The recently proposed regulations interpreting section 951A (REG-104390-18) were eagerly anticipated, yet mostly answered only the easiest questions about global intangible low-taxed income. Left for later are the more controversial topics that could require regulatory rewrites and whose resolution will likely affect companies’ projected 2018 effective tax rates, and thus, earnings. (Prior coverage: Tax Notes Int’l , Sep. 17, 2018, p. 1208.) Taxpayers disagree on many of the unresolved questions, so Treasury’s decisions could help some and hurt others.
In addition to answering some crucial questions, the proposed regulations include a helpful summary of Treasury’s stated view of the legislative purpose of new section 951A, which may provide insight into some coming resolutions; also helpful is the preamble’s justification of the proposed rules for review by the Office of Management and Budget. (Prior coverage: Tax Notes , Sep. 17, 2018, p. 1762.)
The Proposed Regulations
According to Treasury, section 951A was adopted as part of Congress’s goal of enacting a participation exemption system, under which “certain earnings of a foreign corporation can be repatriated to a corporate U.S. shareholder without U.S. tax” (via a 100 percent dividends received deduction under new section 245A). However, Congress recognized that without any base protection measures, the participation exemption system might encourage taxpayers to allocate income — especially mobile income from intangible property — that would otherwise be subject to the full U.S. corporate tax rate to controlled foreign corporations operating in low- or zero-tax jurisdictions. It therefore enacted section 951A to subject intangible income earned by a CFC to U.S. tax on a current basis, similar to the treatment of a CFC’s subpart F income under section 951(a)(1)(A). In other words, the GILTI regime is first and foremost intended to protect the U.S. tax base from profit-shifting.
Congress also recognized that protecting the U.S. tax base had to be balanced against ensuring U.S. corporate competitiveness. According to the proposed regulations, that’s why a corporate U.S. shareholder’s GILTI is taxed at a reduced rate (via the section 250 deduction) and can be offset with a foreign tax credit under section 960(d).
The preamble also explains that the broad formulaic approach in section 951A is the result of administrative difficulty in identifying income attributable to intangible assets; section 951A intangible income is therefore determined by attributing a 10 percent return to tangible assets, with each dollar of income above that “normal return” then generally effectively treated as intangible income.
As Treasury’s explanation highlights, the GILTI rules reflect Congress’s desire to balance several competing goals and related concerns:
making the U.S. more competitive and ending lockout by adopting a territorial regime and not taxing U.S. companies on the repatriation of overseas earnings;
countering the increased profit-shifting incentives created by a territorial regime by expanding subpart F concepts to a broader category of income;
ensuring that the expanded subpart F captures highly mobile intangible income using a bright-line rule; and
ensuring that penalties for profit shifting are appropriately weighted against the need for U.S. companies to remain competitive (by taxing GILTI at a lower rate and allowing an FTC offset).
In June Lafayette G. “Chip” Harter III, Treasury deputy assistant secretary for international tax affairs, described that balancing act, saying Treasury would “have to walk a very fine line between avoiding making tax reform a marginal detriment to using the U.S. as a home office jurisdiction on [the] one hand versus opening up the opportunity for cross-crediting of foreign tax credits on the other.” (Prior analysis: Tax Notes Int’l , Aug. 20, 2018, p. 851.)
In deciding on base erosion protections as part of the adoption of a territorial regime, Congress rejected the per-country FTC limitation proposed by the Obama administration, which multinationals strongly opposed. Congress’s decision to continue to allow multi-jurisdictional cross-crediting can be seen as a lukewarm endorsement of U.S. multinationals’ ability to engage in self-help and overseas tax planning — that is, foreign-to-foreign profit shifting.
Justifications for the Proposed Rules
The proposed regs explain why the rules are needed and how they meet the requirements of Executive Orders 13563 and 12866, which direct executive agencies to assess costs and benefits of available regulatory alternatives and select those that maximize net benefits (including potential economic and distributive effects and equity). They say the rules meet those standards because they help ensure that taxpayers all calculate GILTI similarly. The preamble also points out that the proposed antiabuse rules are meant to prevent taxpayers from inappropriately reducing their GILTI through specific kinds of property transfers, and that other measures prevent taxpayers from avoiding an inclusion through some artificial arrangements involving the ownership of CFC stock.
