On July 20, 2020, the US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (REG-127732-19) (the 2020 Proposed Regulations) that would conform the historic Subpart F high-tax exception under section 954(b)(4) with the new global intangible low-taxed income (GILTI) high-tax exception. In doing so, the 2020 Proposed Regulations would dramatically revise the Subpart F high-tax exception by combining both exceptions into a unified rule that is modeled on the GILTI high-tax exception. As a result, and as compared to current law, the 2020 Proposed Regulations would provide US shareholders with significantly less flexibility in applying the Subpart F high-tax exception to separate controlled foreign corporations (CFCs).
Subpart F High-Tax Exception under Section 954(b)(4) and Treas. Reg. § 1.954-1(d)
Section 951(a)(1) generally requires a US shareholder of a CFC to include in gross income its pro rata share of the corporation’s Subpart F income for a taxable year. However, a US shareholder may elect to exclude from its gross income any item of Subpart F income that is subject to a high foreign income tax rate. Specifically, the CFC’s Subpart F income does not include any item of income if the US shareholder: (i) elects to apply the high-tax exception; and (ii) establishes that such income was subject to an effective rate of foreign income tax greater than 90% of the US corporate rate (i.e., 18.9% for taxable years beginning after January 1, 2018). The election is made annually and can be made on an “item-by-item” basis (subject to certain exceptions for passive income) for each CFC. In other words, a US shareholder can choose to apply the high-tax exception to some items of income of a CFC, but not to other items of income of the CFC or to income of other CFCs.
In applying the Subpart F high-tax exception, a CFC’s items of Subpart F income are generally divided into foreign personal holding company income (FPHCI), foreign base company sales income and foreign base company services income, each within a separate foreign tax credit (FTC) limitation category (in general, the general category and passive category). Passive FPHCI is further subdivided into each category of FPHCI, then further subdivided into separate categories described in the section 904 regulations.
After identifying each item of income and allocating and apportioning deductions (including foreign taxes) thereto, the effective tax rate on an item of income is determined by dividing the amount of the net item of income by the amount of the income plus attributable taxes. If the effective rate on such item is greater than 90% of the US corporate rate, an election can be made to apply the high-tax exception to exclude the item from the CFC’s Subpart F income.
GILTI High-Tax Exception under Treas. Reg. § 1.951A-2(c)
The 2020 Proposed Regulations were released together with final regulations (T.D. 9902) (the Final Regulations) that implement the GILTI high-tax exception, which was introduced in proposed regulations last year (REG-101828-19) (the 2019 Proposed Regulations). The GILTI high-tax exception permits a US shareholder to annually elect to exclude a CFC’s tested income in computing its GILTI if the CFC’s tested income is subject to a high foreign income tax rate (again, 90% of the US corporate rate).
The basic mechanics of computing the foreign income tax rate on tested income are generally similar to the mechanics under the existing Subpart F high-tax exception: Items of gross tested income are identified, deductions are allocated and apportioned thereto, and an effective tax rate is computed. However, whereas the Subpart F high-tax exception applies at the CFC level, the GILTI high-tax exception applies separately to each of a CFC’s “tested units.”
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. Very generally, a CFC’s tested units may consist of the CFC itself, interests in pass-through entities (including disregarded entities) that are tax resident in 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 located in the same country as the CFC are generally treated as a single tested unit.
If tested income attributable to a tested unit meets the foreign tax rate requirement, a US shareholder may elect to exclude such tested income from its GILTI calculations. Notably, disregarded payments made among tested units are taken into account in determining a tested unit’s attributable tested income, using the principles of the disregarded payment rules used to compute foreign branch category income under the section 904 regulations.
If a US shareholder elects to apply the GILTI high-tax exception to income of a tested unit, the election applies to all high-taxed income of other tested units of the CFC and all high-taxed income of all tested units of the US shareholder’s commonly controlled CFCs (a CFC group). A CFC group is generally defined by cross-reference to the section 1504(a) definition of an affiliated group, substituting “more than 50 percent” of voting power and value for “at least 80 percent” and substituting “or” for “and.”
