By Amanda Varma & Greg Kidder, Steptoe & Johnson LLP
The US Treasury and the IRS on September 13 released proposed regulations addressing the global intangible low-taxed income (GILTI) regime enacted in the December 2017 tax reform legislation, commonly known as the Tax Cuts and Jobs Act.
The GILTI rules in section 951A essentially subject 10% US shareholders of controlled foreign corporations (CFCs) to current US tax on certain CFC income exceeding a deemed routine return on tangible assets. A US corporate shareholder is generally permitted a 50% GILTI deduction under section 250, resulting in an effective US federal income tax rate on GILTI of 10.5%. Under section 960(d), a foreign tax credit may be available to offset the US tax on GILTI, subject to several limitations.
Here are some notable highlights from the proposed GILTI regulations.
1. Critical GILTI guidance is still to come
The proposed GILTI regulations provide helpful guidance on numerous computational issues and ambiguities arising under new section 951A.
However, the regulations do not address several vexing issues raised by the interaction of the GILTI regime and other provisions, including with respect to foreign tax credits, the section 250 deduction, section 163(j) (limitation on deductibility of interest expense), section 245A (dividends-received deduction for foreign income), section 267A (anti-hybrid rules), and section 959 (addressing previously taxed income). The preamble to the proposed GILTI regulations states that such issues will be addressed in future guidance.
Although the regulations do not provide guidance on foreign tax credit issues, the preamble does address one credit issue of interest to many taxpayers.
The preamble states that it is anticipated that future proposed regulations will provide rules for assigning the section 78 gross-up attributable to foreign taxes deemed paid under section 960(d) to the GILTI foreign tax credit basket.
2. Computation of GILTI when multiple US shareholders are members of the same consolidated group
The statutory GILTI rules left unanswered whether multiple US shareholders that are members of a single US consolidated group compute GILTI separately as individual shareholders or in the aggregate as a single US shareholder.
GILTI is computed by aggregating income and attributes of all controlled foreign corporations (CFCs) held by a US shareholder, unlike subpart F, which is computed on a CFC by CFC basis. Specifically, GILTI is calculated as the US shareholder’s “net CFC tested income” over “net deemed tangible income return.” Net CFC tested income (a CFC’s gross income, excluding several categories of income) is the excess of the U.S. shareholder’s pro rata share of CFC tested income over CFC tested loss. “Net deemed tangible income return” is calculated as 10% of the shareholder’s pro rata share of the qualified business asset investment (QBAI) of each CFC, over certain interest expense. QBAI is determined as the average of the adjusted U.S. tax basis, determined at the end of each quarter of a tax year, in “specified tangible property” that is used in the CFC’s trade or business and is subject to U.S. tax depreciation.
There can be significant differences between (a) multiple members of a consolidated group computing GILTI separately first and then aggregating the resulting GILTI inclusions to compute consolidated group liability and (b) performing one aggregate group GILTI computation.
The proposed GILTI regulations answer this question and provide that GILTI is determined by aggregating the income and attributes of all CFCs owned by members of the same consolidated group.
Each US shareholder member is then allocated a pro rata share of the resulting aggregate amount to compute GILTI.
The proposed GILTI regulations provide specific definitions of net CFC tested income and net deemed tangible income return.
To determine a member’s GILTI inclusion amount, the pro rata shares of tested loss, QBAI, tested interest expense, and tested interest income of each member (based on each member’s ownership of CFCs and the income and attributes of those CFCs) are aggregated first, and then a portion of each aggregate amount is allocated to each member of the group that is a US shareholder of a tested income CFC based in proportion to such member’s aggregate pro rata share of tested income of the consolidated group.
This is a welcome clarification and sensible application of the GILTI computation rules to consolidated groups.
Computing GILTI strictly on a member-by-member basis could lead to aberrational results and substantially different GILTI consequences as a result of merely combining two members of the same consolidated group through merger or separating a single member of the consolidated group into two entities through a spin-off or other division transaction.
This would have created unfair results and numerous questions about whether such combination or division transactions should be considered abusive.
3. Anti-abuse rules target potential tax avoidance transactions
The proposed GILTI regulations contain several anti-abuse provisions, including to target specific categories of transactions identified in legislative history.
One such transaction involves a taxable transfer of property from one CFC to another to increase basis (and thus potentially increase QBAI and reduce tested income due to increased depreciation or amortization deductions), after the measurement date of post-1986 earnings and profits under the section 965 transition tax but before the first taxable year for which the GILTI rules are effective for a fiscal-year taxpayer.
