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:
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.
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.
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.
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.
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.
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.
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).
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.
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.
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.
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.