On July 23, 2020, the U.S. Department of Treasury (“Treasury”) and the Internal Revenue Service (IRS) finalized regulations (T.D. 9902) with respect to the global intangible low-taxed income (GILTI) high-tax exception (“Final Regulations”). The Final Regulations largely finalize regulations previously proposed on June 14, 2019 (GILTI Proposed Regulations) with some significant changes as described below. In general, the Final Regulations enable certain U.S. shareholders of a controlled foreign corporation (CFC) to exclude amounts that would otherwise be tested income from the shareholders’ GILTI computation if the foreign effective tax rate on such amounts exceeds 90% of the top U.S. corporate tax rate (currently 18.9% based on the current 21% corporate tax rate). In addition, the government issued proposed regulations (REG-127732-19) that generally conform the Subpart F high-tax exception under section 954(b)(4) to the recently finalized GILTI high-tax exception (“Proposed Regulations”). As discussed below in more detail, corporate and non-corporate taxpayers will need to carefully consider the impact of the GILTI and Subpart F high-tax exceptions.
As a general matter, corporate and non-corporate taxpayers that hold a 10% or greater interest (by either vote or value) (“U.S. Shareholders”) in a CFC are subject to taxation under the Subpart F and GILTI regimes. Subpart F was enacted in 1962 with an intent of taxing on a current basis CFC earnings of certain categories of income that are typically passive in nature. GILTI was enacted under P.L. 115-97, the Tax Cuts and Jobs Act (TCJA), on December 22, 2017, with the goal of taxing on a current basis CFC earnings (not including earnings already subject to current U.S. tax such as Subpart F income) at a minimum rate. As a result of a 50% GILTI deduction, a corporate U.S. Shareholders’ effective U.S. federal income tax rate on GILTI is 10.5%. Additionally, corporate U.S. Shareholders are eligible for a foreign tax credit equal to 80% of the foreign taxes imposed on GILTI income (subject to application of the section 904 foreign tax credit limitations). A non-corporate U.S. Shareholder is not eligible for either the 50% GILTI deduction or the foreign tax credit unless such shareholder elects under section 962 to be taxed on its GILTI and subpart F in substantially the same manner as a U.S. corporation.
Contemporaneous with the adoption of the GILTI regime, congressional committee reports suggested that a corporate U.S. Shareholder should not incur a GILTI tax liability if the effective foreign tax rate exceeds 13.125% (10.5% effective tax rate divided by 80%) of the GILTI income. However, because of the application of the foreign tax credit limitation under section 904, certain expenses, such as interest expense incurred by the U.S. parent of a multinational group must be allocated and apportioned to GILTI. As a result of the allocation and the potential mismatch between when an item of income is taken into account for GILTI purposes and when the foreign taxes related to such item of income are deemed paid by the U.S. Shareholder under section 960, corporate U.S. Shareholders may find that including GILTI in their taxable income increases their U.S. tax liability even if GILTI is taxed at a foreign rate greater than 13.125%.
Subpart F also taxes currently certain income of a CFC to a U.S. Shareholder. Section 954(b)(4) contains the Subpart F high-tax election, which provides that foreign base company income and insurance income does not include any item of income of a CFC if such income was subject to an overall foreign effective tax rate that exceeds 90% of the top U.S. corporate tax rate.
As a result of the GILTI and Subpart F high-tax elections, a U.S. Shareholder that makes such elections may opt-out of the Subpart F and GILTI regimes for certain income.
Overview of the Regulations
GILTI High-Tax Exception
The Final Regulations follow many of the same principles from the GILTI Proposed Regulations. The GILTI high-tax exception will exclude from GILTI income of a CFC that incurs a foreign tax at a rate greater than 90% of the U.S. corporate rate, currently 18.9%.
The Final Regulations provide detailed rules for determining whether a CFC’s income incurs a sufficient rate of foreign tax. First, a CFC must identify its “tested units.” The GILTI Proposed Regulations included a similar concept based on qualified business units (QBUs) as defined in section 989. The government received several comments that characterized the QBU approach as overly complex and asserted that a CFC-by-CFC approach would better align the GILTI high-tax exclusion with the Subpart F high-tax exclusion. Other comments suggested that, while the QBU approach was adopted to avoid the blending of low-taxed income with high-taxed income, the blending of low-taxed income and high-taxed income was not a significant risk. The government ultimately concluded that blending of income subject to different rates remained a risk, but a more flexible approach could be adopted for identifying income that should not be blended.
