The IRS released final regulations (T.D. 9902
) on July 20 that expand the utility of the global intangible low-taxed income (GILTI) high-tax exclusion (HTE) and concurrently issued proposed regulations (REG-127732-19
) that conform the GILTI HTE and high-tax exception for Subpart F income under a single election.
Generally, a taxpayer may elect to treat income received by a controlled foreign corporation (CFC) as excluded from Subpart F income under Section 954(b)(4) if the income is sufficiently taxed in a foreign country. An effective tax rate of greater than 90% of the top U.S. corporate income tax rate (i.e. 90% of 21%, or 18.9%) is required to qualify for the exclusion. Section 951A(c)(2)(A)(i)(III) provides, in part, that any gross income excluded from foreign base company income (FBCI) is not treated as gross tested income (referred to in the regulations as the GILTI HTE). Proposed regulations issued in 2019 expanded the scope of the GILTI HTE to other high-taxed tested income regardless of whether the tested income would otherwise be FBCI. Accordingly, under the proposed rules, the GILTI HTE is available with respect to CFC gross tested income subject to a foreign effective tax rate of at least 18.9%. For more details on the proposed regulations, see our prior coverage
The final regulations generally follow the approach and structure of the 2019 proposed regulations but make meaningful modifications to key aspects of the guidance. Changes include revamping the approach for determining the effective tax rate by replacing the qualified-business-unit-by-qualified-business-unit (QBU-by-QBU) approach with a “tested unit” approach. This stops short of the CFC-by-CFC approach desired by several commentators but does provide a more targeted approach and the opportunity for limited blending of income under the tested unit combination rule. The final regulations also adopt a more favorable annual election period as opposed to the five-year binding election in prior proposed regulations. The regulations continue to provide that the election must be made with respect to all income that is considered to be high-taxed, meaning that it cannot be made on a “tested-unit-by-tested-unit” basis. The IRS has also allowed the final regulations to be applied retroactively to tax years of foreign corporations that begin after Dec. 31, 2017, which provides taxpayers additional flexibility.
The Tax Cuts and Jobs Act (TJCA) made most CFC income subject to current taxation in the hands of a U.S. shareholder under the GILTI regime. The GILTI HTE rules alter how U.S. multinationals are taxed on CFC income. Qualifying high-tax income escapes inclusion in the U.S. tax base if the high-tax election is made. Earnings not currently taxed also generally are eligible, when distributed, for the Section 245A dividends received deduction (DRD). In many cases, the GILTI HTE may alleviate the need to rely on foreign tax credits to eliminate incremental tax on GILTI, and significantly reduces the income tax liabilities of taxpayers subject to a foreign tax credit limitation in the Section 951A category as a result of expense apportionment.
Despite the GLITI HTE appearing facially beneficial, taxpayers should be wary of pitfalls when considering the election. In some cases, a taxpayer forgoing the election may ultimately pay less overall tax then if they make the election, when accounting for offsetting foreign tax credits. Additionally, the qualified business asset investment (QBAI) of a CFC with high-taxed income is lost when a CFC’s tested income is excluded under the GILTI HTE. Consideration should also be given to the impact on future distributions. Withholding taxes on distributions of untaxed E&P that qualify under Section 245A are not eligible for credit under Section 901, whereas withholding taxes associated with distributions of GILTI previously taxed earnings may be creditable.
The concurrently issued proposed regulations coordinating the GILTI HTE and Subpart F high-tax exclusion cannot be applied until final, but taxpayers should consider their potential impact.
For tax years beginning after 2017, U.S. shareholders of a CFC 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 exclusion
- 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.
Section 951A(c)(2)(A)(i)(III) provides that any gross income excluded from the FBCI and the insurance income of a CFC by reason of Section 954(b)(4) is not treated as gross tested income. Section 954(b)(4) provides that FBCI and insurance income shall not include any item of income received by CFC if the taxpayer establishes that such income was subject to an effective rate of income tax imposed by a foreign country greater than 90% of the maximum rate of tax specified in section 11 (i.e., 21% or the maximum corporate rate).
