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Proposed New Regs Allow GILTI Exclusion for CFC High-Taxed Income

Posted on Aug. 26, 2019

Proposed new regs allow taxpayers to elect an exclusion from global intangible low-taxed income for a controlled foreign corporation’s high-taxed income, thereby eliminating the incentive to restructure CFC operations to convert gross tested income into foreign base company income (FBCI). The election results in high-taxed non-subpart-F income being treated like high-taxed FBCI and insurance income.

Proposed new regs (REG 101828-19) describe how to elect the GILTI high-tax exclusion. The rules are in prop. reg. section 1.951A-2(c)(1). Specifically, reg section 1.951A-2 is amended by revising paragraph (c)(1)(iii) in previously released proposed regulations (REG 104390-18) and adding paragraph (c)(6). Paragraph (c)(1)(iii) now says that a CFC’s gross tested income is determined without regard to gross income excluded from the FBCI or insurance income by reason of the section 954(b)(4) exception in accordance with an election under section 1.954-1(d), or a tentative gross tested income item of a CFC that elected to apply the exception in section 954(b)(4).

New prop. reg. section 1.951A-2(c)(1)(iii)(6) contains guidance on qualifying for the high-tax exception and electing to apply it. A CFC’s tentative gross tested income (TGTI) item qualifies for the section 954(b)(4) exception if the CFC makes an election, and if the tentative net tested income (TNTI) item with respect to the TGTI item was taxed at an effective rate greater than 90 percent of the maximum U.S. tax rate, or 90 percent of 21 percent, which is 18.9 percent.

TGTI is the aggregate of all items of gross income attributable to a CFC’s single qualified business unit (QBU) that would be gross-tested income and that would be in a single-tested income group as defined in the section 960 regs. A QBU is defined in section 989(a) as a separate and clearly identified unit of a trade or business that maintains separate books and records. A CFC’s QBUs include QBUs owned by the CFC and the QBU that is the CFC, so a CFC may have multiple TGTI items.

Gross income is attributable to a QBU if it is entered on the QBU’s books and records. The rules in section 904 regs apply to adjust a QBU’s income for disregarded payments. A TNTI item with respect to a TGTI item is determined by allocating and apportioning deductions to the TGTI under the section 960 regs by treating each single TGTI item as gross income in a separate-tested income group.

The effective tax rate (ETR) on a CFC’s TNTI item is determined separately for each item and equals the U.S. dollar amount of foreign income tax expense divided by the U.S. dollar amount of the TNTI item plus the foreign income tax expense:

ETR = foreign tax expense/(TNTI item + foreign tax expense)

If the principles of reg. section 1.904-4 apply to adjust a QBU’s gross income to account for disregarded payments, the principles of reg. section 1.904-6 apply to allocate and apportion foreign income tax caused by disregarded payments.

The amount of foreign income tax treated as paid regarding a TNTI item is generally not affected by a subsequent reduction in tax related to a distribution of income to shareholders. However, if the foreign income taxes are reasonably certain to be returned to a shareholder by the foreign jurisdiction through any means (for example, a refund, credit, payment, or discharge of obligation), the foreign income taxes are not treated as paid or accrued on the TNTI item.

A controlling domestic shareholder makes the election by attaching a statement to its tax return. The election applies to each of the CFC’s TGTI items and is binding on all the CFC’s U.S. shareholders. The election is effective in the year made and in subsequent CFC years unless revoked by the controlling domestic shareholder by attaching a statement to its tax return. If an election is revoked, a new one cannot be made for the next 60 months.

However, the commissioner may permit a CFC to make or revoke an election within the 60-month period if there is a change of control, meaning that more than 50 percent of the CFC’s voting power is owned by persons that did not own any interest in the CFC at the close of the year when the election or revocation became effective.

If a CFC is a member of a controlling domestic shareholder group, an election is considered made or revoked for each member of the group. A “controlling domestic shareholder group” is two or more CFCs if more than 50 percent of their voting power is owned by the same controlling domestic shareholder.

If no single controlling domestic shareholder owns more than 50 percent of the voting power of each CFC, controlling domestic shareholder group means two or more CFCs if more than 50 percent of the voting power of each is owned by the same controlling domestic shareholders, and each controlling domestic shareholder has the same percentage of stock in each CFC.

A controlling domestic shareholder is defined in reg. section 1.964-1(c)(5) to mean a CFC’s controlling U.S. shareholders, or U.S. shareholders who aggregately own more than 50 percent of the CFC’s voting power. If the CFC’s U.S. shareholders do not aggregately own more than 50 percent of the CFC’s voting power, the controlling U.S. shareholders are all U.S. shareholders who own stock of the CFC.

Rationale

The new proposed reg’s preamble provides that a CFC’s gross tested income is all its gross income without regard to certain items, including any gross income excluded from FBCI or insurance income because of the section 954(b)(4) GILTI high-taxed exclusion.

Prop. reg. section 1.951A-2(c)(1)(iii) of the GILTI proposed regs clarifies that the GILTI high-tax exclusion applies only to income excluded from FBCI and insurance income through an election to exclude the income under section 954(b)(4). Numerous comments requested that the scope of the GILTI high-tax exclusion be expanded in the final regs, citing legislative history indicating Congress intended for CFC income to be taxed as GILTI only if it is subject to a low rate of foreign tax. The GILTI final regs, however, adopted the GILTI high-tax exclusion in the proposed regs.