Treasury expects the certainty and clarity of the proposed rules to enhance U.S. economic performance relative to a baseline of how the world would look absent those rules. The preamble says that in the absence of that clarity, similarly situated taxpayers might interpret section 951A differently, potentially resulting in inequitable outcomes. It also says the proposed rules fulfill an essential tenet of an economically efficient tax system by generally keeping the choice among businesses’ ownership and organizational structures neutral, contingent on corporate income and other tax provisions that could affect organizational structure. They also ensure that shareholders face uniform tax treatment on their GILTI-relevant investments regardless of ownership or organizational structure, thus encouraging market-driven, rather than tax-driven, structuring decisions.
Informing the Debate
As interpreted by Treasury, the legislative history of the GILTI regime and its relevance to broader international tax reform can help inform the debate over several hot-button questions on section 951A; the New York State Bar Association Tax Section has provided a helpful analysis of many of those topics.
The FTC Gross-Up
The Tax Cuts and Jobs Act (P.L. 115-97) repealed section 902, which allowed corporate shareholders to claim an indirect credit for foreign taxes paid by foreign corporations when a dividend from foreign earnings was paid. But the principles of section 902 live on in section 960, which lets corporate shareholders claim an FTC upon mandatory deemed inclusions of income from foreign corporate holdings, including under section 951 (subpart F) and now section 951A (GILTI). As part of the price of claiming the section 960 FTC, a shareholder must gross up the inclusion by the amount of foreign taxes properly attributable to it (section 78).
To prevent FTCs from offsetting U.S. tax on U.S. taxable income, section 904 generally limits a taxpayer’s ability to claim an FTC to the U.S. income tax that would otherwise be due on its foreign-source income; section 904(d) further limits a taxpayer’s ability to claim an FTC by applying the general principle of section 904 to allocate foreign taxes and foreign-source income among separate categories (for which GILTI is a new category).
Whether the section 78 deemed dividend should be considered income in the same category as the income from which it was paid — that is, for a GILTI inclusion, whether it should be considered income in the GILTI category — could affect many taxpayers’ ability to fully credit foreign taxes attributable to GILTI inclusions (see concerns noted in a July letter from MasterCard ). Big Four firms have been reluctant to conclude that the section 78 gross-up associated with taxes attributable to GILTI should be allocated to the GILTI basket, apparently because of conflicting statutory language (see a March letter requesting guidance on that topic).
Allocating the section 78 deemed dividend associated with GILTI taxes to GILTI income might be among the easiest calls for Treasury on FTCs and GILTI, appearing consistent with the goal of ensuring U.S. competitiveness while discouraging U.S. base erosion. It could also prevent taxpayers from trying to maximize low-taxed general limitation income that could be offset by GILTI-related taxes while otherwise minimizing GILTI inclusions.
Expense Allocation
How to allocate U.S.-shareholder-level expenses (including research and development, interest, and management or stewardship expenses) in calculating tested income under section 951A is more challenging. Section 954, which generally defines subpart F income, provides that gross subpart F income is reduced to take into account deductions properly allocable to that income. Section 951A generally defines tested income as gross income over the deductions (including taxes) properly allocable to that gross income under rules similar to those in section 954(b)(5). The section 954 regs direct taxpayers to, under the principles of sections 861, 864, and 904(d), allocate and apportion any expenses definitely related to less than all gross income, and reduce items of gross income by other expenses allocable and apportionable to that income. Specific, detailed rules apply for allocating various categories of expenses, most notably interest expense and R&D. The rules that require allocating U.S.-shareholder-level expenses to a CFC’s foreign-source income can restrict a U.S. taxpayer’s ability to fully credit foreign taxes paid against foreign-source income, sometimes resulting in a taxpayer having excess credit capacity.
Many commentators and taxpayers have noted that allocating expenses to GILTI in the manner prescribed under the rules for subpart F income could result in many taxpayers having excess uncreditable foreign taxes in their GILTI baskets. The penalty associated with the limitation for GILTI taxes is exacerbated because those taxes can’t be carried over. NYSBA noted that if a U.S. shareholder’s expenses are treated as foreign-source expenses allocated to the GILTI basket and the foreign tax rate is at least 13.125 percent, U.S. tax will generally be payable on a GILTI inclusion no matter how far above 13.125 percent the foreign tax rate is. And at least one taxpayer not intended to be affected by the new rules has noted adverse financial statement effects resulting from perverse allocation results.
Fixing those problems would require a fairly comprehensive rewrite of the exhaustive expense allocation regulations. Alternatively, Treasury could simply decide that no U.S. shareholder expenses are properly allocable to income in the GILTI basket — which seems unlikely if for no other reason than it could create distortions elsewhere because those expenses would have to be allocated to another category of income. NYSBA has also argued that rewriting the expense allocation rules to allocate all otherwise allocable GILTI deductions to U.S.-source income or to other baskets of foreign-source income could encourage foreign countries to raise their tax rates at the expense of the U.S. fisc.