Under final GILTI regulations released in June 2019, a taxpayer may not exclude any item of income from gross tested income under Section 951A(c)(2)(A)(i)(III) unless the income would be FBCI or insurance income but for the application of section 954(b)(4).
The application and scope of the GILTI high-tax exclusion has been widely debated. In response to these comments, the IRS proposed that the GILTI high-tax exclusion be expanded to include certain high-taxed income even if that income would not otherwise be FBCI or insurance income and issued proposed regulations in June of 2019 to that effect.
Final GILTI HTE election rules
The proposed regulations provide several distinct rules for effectuating the election for the GILTI HTE. First, the proposed rules require that the election or revocation be made by the “controlling domestic shareholder” on an original or amended return. This means that decisions made with respect to the election by the controlling domestic shareholder also binds other U.S. shareholders of CFCs for which the election has been made. For this purpose, controlling domestic shareholder is defined by reference to Treas. Reg. Sec. 1.964-(1)(c)(5). Additionally, the rules contain a consistency requirement where, if a CFC is a member of a controlling domestic shareholder group (CFC Group), the election or revocation is either made for all members of such group or not for any member. The proposed regulations also generally provide that the election is effective for the CFC inclusion year in which it is made, and all subsequent CFC inclusion years, unless the election is revoked. Once revoked, the proposed rules require taxpayers to wait 60 months to change their election.
The final GILTI HTE regulations retain the rule that requires the election or revocation to be made by the “controlling domestic shareholder” and consistency requirement with respect to members of the CFC Group. Under the final regulations, a CFC group is an affiliated group as defined in Section 1504(a) with certain modifications that broaden the definition. The final rules also clarify that the determination of whether a CFC is included in a CFC Group is made as of the close of the CFC inclusion year of the CFC that ends with or within the taxable years of the controlling domestic shareholders, and a tie-breaker rule is provided for situations where a CFC could be a member of multiple CFC groups. Additionally, the final GILTI HTE regulations require that the controlling domestic shareholder must provide notice of elections or revocations to each U.S. shareholder that is not a controlling U.S., shareholder. The final rules also favorably provide that the election for the GILTI HTE may be made on an annual basis and eliminate the aforementioned 60-month restriction.
Grant Thornton Insight: Although many taxpayers and practitioners hoped that the GILTI HTE would be available on a CFC-by-CFC basis, the GILTI HTE under the final rules remains an “all or nothing” election. That is, the election must be made with respect to all high-taxed tested income of the CFC Group. On the other hand, taxpayers will appreciate the flexibility of being able to make the election on an annual basis, eliminating the guessing game as to the result of the election on future years that would have otherwise been required under the proposed rule.
Calculation of the effective foreign tax rate
Tested unit standard
The 2019 proposed regulations apply based on the effective foreign tax rate imposed on the aggregate of all items of tentative net tested income of a CFC attributable to a single QBU of the CFC that would be in a single tested income group. The proposed regulations define QBU by reference to Section 989(a), which provides that a QBU is any separate and clearly identifiable unit of a trade or business of a taxpayer that maintains separate books and records. Regulations under Section 989(a) provide further guidance as to the identification of a trade or business, based on a facts and circumstances analysis and the determination of separate books and records. The intent of this design was to minimize blending of income subject to different tax rates, such that income subject to a high rate of foreign tax could be more easily identified.
The final GILTI HTE regulations replace the QBU-by-QBU approach of the proposed regulations with a tested unit approach. The tested unit approach employed by the final regulations is generally applicable to the extent that an entity or the activities of an entity are subject to tax, either as a tax resident or a permanent establishment, under the tax law of a foreign jurisdiction. This more closely aligns with the intent of minimizing the blending of income and more easily identifying income that is subject to a different foreign tax rate. It may also reduce the amount of factual analysis to be undertaken by taxpayers. The final regulations specify that a “tested unit” includes 1) CFCs, 2) pass-through entities held directly or indirectly by a CFC (including disregarded entities) and 3) certain branches of CFCs.