The proposed regulations disregard certain “deductions or losses” for purposes of determining tested income and loss where the deduction or loss is attributable to basis in specified property (a concept broader than specified tangible property that gives rise to QBAI) resulting from transfers between January 1, 2018 and the close of taxpayer’s last year before the GILTI regime applies. Another rule disregards certain basis relating to such transfers for purposes of determining QBAI.
The proposed GILTI regulations also provide that basis is disregarded if a tested income CFC acquires property with a principal purpose of reducing a shareholder’s GILTI inclusion and the property is held over at least one-quarter end but temporarily.
In addition, a new anti-abuse rule in proposed section 951 regulations disregards “any transaction or arrangement that is part of a plan a principal purpose of which is the avoidance of Federal income taxation” for purposes of determining a US shareholder’s pro rata share of subpart F income as well as for applying the GILTI rules that require a US shareholder to determine its pro rata share of CFC income and attributes, including QBAI.
4. The proposed GILTI regulations add new rules for basis adjustments as a result of the use of tested losses
A US shareholder computes GILTI by determining the excess of net tested income over a net deemed tangible income return. As a result, the tested loss of one CFC owned by a US shareholder can offset the tested income of another CFC owned by that US shareholder and therefore reduce net tested income and GILTI.
Under the statute, such a “use” of a tested loss to reduce GILTI did not otherwise reduce the shareholder’s basis in the stock of the tested loss CFC, increase the stock basis of the tested income CFC, or affect the earnings and profits of either CFC.
The preamble to the proposed GILTI regulations states that these lack of adjustments can lead to inappropriate results by allowing a single loss to result in two tax benefits—(1) a reduction in GILTI and (2) a recognition of loss or reduction in gain upon the disposition of the tested loss CFC.
The proposed GILTI regulations address this by including a rule that provides that, in the case of a corporate US shareholder (excluding regulated investment companies and real estate investment trusts), for purposes of determining the gain, loss, or income of the direct or indirect disposition of stock of a CFC, the basis is reduced by the amount of tested loss that has been used to offset tested income in calculating net CFC tested income of the US shareholder.
The proposed regulations provide that this basis reduction is only made at the time of the disposition and does not affect stock basis prior to disposition. This “only at the time of disposition” rule is intended to prevent the use of tested losses alone from causing the recognition of gain if the reduction exceeds the amount of available stock basis at the time of use.
There are additional rules to compute how much of a tested loss is “used,” as well as to make adjustments when a tested loss CFC is treated as owned by the US shareholder through intervening foreign entities and when a disposition of the stock of a CFC results in the indirect disposition of the stock of one or more lower tier CFCs.
In addition, there are also rules that address nonrecognition transactions and dispositions of CFC stock by another CFC that is not wholly owned by a single US corporation.
These proposed GILTI regulations address an understandable concern about a double benefit arising from the use of net tested income in computing GILTI, but they make the computation of basis to determine the tax consequences of the disposition of a CFC very complicated.
Under these proposed rules, a taxpayer must review the tested income/tested loss history of that CFC, as well as the GILTI computation history at the US shareholder level to determine the required basis adjustment.
5. The proposed GILTI regs also provide answers to numerous computational issues
The proposed regulations address numerous GILTI computational issues, including clarifying certain ambiguities raised by the statute. For example, the proposed regulations:
- Indicate that determinations of gross income and allowable deductions for GILTI should be made in a manner similar to the determination of subpart F income under Treas. Reg. § 1.952-2. Thus, tested income or tested loss of a CFC is determined by treating the CFC as a domestic corporation;
- Address various issues relating to the calculation of QBAI and net tangible deemed income return, including confirming that tested loss CFCs do not have specified tangible property taken into account in the QBAI calculation;
- Confirm that income is excluded from tested income under the subpart F high-tax exception only where it is excluded from foreign base company income or insurance income solely by reason of an election to exclude the income under the high-tax exception (i.e., non-subpart F income subject to a high rate of tax is still considered tested income);
- Provide rules with respect to partnerships, including a hybrid aggregate/entity approach to determine GILTI inclusions in the case of a US partnership.
–Greg Kidder is a partner at Steptoe & Johnson LLP, where his practice focuses on the taxation of corporate entities and cross-border transactions.