The IRS has released much-anticipated proposed regulations (REG-104390-18
) addressing global intangible low-taxed income (GILTI). The regulations provide welcome clarity in some areas but fail to give immediate direction on other key issues. Taxpayers hoping to gain insight into how their foreign tax credits might be utilized against GILTI will have to wait. Similarly, those interested in how Section 250 or the previously taxed income rules might operate are also left without answers. Those regulations will come in a separate release in the coming months.
The GILTI provisions were enacted by the Tax Cuts and Jobs Act (TCJA) under Section 951A, and impose a minimum tax on certain foreign income deemed to be in excess of a routine return. They aim to provide “base protection measures” in light of the participation exemption system enacted under the TCJA. Congress recognized that mobile income from intangibles was especially at risk of being shifted to low-tax jurisdictions. The provisions are designed to discourage income shifting to foreign jurisdictions by subjecting certain foreign earnings to current U.S. tax.
The proposed regulations provide guidance in a number of areas ranging from combined treatment of consolidated groups to complex rules addressing treatment of domestic partnerships. They also clarify how tested income and tested loss are determined along with how the routine return is measured, and introduce new anti-abuse rules.
However, significant uncertainty remains in other areas. Treasury has indicated the proposed rules are the first of three tranches of guidance on GILTI. Treasury is expected to release further guidance addressing foreign tax credits and expense allocation under GILTI, the Section 250 deduction, and previously taxed income under Section 959. Treasury also requested comments on, but did not address, several other ambiguous areas including the interaction between GILTI and Sections 163(j), 245A and 267A, adjustments to partners’ Section 704(b) capital account for GILTI amounts as well as various other issues that may arise under the consolidated return regime.
The proposed rules are extremely technical and may be applicable taxpayers as soon as the 2018 taxable year. Taxpayers should begin carefully assessing the guidance for immediate and long-term impact and be prepared to compute taxable income for all controlled foreign corporations on an annual basis, making sure appropriate systems and controls are in place to track and timely collect the new data while ensure accuracy. Taxpayers should also consider the potential impact of issues to be addressed in future guidance as well as related issues that stand to remain unaddressed.
For tax years beginning after 2017, U.S. shareholders of a controlled foreign corporations (CFCs) are subject to current U.S. tax on its GILTI inclusion. GILTI is generally defined as the excess of a U.S. shareholder’s aggregated “net tested income” from CFCs over a routine return on certain qualified tangible assets. This aggregated approach allows loss entities to offset other entities with tested income within the group, but not below zero.
“Tested income” is the excess (if any) of the corporation’s gross income over its allocable deductions. Certain types of gross income are excluded from being classified as “tested income” including:
- Income taxed as effectively connected with a U.S. trade or business
- Subpart F income
- Income excluded from foreign-based company income or insurance income by reason of the high-tax exception
- Any dividend received from a related person
- Certain foreign oil and gas income
The reduction allowed against tested income for the routine return on tangible assets is defined as 10% of the CFCs’ average aggregate adjusted tax bases in depreciable tangible property (referred to as qualified business asset investment or QBAI) adjusted downward for certain interest expense (collectively, referred to as net deemed tangible income return). The average of the aggregate adjusted tax bases is determined as of the close of each quarter of the taxable year.
The GILTI amount is included in a U.S. shareholder’s income in a similar fashion to Subpart F income. The TCJA provides domestic corporations a 50% deduction of its GILTI amount (37.5% for tax years beginning after 2025), resulting in an effective tax rate on GILTI of 10.5% (13.125% for tax years beginning after 2025), subject to a number of complicating factors.
Consolidated tax return rules
The regulations provide welcome relief for taxpayers in consolidated groups. By allowing the items of each consolidated group member to be aggregated when determining the consolidated group’s GILTI inclusion, the rules have eased concerns about the ability to share certain GILTI items amongst group members.
To determine a consolidated group member’s GILTI inclusion, the regulations provide that a pro rata share of each members components of GILTI (e.g., tested income, tested interest expense, QBAI, etc.) are aggregated, and then a portion of each aggregate amount is allocated to each member of the group that is a U.S. shareholder of a tested income CFC. The amount allocated to each consolidated member is determined based on the ratio of the aggregate pro rata share of a member’s tested income to the total tested income of the consolidated group (referred to in the proposed regulations as the GILTI allocation ratio).
The regulations also contain certain adjustments to a consolidated group member’s stock basis to account for adjustments to the basis in the subsidiary CFC stock. The preamble provides that the adjustments are necessary to “not incentivize a sale of the stock of a CFC over a sale of stock of a member,” which might otherwise result from the application of sections 1248 or 964 and the new dividends received deduction.