Tested units include (1) a CFC, (2) a branch that has a taxable presence in the country in which it is located, (3) a branch that is not regarded as a taxable presence in the country in which it is located but which is eligible for an exemption or reduced rate of tax in the branch owner’s country of residence, (4) a pass-through entity (including a disregarded entity) that is tax resident in a foreign country and (5) a pass-through entity treated as a corporation by its owner’s home country. Under a combination rule, tested units that are resident of, or have a taxable presence in, the same country are combined for purposes of determining the effective rate of foreign tax. In addition, the combination rule applies without regard to whether the separate tested units are subject to the same foreign tax rate or have the same functional currency. The combination rule is mandatory under the Final Regulations. In adopting the tested unit approach, the government rejected comments that the analysis be done on the CFC-by-CFC basis that taxpayers had advocated out of concern that check-the-box elections could be used to inappropriately blend high-tax income and low-tax income. The tested unit approach will require minority investors in a CFC to have a significant amount of information regarding the structure and activities of a CFC if they wish to benefit from the GILTI High-Tax Election with respect to such CFC. Assuring access to such information is something that minority investors will need to negotiate for up-front as part of its initial investment in a foreign corporation that is, or may become, a CFC.
Upon determining the tested units, a CFC’s gross income items are attributed to each of the tested units. The gross income attributable to a tested unit is called a “tentative gross tested income item.” Gross income is attributable to a tested unit to the extent that such income is properly reflected on the separate books and records of the tested unit (or to the extent it would be so reflected if such books and records were kept). For this purpose, payments that are generally disregarded for U.S. tax purposes because they are made to, from or between branches or disregarded entities of the CFC are generally regarded for purposes of determining the gross income attributable to a tested unit. After the tentative gross tested income item of each tested unit is determined, the CFC’s deductions and foreign taxes are allocated and apportioned to each tested unit (or to a residual category) in order to determine the “tentative tested income item.” The allocation and apportionment process generally follow the rules promulgated for calculating the foreign tax credit limitation under section 904 and deemed paid foreign taxes under section 960.
Finally, the effective foreign income tax rate on each tentative tested income item is calculated by dividing the U.S. dollar amount of foreign income taxes paid or accrued that have been allocated and apportioned to the tentative tested income item by the U.S. dollar amount of the tentative tested income item, which is grossed-up by the amount of such foreign income taxes. To the extent that the foreign tax rate is in excess of 90% of the maximum U.S. corporate rate, the tentative gross tested income item may be excluded from tested income, and thus from the U.S. shareholder’s GILTI computation.
A GILTI high-tax election must be made by the “controlling domestic shareholder” of a CFC, generally the U.S. Shareholder(s) owning more than 50% or more of the total combined voting power of all classes of stock (or, where there are no such shareholders, all of the U.S. Shareholders of the CFC). Where a controlling domestic shareholder holds a more than 50% interest by vote or value of more than one CFC (taking into account the attribution rules under section 318), the CFCs are considered a “CFC Group.” For CFCs in a CFC Group, a shareholder that makes a GILTI high-tax election must make the election for all or none of the CFCs in the group. The controlling domestic shareholder makes the election on its original tax return for the taxable year in which ends the relevant taxable year of the CFC or on an amended federal tax return filed within 24 months of the unextended due date for the original return. A taxpayer that has made the election may revoke the election in the same manner as prescribed for an election made on an amended return. In the case of an election or revocation on an amended return, the Final Regulations require that all U.S. Shareholders of the CFC file their original or amended tax returns reflecting the effect of the election or revocation for the relevant taxable year and for any other taxable year in which the U.S. tax liability of the U.S. Shareholder would be increased by reason of the election or revocation within a single period no greater than six months with the 24-month period described above. Each U.S. Shareholder also must pay any tax due as a result of such adjustments within such six-month period. In the case of a U.S. Shareholder that is a partnership, the election may be made (or revoked) with an amended Form 1065 or an administrative adjustment request under section 6227, as applicable.