The final regulations also provide a mandatory “combination rule”, which provides generally that tested units of a CFC (which includes the CFC tested unit) are treated as a single tested unit if the tested units are located in or are residents of the same foreign country. This rule applies irrespective of whether tested units are subject to the same foreign tax rate or whether they have the same functional currency.
Proposed Subpart F high-tax exception regulations
The proposed regulations that were issued concurrently with the GILTI HTE final regulations align the rules implementing the Subpart F high-tax exception with the GILTI high-tax exclusion. This would combine the two separate elections into one single election and eliminate the incentive to structure into the Subpart F high-tax exception. The proposed regulations also provide for a single election under Section 954(b)(4) for purposes of the GILTI HTE and the subpart F high-tax exception.
These proposed regulations adopt the aforementioned tested unit standard. This is a significant departure from existing rules that determine the effective tax rate for purposes of the Subpart F high-tax exception at the CFC level. The final GILTI HTE regulations generally use items properly reflected on the separate set of books and records for the starting point for determining gross income attributable to a tested unit. The proposed regulations adopt this approach as well, but adjust the standard to gross income attributable to an “applicable financial statement.”
The proposed regulations also include a mandatory “de minimis combination” rule that combines tested units that are attributed gross income less than the lesser of 1% of the gross income of the CFC, or $250,000. Also, anti-abuse rules have been put in place to quell concerns that taxpayers may include, or fail to include, items on applicable financial statements or make, or fail to make, disregarded payments to manipulate the GILTI HTE and Subpart F high-tax exception rules. The proposed regulations provide that U.S. shareholders must maintain specific contemporaneous documentation to substantiate their high-tax exception computations. In addition, the proposed regulations add this information to the list of information that must be included on Form 5471.
Other changes were made in the proposed regulations to the way that the Subpart F high-tax exception interacts with other parts of the Subpart F calculation. For example, the proposed regulations provide that the high-tax exception should apply before the Section 952(c) E&P limitation. Additionally, the Subpart F high-tax exception would apply before the “full inclusion rule”, which may eliminate the need to undertake the analysis required by this rule in many cases.
Grant Thornton Insight: The proposed regulations appear to thwart affirmative Subpart F high-tax exception planning by adopting the tested unit standard. However, due to the delayed applicability date (discussed below), taxpayers may want to explore this avenue prior to the effective date.
The final GILTI HTE regulations are generally applicable to tax years of foreign corporations beginning after July 23, 2020, and to tax years of U.S. shareholders in which or with which such tax years end. However, taxpayers may choose to apply the final regulations to tax years of foreign corporations that begin after Dec. 31, 2017, and before July 23, 2020, and to taxable years of U.S. shareholders in which or with which such taxable years of the foreign corporation’s end.
The proposed regulations conforming the GILTI HTE and Subpart F high-tax exception are generally proposed to apply to taxable years of CFCs beginning after the date the rules are published in the Federal Register as final regulations, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
The final GILTI HTE regulations significantly change the landscape for high-taxed tested income of CFCs. Such income now may find a path back to the United States through the Section 245A DRD and escape additional U.S. taxation altogether. But the election could come with trade-offs, such as the elimination of excess credits that may be beneficial.
The final rules replace the QBU-by-QBU approach for determining the effective tax rate with a “tested unit” approach and adopt a more favorable one-year election period. They also permit taxpayers to retroactively apply the GILTI HTE to tax years of CFCs beginning after Dec. 31, 2017. As such, taxpayers may consider amending tax returns to reap the benefit of making the election.
Nonetheless, multinational taxpayers should exercise caution before making the election. The knock-on effects of the GILTI HTE necessitate modeling exercises to ensure that making the election will provide an overall benefit. It is also essential to continually model the impact of the election year-over-year and evaluate the impact on the election on future distributions of earnings. Taxpayers that are currently relying on the Subpart F high-tax exception should also consider the possible future impact of the proposed coordinated election.
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