Domestic partnerships and their partners
The proposed regulations apply both the aggregate and entity theories because Treasury and the IRS determined that such an approach “best harmonizes the treatment of domestic partnerships and their partners across all provisions of the GILTI regime.” A domestic partnership is treated as an entity with respect to partners that are not U.S. shareholders (i.e., indirectly hold less than 10%) of any CFC owned by the partnership, while a domestic partnership is treated as an aggregate for purposes of partners that are U.S. shareholders (i.e., indirectly hold at least 10%) of one or more CFCs owned by the partnership. These rules also apply to S corporations and their shareholders, which are treated as partnerships and partners for purposes of Section 951 through Section 965.
The preamble explains that this approach ensures that non-U.S. shareholder partners take into income their distributive share of the domestic partnership’s GILTI inclusion amount, while allowing those U.S. shareholders (i.e. 10% or more indirect partners) to determine their GILTI inclusion amount by reference to all their CFCs, whether owned directly or indirectly through a partnership. The regulations also provide special rules for tiered partnerships that essentially require the aggregate approach for each partner that is itself a partnership and also an indirect U.S. shareholder in a lower-tier CFC. Each partnership in a tiered partnership structure must provide on the Schedule K-1 of a non-U.S. shareholder partner its share of the partnership’s GILTI inclusion amount, while providing a U.S. shareholder partner both (1) its share of the partnership’s GILTI inclusion amount along with (2) its proportionate share of the partnership’s pro rata share (if any) of each CFC tested item of each CFC owned directly or indirectly by the partnership.
Tested income and tested loss computation
The GILTI inclusion is the excess of a U.S. shareholder’s net tested income over such shareholder’s net deemed tangible return for that period.
Tested income and loss of a CFC are determined using a taxable income approach — treating the CFC as a domestic corporation taxable under Section 11 and applying the principles of Section 61 and regulations thereunder. Under this approach, only items that may be deducted in determining the taxable income of a domestic corporation will be taken into account for purposes of determining a CFC’s net tested income or loss. Unlike Subpart F, tested income is not subject to the current earnings and profits limitation under Section 952(c)(1)(A). Therefore, tested income may exceed current earnings and profits of a CFC.
When determining net tested income or loss, allocable deductions allowed against a CFC’s gross income are determined under the rules of Section 954(b)(5). Expenses are allocated and apportioned under the principles of Sections 861, 864 and 904(d) (i.e., the general expense allocation and apportionment rules). These allocation and apportionment rules generally seek to match expense items with the category of gross income to which they relate. Taxpayers having multiple categories of gross income should take care to evaluate their expense apportionment and allocation methods to ensure net tested income or loss of each CFC is properly determined.
The proposed regulations also provide guidance on the types of gross income which are specifically excluded from the determination of tested income or tested loss. The exclusions include income excluded from being Subpart F income due to the so-called “high-tax exception.” With respect to this exception for income qualifying as “high tax,” the proposed regulations affirmatively provide that the exception does not apply to items that would not otherwise constitute Subpart F income. Therefore, the exception only applies to Subpart F income excluded from gross income by reason of electing the high tax.
Pro rata share rules
For purposes of determining a U.S. shareholder’s GILTI inclusion, Section 951A(e)(1) provides that a shareholder’s pro rata share of a CFC’s tested income, tested loss or QBAI will generally be determined in the same manner as Subpart F income. The proposed regulations follow this approach with certain modifications to reflect differences between Subpart F income and CFC items necessary for calculating GILTI. Accordingly, a U.S. shareholder’s pro rata share of CFC items necessary for calculating GILTI is generally determined by reference to stock ownership (within the meaning of Section 958(a)) and through domestic partnerships (as described above).
Under these general rules, the pro rata share of tested income is determined based upon the proportionate amount that the U.S. shareholder would have received in a year-end hypothetical distribution of all the CFC’s current year earnings and profits. The pro rata share of a U.S. shareholder’s QBAI would generally be proportionate to the CFC’s tested income distributed in the hypothetical distribution. There are several exceptions to this general rule, including provisions related to allocations of QBAI where a CFC has preferred stock that is outstanding. Further, the determination of a U.S. shareholder’s share of tested loss is determined only with respect to common stock. There are also a number of special rules to ensure that allocations of CFC-tested losses (as well as Subpart F income) are commensurate with the economic loss actually incurred.
The proposed regulations introduce new anti-abuse regulations promulgated under authority granted in the statute to prevent avoidance of the GILTI rules. The first anti-abuse rule targets transactions undertaken by a CFC to reduce GILTI by stepping up basis in its assets prior to the effective date of the GILTI rules. Transactions undertaken after Dec. 31, 2017, but before the effective date of Section 951A, may create additional basis in depreciable or amortizable property and thereby reduce the transferee CFC’s tested income (or increase a tested loss) without incurring U.S. tax on the transfer.