Additional analysis of the GILTI high-tax exception will provided in future On the Subject entries.
Modifications to the Subpart F High-Tax Exception under the 2020 Proposed Regulations
Numerous comments to the 2019 Proposed Regulations recommended that the GILTI high-tax exception be conformed with the Subpart F high-tax exception, in part because of the adoption in the 2019 Proposed Regulations of a “QBU-by-QBU” approach in determining high-taxed tested income, as well as the requirement that the GILTI high-tax exception election be made with respect to an entire CFC group.
Treasury and the IRS agreed that the Subpart F and GILTI high-tax exceptions should be conformed, but concluded that the more restrictive rules of the GILTI high-tax exception better reflect the policies of section 954(b)(4) following the enactment of the Tax Cuts and Jobs Act (TCJA). As a result, the 2020 Proposed Regulations conform the Subpart F high-tax exception to the GILTI high-tax exception, with the following key changes:
- The Subpart F high-tax exception and GILTI high-tax exception are combined into a single rule. As a result, the 2020 Proposed Regulations would withdraw the GILTI high-tax exception set forth in the Final Regulations.
- The high-tax exception applies on a tested unit basis, rather than on an item-by-item basis within each CFC.
- In determining items of income to which the high-tax exception applies, general category items of income attributable to a tested unit that would otherwise be tested income or foreign base company income are grouped into a single item of income. Passive FPHCI continues to be separately grouped under existing rules, and “equity gross items” (which generally consist of dividends, income or gain arising from dispositions of stock, as well as dispositions or distributions with respect to pass-through entities) are also separately grouped.
- A single unified election applies for purposes of both Subpart F and GILTI, with such election applicable to all high-taxed items of income of all CFCs that are members of a CFC group. In other words, the 2020 Proposed Regulations eliminate the ability to apply the Subpart F high-tax exception to particular CFCs and particular items of income of CFCs. The election remains an annual election (a favorable development, as the election for GILTI purposes under the 2019 Proposed Regulations would have been binding for a 60-month period).
- Currently, a controlling US shareholder may make (or revoke) a Subpart F high-tax exception election by attaching a statement to its amended income tax return, with such election or revocation binding on all US shareholders of the CFC. The 2020 Proposed Regulations modify this rule by requiring amended returns for all US shareholders of the CFC to be filed within a single 6-month period within 24 months of the unextended due date of the original income tax return of the controlling domestic shareholder’s inclusion year.
- The Final Regulations use items properly reflected on the separate set of books and records as the starting point for determining gross income attributable to a tested unit. The 2020 Proposed Regulations modify this approach by substituting “applicable financial statements” for “books and records.” The regulations list different types of financial statements (in order of priority) that may qualify, with higher priority given to audited financial statements prepared in accordance with US Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
The 2020 Proposed Regulations also contain other changes, including changes addressing the interaction of the high-tax election, the earnings and profits limitation under section 952(c) and the full inclusion rule.
Prospective Applicability Date
The 2020 Proposed Regulations addressing the high-tax exception are proposed to apply to taxable years of CFCs beginning after the date the Treasury decision adopting the 2020 Proposed Regulations as final regulations is filed with the Federal Register, and to taxable years of US shareholders in which or with which such taxable years of foreign corporations end.
Implications for Taxpayers
The modifications to the Subpart F high-tax exception are notable in view of multiple changes introduced by the TCJA, including the US corporate tax rate reduction from 35% to 21% (which has increased the availability of the exception), the introduction of a separate FTC limitation category for GILTI (with no ability to carryover or carryback FTCs attributable to GILTI) and the introduction of the section 245A 100% dividends received deduction (DRD).