As a general matter, the final GILTI regulations issued in June 2019 adopted a partner-level approach (or aggregate approach) to domestic partnerships for purposes of determining a partner’s GILTI inclusion for a CFC owned by a domestic partnership. A domestic partnership does not have a GILTI inclusion amount. As currently proposed, partners who have a 10% or greater interest in a CFC through their interests in a domestic partnership would determine their pro rata share of the tested items of the CFC and may have GILTI or Subpart F.
Although the government finalized GILTI regulations in 2019 that address certain GILTI issues for domestic partnerships, the government did not finalize certain proposed regulations regarding the treatment of domestic partnerships under the Subpart F, consolidated return, direct/indirect/constructive ownership and investment in United States property rules.
The preamble to the Final Regulations provided that under the currently applicable proposed Subpart F and section 956 regulations, a domestic partnership can be a controlling domestic shareholder for purposes of determining which party makes the GILTI high-tax election. The government intends to address this proposed rule in forthcoming final regulations.
The GILTI Proposed Regulations generally provided that the election is effective for the CFC inclusion year for which it is made and all subsequent CFC inclusion years, unless the election is revoked. Furthermore, the GILTI Proposed Regulations stated that if the election was revoked, an election may not be made again for 60 months. This proposed rule has been eliminated in the Final Regulations. Under the Final Regulations, the election may be determined on an annual basis. A GILTI high-tax election may be made on or after July 23, 2020. In addition, taxpayers may choose to apply the election to taxable years that begin after December 31, 2017, provided that the taxpayers consistently apply the Final Regulations to such periods. Notably, the GILTI Proposed Regulations did not provide for retroactive application.
Subpart F High-Tax Exception
After the release of the GILTI Proposed Regulations, taxpayers submitted comments to the government that the GILTI high-tax exception should generally conform to the Subpart F high-tax exception. The Subpart F high-tax exception generally allowed a U.S. Shareholder to exclude from Subpart F income of a CFC income that was high-taxed on an item-by-item basis.
In releasing the Proposed Regulations, the government agreed that the GILTI and Subpart F high-tax exceptions should be conformed. However, rather than adopt the previous method for applying the Subpart F high-tax exception to the GILTI High-Tax Exception, the government generally conformed in the Proposed Regulations, the Subpart F high-tax exception to the finalized GILTI high-tax exception, requiring that the Subpart F high-tax exception be applied on a tested units basis.
Under the Proposed Regulations, the GILTI and Subpart F high-tax exceptions will be a single election that must be made (or not made) annually for all CFCs in a CFC Group on a consistent basis. The Proposed Regulations would also bring greater conformity of the process for determining whether income is high-taxed for Subpart F purposes with the process applicable to GILTI under the Final Regulations. There are other additional technical changes that would be made to the Subpart F high-tax exception under the Proposed Regulations, including requirements to have certain contemporaneous documentation, changes to the earnings and profits limitation, and changes to the application of the full inclusion rule. The Proposed Regulations are proposed to be effective for taxable years of CFCs beginning after the date the Proposed Regulations are finalized. Taxpayers may not rely on the Proposed Regulations currently.
Considerations for US Parented Multinational Groups
As described above, U.S. parented multinational groups frequently pay GILTI tax despite having CFCs with an overall effective foreign tax rate in excess of 13.125%. This most commonly results from the apportionment of expenses incurred in the United States to the GILTI foreign tax credit basket and timing mismatches between when an item of income is taken into account for GILTI purposes and when the foreign taxes related to such item of income are deemed paid by the U.S. Shareholder under section 960. Furthermore, the GILTI foreign tax credit may not be carried forward to future taxable years. The GILTI high-tax election permits U.S. parented groups to avoid potential residual GILTI tax liability resulting from expense apportionment provided that the effective foreign rate of the group’s CFCs exceeds 18.9%. While it may be tempting to assume that U.S. parented groups eligible for the GILTI high-tax election should always elect to apply it, negative side effects could outweigh the benefits in some cases.