Accordingly, the proposed regulations disallow the deduction associated with the stepped-up basis in depreciable or amortizable property. The disallowance applies only for property transferred between a CFC and a related person during the period before the beginning transferor CFC’s first inclusion year for purposes of calculating the transferee CFC’s tested income or loss. The proposed regulations also disallow the tax benefit associated with the basis increase and resulting QBAI increase when such increases are derived from a transaction between the CFC and a related person occurring after Dec. 31, 2017, but before the effective date of the GILTI provisions.
Finally, the proposed regulations operate to disregard certain depreciable tangible property acquired by a CFC with a principal purpose of reducing the GILTI inclusion of a U.S. shareholder. This principal purpose rule applies when a CFC with tested income holds certain property temporarily but over at least the close of one quarter. If the rule applies, the property is disregarded when computing the acquiring CFC’s average adjusted basis for purposes of determining QBAI. Property held by a tested income CFC for less than a 12-month period that includes at least the close of one quarter is treated as temporarily held and acquired with a principal purpose.
CFC basis adjustments for used tested loss
As a general rule, a U.S. shareholder’s use of tested losses of a CFC would have no impact on the U.S. shareholder’s tax basis of either CFC. However, the proposed regulations require a U.S. corporate shareholder to reduce its tax basis in the stock of the tested loss CFC by the “used-tested loss” for purposes of determining gain or loss upon disposition of the tested loss CFC.
A basis adjustment only occurs in the event of a disposition and is deemed to occur immediately before the disposition. This timing mechanism prevents the use of tested losses from causing immediate gain when the basis of the tested loss CFC is less than the used-tested loss for a given tax year. The basis adjustment rule also applies to dispositions of stock in a lower-tier CFC (owned by a parent CFC) that has used tested losses.
This basis adjustments are intended to eliminate the duplicative use of losses by holders of CFC stock. The regulations provide a number of operational rules addressing, among other things, the application of the rules to tiered groups of CFCs, treatment of non-recognition transactions and treatment of dispositions of lower-tier CFCs by upper-tier CFCs.
Interest expense and interest income
For purposes of determining the net deemed tangible return of any CFC, Section 951A(b)(2) requires a reduction for interest expense of the CFC taken into account in determining net CFC tested income. The reduction is limited, however, when interest income “attributable” to the interest expense is also taken into account when determining net CFC tested income.
The IRS determined that a strict tracing approach would be burdensome and challenging when calculating the interest income of a U.S. shareholder attributable to interest expense. Instead, the proposed regulations contain a computational approach that allows for the netting of a U.S. shareholder’s aggregate “tested-interest income” and “tested-interest expense.” Under the proposed regulations, tested interest expense and tested interest income are generally defined by reference to all interest expense and interest income that is taken into account in determining a CFC’s tested income or tested loss. This arguably broadens the statute, which presumably only reduces interest expense by a limited amount of interest income (i.e. that which is “attributable to”) taken into account in determining the shareholders net CFC tested income.
The proposed regulations also provide that whether interest expense is generated by a tested-loss CFC or a tested-income CFC, the interest expense is taken into account in determining whether such amounts reduce QBAI for purposes of calculating a shareholder’s net deemed tangible income return.
New reporting requirements
The proposed regulations provide new reporting requirements under the GILTI regime. U.S. shareholders must file a new Schedule I-1, Information for Global Intangible Low-Taxed Income, with Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. U.S. shareholders will also be required to file Form 8992, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI). If taxpayers fail to comply with the new reporting requirements, a $10,000 penalty could apply.
The proposed regulations applicable to GILTI generally apply to the taxable years of foreign corporations beginning after Dec. 31, 2017, and to taxable years of U.S. shareholders in which the taxable year of such a foreign corporation ends.
Taxpayers should assess how the proposed rules will affect them, and begin to evaluate whether existing operations are tax-inefficient under the GILTI regime. The proposed regulations left many unanswered questions. Although some of these issues will be addressed in future guidance packages, taxpayers will need to consider those that remain unaddressed. The regulatory guidance, and lack thereof, could impact financial statement reporting in the short-term, and 2018 tax returns in the longer term.
The proposed rules are mechanical and complex. Complying with the GILTI regime will be an onerous and time-consuming task. The regulations do not offer simplifying approaches or taxpayer favorable elections. Going forward, taxpayers must be prepared to compute taxable income for all controlled foreign corporations on an annual basis. Taxpayers should begin work now to ensure that they have the appropriate systems in place to track and collect the various new data points, and controls to ensure accuracy.
For more information contact:
Partner, Washington National Tax Office Grant Thornton LLP
+1 202 861 4104
Managing Director, Washington National Tax Office Grant Thornton LLP
+1 202 521 1543
Senior Manager, Washington National Tax Office
+1 202 521 1509
Mike Del Medico
Manager, Washington National Tax Office, Grant Thornton LLP
+1 202 521 1522
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