While there may be good policy reasons for rejecting an approach that wouldn’t allocate any expenses to GILTI, there are important differences between GILTI and the more expansive allowance for FTCs that the U.S. tax system has historically provided to taxpayers that could mandate a different approach than used now. NYSBA has suggested that existing rules be modified “to minimize allocations to GILTI inclusions that are not economically justified,” and there are various ways Treasury could do that.
As noted in the preamble to the proposed regs, Congress wanted to ensure that the GILTI base erosion protections wouldn’t reduce the competitive footing of U.S. multinationals; worries about providing U.S. companies incentives to invert overseas underlie competitiveness concerns. Those types of fears should be motivating Treasury as it seeks to rewrite expense allocation rules. Fixing the problems without creating perverse incentives to locate U.S.-shareholder-level expenses overseas won’t be easy: Allowing taxpayers to make irreversible elections could be one way to smooth out disparate industry effects while addressing competition concerns.
Looking Through CFC Payments
Related to the expense allocation questions is how to allocate income received by U.S. shareholders as deductible payments from CFCs, with section 904 suggesting that look-through treatment should apply to those payments. Under section 904(d), dividends, interest, rents, and royalties a U.S. shareholder receives from a CFC are generally not treated as passive income unless properly allocable to the CFC’s passive income. The section 954 regulations are more expansive, stating that any rents or royalties received or accrued from a CFC are treated as income in a different category if allocable to the CFC’s income in that same category under reg. section 1.861-8 through 1.861-14T; there are also rules for allocating interest and dividend income among different categories under reg. section 1.904-5(c).
Taxpayers whose CFC income is mostly GILTI (most multinationals) would generally be in a better position if look-through applies to those types of payments because it would increase income in the GILTI basket, and most taxpayers can otherwise be expected to have excess taxes in that basket. But taxpayers with large amounts of taxes in the general basket (such as with the Puerto Rico excise tax) would generally prefer look-through income to be in the general income category. NYSBA has argued for that treatment, saying that only section 951A inclusions can give rise to taxes in the GILTI basket, and that nothing in section 951A turns those payments into section 951A inclusions. Increasing the GILTI basket by an item of income that reduces foreign taxes is arguably contrary to the purpose of the FTC baskets, according to NYSBA.
It’s unclear how the legislative goals behind GILTI’s enactment balance out in this case. But here, too, Treasury might consider allowing taxpayers to make a one-time election to look through deductible payments — which could both curtail base erosion and help maximize U.S. corporate competitiveness (along with addressing other ancillary concerns, such as ensuring that valuable IP remains in the United States while continuing to use the FTC system to help Puerto Rico’s finances).
How to Treat Individuals and Small Businesses
Most of the topics discussed involve large multinationals; a different set of questions concern individual and small businesses with overseas investments, which the TCJA uniquely penalizes. Individual shareholders must include amounts in income under section 965, but don’t benefit from the section 245A dividends received deduction; similarly, they have mandatory inclusions under section 951A but aren’t entitled to a deduction under section 250 and can’t claim an FTC under section 960. (Prior analysis: Tax Notes Int’l , Jan. 22, 2018, p. 277.)
Section 962 — an old but infrequently used provision — is designed to mitigate some of that disparity. In general, it allows an individual U.S. shareholder of a CFC to elect to be placed in approximately the same position for subpart F inclusions as if the CFC stock were held through a domestic corporation. (Prior analysis: Tax Notes Int’l , Feb. 19, 2018, p. 771.) Congress clearly contemplated that a section 962 election could be available for a section 951A inclusion, as noted in the cross-reference in section 951A(f)(1)(A), but regulations under section 962 provide that the includable amount can’t be reduced by any deduction of the U.S. shareholder. An important question for many individual shareholders is therefore whether taxpayers that make a section 962 election can claim the section 250 deduction — a corporate-level deduction.
From a policy perspective, the rationale for allowing the section 250 deduction seems obvious. Unlike other deductions that involve outlays of expenses that reduce the calculation of taxable income, the section 250 deduction is all about ensuring the competitiveness of U.S. businesses operating overseas. The TCJA is meant to encourage “hardworking families, entrepreneurs, and Main Street innovators,” so doubly penalizing small business owners who expand overseas by denying them a corporate rate reduction seems contrary to those goals.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, director of its International Tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu
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