F high-tax exclusion under section 954(b)(4) with the GILTI high-tax exclusion. The proposed regulations’ Subpart F high-tax exclusion rules, if finalized in their current form, would provide for a single election under section 954(b)(4) for purposes of both Subpart F income and tested income. Thus, if those regulations are finalized and applicable, the US shareholder should consider the impact of the Subpart F high-tax exclusion in addition to the GILTI high-tax exclusion. Additional background on the unitary election under the proposed regulations was provided in a separate On the Subject entry.
2. Certain Features of the GILTI High-Tax Election that Limit the Utility of the Election
The following features of the GILTI high-tax election are expected to limit its utility:
Retention of the 18.9% High-Tax Threshold
The Final Regulations retain the rule from the proposed regulations that applied the election by comparing the effective foreign tax rate with 18.9% (90% of the current maximum corporate tax rate of 21%). The Treasury and the IRS considered, but rejected, taxpayers’ request to reduce the rate threshold from the current 18.9% to 13.125%, reasoning that section 954(b)(4) dictates the relevant rate, and the legislative history describing the lower rate addresses situations in which income is subject to GILTI and the associated foreign tax credit rules.
“Tested Units” Standard
The “tested unit” standard retains in substance some unfavorable features of the QBU approach under the proposed regulations that do not necessarily outweigh the administrative and compliance improvements. Taxpayers highlighted issues with the QBU standard, including identifying QBU activities, inviting avoidance of QBU status, applying QBU rules inconsistently and tracking QBU-level data. In response, the Final Regulations apply the GILTI high-tax exclusion based on the gross tested income of a CFC attributable to a tested unit. The Treasury and the IRS concluded the tested unit standard is a more targeted measure than the QBU standard and “will be more easily” applied than the QBU standard. But it is not entirely clear whether the differences between the standards make the GILTI high-tax election more attractive, particularly because disregarded payments still need to be identified with corresponding adjustments, and taxpayers still need to produce data and perform computations on the tested unit basis (rather than the CFC basis).
Retention of the Consistency Requirement
The Final Regulations retain the approach of applying the GILTI high-tax exclusion to every member of a group of commonly controlled CFCs under an “all or nothing” approach. The binary “choice” is a new application of section 954(b)(4). Section 954(b)(4) historically allowed a taxpayer to decide what high-taxed items to exclude on an item-by-item basis, including less than all of the high-taxed income of the CFC. The flexibility allowed taxpayers to exempt some income and to use excess credits on income bearing high levels of foreign tax as needed to eliminate the residual US tax on low-taxed income. Taxpayers now have to make a judgment call on what helps or hurts, but with materially less flexibility with respect high-taxed GILTI.