Because there are many ways in which the presence of GILTI income in a taxpayer’s tax return may affect the taxpayer’s U.S. tax liability, it is important to consider carefully all of the consequences of making (or revoking) a GILTI high-tax election. For example, a U.S. Shareholder of CFCs with both high-taxed and low-taxed foreign operations could find that removing high-taxed tested income from its GILTI computation eliminates the ability to cross-credit foreign taxes paid or accrued on the high-taxed income against its residual GILTI tax liability on the low-taxed tested income. Similarly, making the election may reduce a U.S. shareholder’s “net deemed tangible income return” that may then reduce GILTI tax liability on low-taxed foreign income if the tangible income return arises from qualified business asset investment (QBAI) in high-taxed jurisdictions. Taxpayers also may need to consider the effects of the election on the allocation and apportionment of expenses, on the calculation of the taxpayer’s section 163(j) limitation, and on the eligibility for payments on hybrid instruments or involving hybrid entities for exclusion from the anti-hybrid rules of section 267A.
Furthermore, as a result of electing the GILTI high-tax regime, CFC earnings attributable to income excluded from tested income will not be treated as previously taxed earnings and profits (PTEP). This has two major consequences that U.S. parented groups will want to consider. First, dividends of such earnings and profits (E&P) will need to satisfy the requirements of section 245A rather than the requirements of the PTEP rules in order to be received tax-free by the U.S. parent. Unlike the PTEP rules, section 245A has certain holding period requirements, anti-hybrid rules, and other rules that must be satisfied for distributions from CFCs to the U.S. parent to be tax-free. Second, dividends of E&P that satisfy the requirements of section 245A are not eligible for foreign tax credits. Under section 960(b), distributions of PTEP can generate GILTI foreign tax credits where withholding and other foreign taxes are imposed on distributions of PTEP from a CFC to its U.S. parent. However, distributions of E&P that are eligible for the section 245A dividends received deduction are not eligible for such foreign tax credits. As a result, U.S. parented groups will want to consider the post-CFC earnings repatriation tax cost associated with forgoing GILTI PTEP when deciding whether to elect into the GILTI high-tax regime.
Considerations for Non-US Parented Multinational Groups
Non-U.S. parented multinationals generally have less exposure to the GILTI rules than U.S.-parented multinationals. However, a non-U.S. parented group may own a U.S. subsidiary that has a GILTI income inclusion. In such a case, the same considerations discussed above, with respect to a U.S. parented multinational, may apply to the U.S. subsidiary.
In addition, a U.S. subsidiary of a non-U.S. parented multinational group is more commonly subject to a base erosion and anti-abuse tax (BEAT) liability. The intended purpose of the BEAT is to prevent U.S. corporations from unduly reducing their U.S. taxable income through payments to related foreign parties. A BEAT tax liability equals the excess of (1) the applicable BEAT tax rate (currently 10.5%) multiplied by the taxpayer’s “modified taxable income” over (2) the taxpayer’s adjusted regular tax liability, each as determined for that taxable year. In computing the taxpayer’s regular tax liability for a taxable year, certain credits (including foreign tax credits) generally are subtracted from the regular tax liability amount. Because a GILTI inclusion is included in modified taxable income for purpose of BEAT and a taxpayer’s regular tax liability is decreased for foreign tax credits, a non-U.S. parented multinational that is subject to the BEAT may have its BEAT tax liability increased to the extent that it also has a GILTI income inclusion. Therefore, to the extent that a U.S. subsidiary of a non-U.S. parented multinational is (or could potentially be) subject to the BEAT, such U.S. subsidiary may be more inclined to make the GILTI high-tax election.
Considerations for Corporations with Net Operating Loss Carryovers or Carrybacks
Prior to the Coronavirus Aid, Relief and Economic Security Act (the CARES Act), net operating losses (NOLs) generated in taxable years beginning after December 31, 2017 could be carried forward indefinitely, but such NOLs generally could not be carried back. However, the CARES Act amended section 172 in order to permit NOLs generated in taxable years beginning after December 31, 2017, and before January 1, 2021, to be carried back to each of the five taxable years preceding the taxable year in which the NOL arose.