In the explanation accompanying the 2020 Proposed Regulations, Treasury and the IRS note that combining the Subpart F and GILTI high-tax exceptions into a single rule that applies on a CFC group basis reduces the incentive for taxpayers to structure CFC activities in a way that causes high-taxed income to be treated as Subpart F income. Under the existing rules, taxpayers could, through selective application of the Subpart F high-tax exception, maximize the ability to utilize FTCs attributable to high-taxed Subpart F income inclusions against low-taxed Subpart F income inclusions (typically, within the general category). Although section 904 generally serves to prevent inappropriate cross-crediting, Treasury and the IRS nevertheless stated that in a post-TCJA world, this cross-crediting result is “problematic,” insofar as the earnings excluded from Subpart F income under the high-tax exception may be exempt upon distribution under section 245A, with related US shareholder-level expenses disregarded under section 904(b)(4) (and thereby not taken into account in computing the FTC limitation).
Because the 2020 Proposed Regulations would prevent taxpayers from selectively applying the Subpart F high-tax exception and GILTI high-tax exception, taxpayers should consider the following implications:
- Unitary High-Tax Exception: The 2020 Proposed Regulations combine the Subpart F high-tax exception and GILTI high-tax exception elections into a unitary rule. As a result, electing to apply the high-tax exception would impact all aspects of a taxpayer’s Subpart F and GILTI computations as well as calculation of section 904(d) limitation for the relevant section 904(d) category. The utility of the high-tax exception should be confirmed by modeling, and given the complicated interactions among these rules, the high-tax exception may provide limited or no benefits to many taxpayers.
- Restricted Cross-Crediting: Because the unified high-tax exception applies on a CFC group basis, US shareholders electing to apply the exception should have reduced inclusions of high-taxed income. As remaining Subpart F and GILTI inclusions would generally consist of low-taxed income, there would be a higher probability of excess limitation in the corresponding section 904 categories. Conversely, if US shareholders do not make the election, inclusions of high-taxed income (and attributable deemed paid FTCs) may result in excess credit positions in the corresponding section 904 categories.
- Reduced Foreign Tax Credits: Similarly, if the unified high-tax exception election is made, FTCs attributable to excluded high-taxed income would generally be “lost.” Although the associated earnings may qualify for the section 245A DRD, taxpayers may not be indifferent to losing these FTCs, even if in an excess credit position, because deemed paid FTCs attributable to Subpart F inclusions may be carried forward or back to other taxable years (whereas deemed paid FTCs attributable to GILTI inclusions are “lost” if not absorbed in the current year). Thus, taxpayers may still have an incentive to structure into high-taxed Subpart F income and not make the high-tax election.
- Interest Expense Apportionment: If the unified high-tax exception election is made, a greater portion of interest expense deductions apportioned to the corresponding category of high-taxed income would be subject to section 904(b)(4), which disregards such deductions in computing taxable income under section 904. As a result, while the section 904 limitation in such category would typically not be adversely impacted, such deductions would also be disregarded in the denominator in the other section 904 categories, thereby reducing FTC capacity in those categories.
- Importance of 245A Availability: Because the unified high-tax exception applies on a CFC group basis, the high-taxed earnings of all CFCs in the CFC group would be excluded from Subpart F income and tested income under the high-tax exception. A distribution of these earnings to the US shareholder generally may be deducted entirely from income under section 245A. As a result, taxpayers should take care to ensure that section 245A treatment is in fact available with respect to such earnings, which would require navigating the hybrid dividend rules, as well as the extraordinary reduction and extraordinary disposition rules of the temporary section 245A regulations.
It remains to be seen whether Treasury and IRS may be amenable to changes in the course of finalizing the 2020 Proposed Regulations to preserve some of the flexibility of the current rules while still curtailing strategies of concern to the government. In addition, the timing of finalization is an open question. Because the 2020 Proposed Regulations (appropriately) would apply purely prospectively to taxable years beginning after finalization, taxpayers may still enjoy the benefits of the greater flexibility under the current rules for some period of time (the current taxable year at a minimum) while they evaluate the impact of the new approach on their existing structures.