The GILTI high-tax exclusion was expanded on an elective basis to include certain high-taxed income even if the income is not FBCI or insurance income. Taxpayers can apply the section 954(b)(4) exception to income subject to high foreign taxes. Before the Tax Cuts and Jobs Act, an election would have had no effect on items excluded from FBCI or insurance income for reasons besides high foreign taxes. Moreover, section 954(b)(4) is not explicitly restricted to items of income that first qualify as FBCI or insurance income; rather, it applies to “any item” of income received by a CFC.

Therefore, any item of gross income, including one that would otherwise be gross tested income, can be excluded from FBCI or insurance income “by reason of” section 954(b)(4) if that provision is one of the reasons for the exclusion, even if it isn’t the only reason.

Electing to exclude a CFC’s high-taxed income from GILTI means high-taxed non-subpart-F is treated the same as high-taxed FBCI and insurance income, eliminating the incentive to restructure CFC operations to convert gross tested income into FBCI.

Income items of gross tested income attributed to a QBU are relevant to the election. For example, a CFC that owns a disregarded entity that is a QBU may have an income item of the CFC itself (a per se QBU) and another item of income of the disregarded entity. Income attributable to a QBU must be adjusted for certain disregarded payments, as explained in the example (see below).

Taxes paid or accrued on an income item are determined for each U.S. shareholder based on the amount of foreign income tax deemed paid under section 960 if the income item were included by the U.S. shareholder under section 951(a)(1)(A).

Moreover, the TCJA’s section 960(a) change from a pooling-based approach to an annual attribution of taxes to income requires revising reg. section 954-1(d)(3). The proposed regs provide that the ETR of foreign tax imposed on an item of income is determined solely at the CFC level by allocating foreign income taxes paid to the CFC’s gross income, based on the section 960 regs in reg. section 1.960-1(d) for purposes of both the section 954(b)(4) exception and the GILTI high-tax exclusion.

To the extent foreign taxes are attributable to tested income excluded from gross tested income by the high-tax exclusion, none of the foreign taxes are attributable to tested income and so are not allowed as a section 960 deemed paid foreign tax credit. Moreover, property used to produce excluded income does not qualify as specified tangible property and its basis is not considered in determining a CFC’s qualified business asset investment.

Put another way, the election to apply the high-tax exception eliminates a taxpayer’s need to use FTCs to reduce GILTI tax liability by excluding high-tax income from gross tested income. However, those taxpayers will not be able to use the FTCs associated with that income against other section 951A category income and will not be able to use tangible assets owned by high-tax QBU’s in their qualified business asset investment calculation.

Prop. reg. section 1.951A-7(b) provides that the new high tax exclusion applies to CFC tax years beginning on or after the date Treasury publishes its decision to adopt the rules as final regulations, and to U.S. shareholder tax years in or with which the CFC tax year ends.

Exam ple

The proposed regs have one example that clarifies the effects on the GILTI high-tax exception of disregarded payments between a CFC’s two QBUs. Foreign Parent (FP) is a CFC and a QBU in country A that conducts a business in country A and enters its tax items on its country A home office books. FP has a calendar tax year and its functional currency is the U.S. dollar. FP’s shareholders make an election to apply the high-tax exception in section 954(b)(4).

FP also wholly owns foreign disregarded entity (FDE), a hybrid entity that is disregarded in country A but not disregarded in country B. FDE is a QBU that conducts a business in country B and enters its tax items on its country B books. FDE also has a calendar tax year and its functional currency is the U.S. dollar.

FDE accrues $100 in interest income from X, an unrelated third party; and FP excludes the $100 from its foreign personal holding company income under section 954(h). In the same year, FDE accrues and pays $20 interest expense to FP. FP enters the interest income on its country A books, and FDE enters the $20 interest expense on its country B books. FP has no tax deductions other than FDE’s $20 interest deduction in country B.

Country A has no income tax and country B has a 25 percent income tax. For country B tax purposes, FDE recognizes $80 of taxable income ($100 interest income minus $20 interest expense) and has an income tax liability of $20 (25 percent of $80). If FDE were not a disregarded entity in country A, FP would recognize $20 interest income and FDE would have $80 income.

A separate TGTI item must be determined for FP’s country A and country B businesses (each of which is a QBU) by determining the gross income attributable to each of the two businesses. If the $20 interest payment from FDE to FP is disregarded, the country A business’s income would be $0, and the country B business’s income would be $100.

However, the $20 payment from FDE to FP is a disregarded payment under the section 904 regs that adjusts the gross income of the country A business from $0 to $20, and the gross income of the country B business from $100 to $80. Accordingly, FP’s TGTI attributable to the country A business is $20 and to the country B business is $80.

Because there are no deductions allocated or apportioned under the section 960 regs to the TGTI items of the country A business, FP’s TNTI item attributable to the country A business (QBU) is $20.

Taking into account the $20 interest deduction for country B income tax purposes allocable to the country B business under the section 960 regs, FP’s net tested income item attributable to the country B business is $60.

The effective tax rate on FP’s $60 net tested income item for country B’s business is 25 percent (that is, the $20 of country B taxes accrued on FP’s $60 TNTI item attributed to the country B business) divided by $80 (the U.S. dollar amount of FP’s $60 TNTI item increased by the $20 country B income taxes accrued on that TNTI item):

$20 taxes/($60 TNTI item + $20 taxes)

FP’s TNTI item attributable to its country B business was subject to foreign income taxes at an effective rate (25 percent) that is greater than 18.9 percent (or 90 percent of the maximum 21 percent U.S. tax rate). FP’s $80 TGTI item for its country B business qualifies for the section 954(b)(4) high-tax exception.

On the other hand, FP’s $20 item of TNTI attributable to its country A business is not subject to foreign income tax, therefore does not satisfy the high-tax exception requirements, and does not qualify for the high-tax exception to subpart F or GILTI.

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