As 2021 winds to a close, the future of the Build Back Better Act (BBBA)– the Biden administration’s blockbuster $1.75 trillion spending plan – hangs in the balance. The measure, which passed the House on November 19th, is currently being debated in the Senate, but there is little indication that it will pass by Christmas as Democrats had hoped.
The BBBA’s future matters for taxpayers and tax practitioners because the Act contains several important tax changes, including substantial revisions to the Global Intangible Low-Taxed Income (GILTI) tax, which was enacted in 2017 under the Tax Cuts and Jobs Act (TCJA) (creating a new Internal Revenue Code Section 951A).
The GILTI tax applies to U.S. shareholders of Controlled Foreign Corporations (CFCs) and imposes a 10.5 percent to 13.125 percent minimum rate on their income from intellectual property and other assets held overseas. In this way, it functions as a minimum tax. The version of the Build Back Better Act passed by the House (HR 5376) seeks to increase the GILTI tax in a few key ways.
Section 250 Deduction
U.S. persons (citizens, residents, substantial presence or green card holders, domestic entities) are treated as a U.S. shareholder of a Controlled Foreign Corporation (CFC) if those persons directly or indirectly own at least 10 percent of a foreign corporation’s voting stock or value. A CFC is any foreign corporation of which more than 50 percent of the vote or value of the stock is owned by U.S. shareholders on any day during a given year.
The TCJA created significant tax savings opportunities for U.S. domestic corporations through deductions created under IRC Section 250 for GILTI and the Foreign-Derived Intangible Income (FDII) provision. Taxpayers can calculate those deductions by filling Form 8993. But the Build Back Better Act seeks to reduce some of those savings opportunities.
Currently, U.S. CFCs can claim a 50 percent deduction rate on their GILTI, under the IRC Section 250 deduction. The BBBA intends to lower the IRC Section 250 deduction rate to 28.5 percent, which would increase the effective GILTI tax rate up to 15 percent.
GILTI works in tandem with FDII, which the BBBA would also modify. FDII entitles U.S. corporations to a separate deduction, also under IRC Section 250, on income derived from selling property and services to foreign customers for foreign use. The current IRC Section 250 deduction rate for FDII is 37.5 percent, which generates a 13.125 effective tax rate. But the BBBA intends to reduce the FDII deduction rate to 24.8 percent, which would generate a 15.8 percent effective tax rate.
Both would apply to tax years beginning after December 31, 2022.
On the upside, the BBBA would allow taxpayers whose IRC Section 250 deductions exceed taxable income to use the excess to calculate their net operating losses, potentially leading to additional NOL carryovers. This new treatment under IRC Section 951A(c) would apply to taxable years beginning after December 31, 2022.
The Qualified Business Asset Investment Exemption
Another taxpayer savings opportunity that is slated to change is the Qualified Business Asset Investment exemption, which currently allows taxpayers to exclude a ten percent return on foreign tangible assets from their GILTI base. Under BBBA, the exclusion would be cut in half under Section 951A(b)(2)(A), to a five percent return.
Country by Country Averaging
Under current GILTI rules found in IRC Section 951A, the tax is calculated by averaging a U.S. taxpayer’s worldwide foreign income and taxes to determine its liability. Critics argue this averaging approach is ineffective because taxpayers can use income from their operations in low-tax jurisdictions to offset income earned in higher tax jurisdictions.
The Build Back Better Act plans to scrap GILTI averaging and calculate the tax on a country-by-country basis to avoid potential abuse. Under this plan, income from foreign branches (which are business units taxable under the laws of the foreign country where they operate) would be included in this calculation. This also means that taxpayers will likely face additional compliance costs.
Smaller GILTI Haircut
One of the more controversial aspects of the GILTI regime is a limitation on the amount of foreign tax credits (FTCs )that can be used to offset GILTI liability under IRC Section 960(d). Taxpayers computing their FTCs can do so on Form 1118, Foreign Tax Credit, under IRC Section 951. Under current law, taxpayers can use 80 percent of their foreign tax credits to offset their GILTI liability. This is known as the GILTI foreign tax credit haircut. Some taxpayers were hoping the haircut would be eliminated so they could use all of their foreign tax credits for offsets, but the BBBA retains the haircut.
That said, the BBBA provides a more generous treatment. Under the Act, taxpayers would be allowed to use 95 percent of their foreign tax credits as an offset. Given the additional complexities and increased tax burdens contemplated by the BBBA, if a taxpayer does not have voting power and never wanted to participate in CFC management, one of the options to avoid the complexity of GILTI tax is to form a foreign trust and place the CFC stock(s) under the ownership of said foreign trust. Doing this eliminates GILTI tax calculation and reporting.
There are some downsides to the foreign trust strategy, as, as previously discussed in a prior article. There are potential gift tax implications, additional tax filing fees and the taxpayer may be required to calculate Distributable Net Income (DNI), which is reported on Form 3520 and potentially Form 3520-A.
Overall, these changes, if implemented, will considerably reshape the GILTI regime. They could also create new complexities and tax burdens for taxpayers that will require careful and thoughtful attention from an experienced tax practitioner.