Two large pieces of space rock collided some 4 billion years ago to make Ultima Thule, the snowman-shaped object orbiting the sun that the New Horizons space probe flew by to great fanfare on January 1. We’ll probably learn more about the distant binary satellite of the sun when the federal government reopens for business, just as we’ll eventually learn about two other worlds that collided more recently: the global intangible low-taxed income regime and subpart F. The hasty attachment of the former to the latter had some unanticipated results, and Treasury is busy mapping the new combined system.
The GILTI regime and subpart F are both grounded in the controlled foreign corporation status of a foreign corporation, but whereas subpart F uses earnings and profits and includes in section 952 a carryforward for purposes of the E&P limitation, GILTI uses the new concepts of tested income and tested loss, which aren’t rooted in E&P. The combination of two separate regimes, one of which takes an annual approach and another that allows carryforwards, means they interact in unexpected ways, said Christopher Hanfling of Jones Day. Treasury proposed that the E&P limitation in subpart F is irrelevant for GILTI purposes, but that thinking may result in a double inclusion of income likely unintended by Congress. Relatedly, there could be a double benefit in some cases if a tested loss meets the requirements for being a qualified deficit in a subsequent year. Congress probably didn’t intend to subject the same income to tax under both subpart F and GILTI or allow a single economic loss to be both a tested loss and a qualified deficit.
Treasury is aware of the potential for a double inclusion of income and a double benefit from a single loss and has been seeking a solution that is consistent with the statutory language and congressional intent. In a comment letter on section 951A, the American Bar Association Section of Taxation recommended an ordering rule that would prevent a double inclusion and deny a U.S. shareholder the ability to use a single economic loss to both offset tested income with tested loss and create or increase a qualified deficit.
Double Inclusion of Income
Because prop. reg. section 1.951A-2(c)(4) turns off the E&P limitation in section 952(c) when determining gross tested income, over the course of at least two years, the same income could be taxed as subpart F income in one year and again as tested income under GILTI in another year. The ABA pointed out that the proposed rule isn’t part of the statute. Congress likely did not intend to create the potential for double taxation of some items of income.
Devon Bodoh of Weil, Gotshal & Manges LLP agreed that Congress didn’t intend for income to be taxed both under the subpart F regime at the full rate of 21 percent and then again as GILTI at 10.5 percent. Subpart F ensures that specific types of mobile passive income are taxed currently. The GILTI regime was added to ensure that the long-term operational income of CFCs is subject to a minimum tax. Accordingly, the two sets of rules should be discrete and the categories of income that they cover should be coordinated, Bodoh said.
The ABA proposed an ordering rule that would ensure that E&P that results in tested income isn’t also E&P for purposes of the section 952(c) recapture rule, thus keeping subpart F income and GILTI income separate. It recommended that “gross income taken into account in determining the Subpart F Income” in prop. reg. section 1.951A-2(c)(1)(ii) be defined as subpart F income that includes foreign base company income and insurance income, without regard to the application of section 952(c)(1) but with regard to the application of the recapture rule in section 952(c)(2) and the de minimis rule for foreign base company income in section 954(b)(3). Hanfling noted that this proposal imports the E&P limitation concept into the GILTI regime, which Treasury might want to avoid because it was not expressly included in section 951A. However, Scott M. Levine of Jones Day said that from a policy perspective, it may be more appropriate to pick up subpart F income and not GILTI because GILTI is a residual income category in the Tax Cuts and Jobs Act. The ABA letter said that although the coordination rule may result in tested income being recharacterized as subpart F income, that isn’t problematic because section 952(c) also recharacterizes other income as subpart F income in some circumstances, and the recharacterization is necessary to avoid double taxation.
The ordering rule fits with the statutory scheme of GILTI because Congress seems to have wanted to prioritize removing subpart F income when determining the base on which GILTI is calculated, Bodoh said. He pointed to the exclusions from tested income in section 951A(c)(2)(A) as indicative of congressional intent because they are consistent with first figuring out the subpart F income that is removed and then determining GILTI from the remainder.
Qualified Deficits and Double Benefits
There’s a potential double benefit for another group of taxpayers that Congress most likely didn’t intend and that contradicts the overall policy goal of GILTI. Under the qualified deficit rule in section 952(c)(1)(B), if a CFC has a loss in an activity in year 1 and then in year 2 has income from the same or a similar activity, the taxpayer can use the earlier loss to offset the current subpart F income. When GILTI and the proposed regulations are layered on top of that rule, the CFC would have a tested loss in year 1 but could also use that same loss as a qualified deficit for subpart F purposes in year 2. That legislative oversight should be fixed either through regulations or a technical correction.
The qualified deficit rule is narrower and more fact-intensive than the rules that give rise to a double inclusion, Levine noted. Under the qualified deficit rule, taxpayers must show that the initial loss and the income are from the same activity, and passive income is generally ineligible for a qualified deficit. Under the proposed GILTI rules, the problem with the qualified deficit rule is that in a single year, a taxpayer may not know whether an activity will generate subpart F income in the future. That’s particularly relevant in a company’s start-up phase when it may be unclear whether an activity will generate subpart F income, but there are losses, Hanfling said. In subsequent years, if the business generates subpart F income, there may be qualified deficits, but because of the year-by-year GILTI analysis, the prior-year losses may have already been used as tested losses. “This may be a fact pattern mostly for the start-up phase, and it may be more or less likely in some industries,” Hanfling said.
The guidance Treasury develops on the double inclusion problem should inform the way it addresses preventing a double benefit. “It would be helpful to know Treasury’s view of the E&P limitation for tested income and losses generally in fixing the section 952(c)(1) and (2) rules,” Hanfling said. One approach could be to prohibit tested losses from creating qualified deficits. Or taxpayers might be required to choose whether a loss will be used as a tested loss, making it unavailable for use as a qualified deficit, or whether it will be claimed as a qualified deficit and not used as a tested loss. That approach seems unlikely because it would mean some taxpayers would end up worse off than they might have been otherwise given their inability to use a qualified deficit in a later year.