Because a taxpayer may elect to retroactively apply the GILTI high-tax election to taxable years that begin after December 31, 2017, a taxpayer generating NOLs in its 2018, 2019 or 2020 taxable years may increase the amount of the NOLs that may be carried back to prior years (including years where the top marginal corporate tax rate was 35%) by making the GILTI high-tax election for its 2018, 2019 or 2020 taxable years. Such an election would decrease the taxpayer’s taxable income in its 2018, 2019 or 2020 taxable years by eliminating or reducing the GILTI inclusion for such years, which would potentially benefit the taxpayer by (a) increasing the amount of NOLs that could be carried back to prior years (including to pre-2018 taxable years when the top marginal effective tax rate was 35%) and (b) preventing the NOL carryback from simply replacing the 50% GILTI deduction that would have been otherwise available to the taxpayer with respect to its GILTI inclusion (which would effectively result in the taxpayer reducing its NOLs dollar-for-dollar by the GILTI inclusion (without the benefit of the 50% GILTI deduction)).
Furthermore, because the GILTI high-tax election may now be made on an annual basis, a taxpayer carrying forward NOLs may consider making the GILTI high-tax election solely in a taxable year that it expects to utilize NOL carryforwards in order to prevent the NOL carryforwards from displacing the 50% GILTI deduction that would have otherwise been available with respect to the taxpayer’s GILTI inclusion.
Accordingly, a taxpayer that is carrying forward or carrying back NOLs should consider making the GILTI high-tax election along with the ancillary consequences of such election, as described above.
Considerations for Individuals and Domestic Partnerships that Own CFCs
Individual U.S. Shareholders of CFCs generally are subject to a tax on their pro rata share of GILTI at a top marginal rate of 37%. Individual U.S. Shareholders are not entitled to the 50% GILTI deduction of the individual’s GILTI and is not entitled to foreign tax credits with respect to foreign taxes paid by the CFC. Accordingly, an individual U.S. Shareholder of a CFC directly may be subject to a more significant tax burden with respect to his or her GILTI than a comparable domestic corporation.
A section 962 election permits an individual U.S. Shareholder to be taxed on its GILTI in substantially the same manner as a U.S. corporation. Accordingly, an individual U.S. Shareholder who makes a section 962 election will receive a 50% GILTI deduction and to be subject to tax on such GILTI inclusion at the corporate income tax rate. Furthermore, an individual U.S. Shareholder who makes a section 962 election generally will be entitled to a GILTI foreign tax credit under section 960 for foreign taxes paid by the CFC in the same manner as a domestic corporation. An individual who makes such an election, however, will be subject to a second level of tax following an actual distribution of cash by the foreign corporation in an amount equal to the excess of the earnings and profits of the CFC distributed to the individual U.S. Shareholder over the amount of tax paid by the individual U.S. Shareholder on the amounts to which the section 962 election applied. An individual U.S. Shareholder’s eligibility for preferential tax rates on qualified dividend income is based on whether the individual would be eligible for such lower tax rates with respect to distributions from a “qualified foreign corporation” eligible for the benefits of a comprehensive income tax treaty with the United States. In these respects, a section 962 election is similar to an interposition of a domestic C-corporation between the individual and the CFC (however, upon the disposition of shares of the CFC, there generally is not a second level of tax for an individual who has made a section 962 election).
Where available, the GILTI high-tax election may be advantageous to an individual U.S. Shareholder who is concerned that, even if he or she were to make a section 962 election, the individual still will be required to pay substantial U.S. tax on its GILTI inclusion. The considerations for an individual U.S. Shareholder may include that he or she is not able to utilize the 50% GILTI deduction and sufficient GILTI foreign tax credits to eliminate all or most of the U.S. tax imposed on the GILTI inclusion (which, similar to corporations, may be the case as a result of foreign tax credit limitations under section 904 or differences between the time that the GILTI is recognized for U.S. tax purposes and the foreign tax purposes) or the individual may simply not want to deal with the complexity of the foreign tax credit limitation rules under section 904. However, individual U.S. Shareholders will also need to consider the potential costs of making the GILTI high-tax election, including the implications under section 163(j) (to the extent that a CFC group election has been made), the loss of GILTI tax credits under section 960 (for an individual who makes a section 962 election) and the loss of the tangible income return on QBAI with respect to high-taxed CFCs.