Firm Suggests Changes to GILTI Regs for Consolidated Groups

November 13, 2018

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
U.S. Department of Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Mr. William M. Paul
Principal Deputy Chief Counsel and Deputy Chief Counsel (Technical)
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Re: Proposed Regulations on Section 951A and Consolidated Returns

Dear Sirs:

I. Introduction

This letter is in response to the request for comments by the Treasury Department and IRS regarding the application of the consolidated return rules to section 951A, relating to global intangible low taxed income (GILTI). The decision reflected in the proposed regulations to treat a consolidated group as a single corporation for purposes of determining the total amount of GILTI included in the gross income of members of the consolidated group is absolutely appropriate. Thus, the proposed regulations, if finalized as proposed, would achieve the laudable objective of making the location of ownership of controlled foreign corporation (CFC) stock within the group irrelevant for purposes of determining the group's consolidated GILTI inclusion amount. However, as explained more fully below, the method employed by the regulations for achieving that result is more cumbersome than is necessary. Furthermore, the timing of basis adjustments and the method for allocating the consolidated GILTI inclusion amount among the group members contained in the proposed regulations results in distortion rather than a clear reflection of particular members' incomes. Consequently, the allocations will have distortive effects on subsidiary stock basis and earnings and profits that do not clearly reflect true economic results.

In addition, Reg. § 1.1502-32(b)(3)(ii) should be revised to simply provide that the offset tested income of a CFC allocated to an owning subsidiary should be treated as tax-exempt income in the year it is offset and should immediately result in a positive investment adjustment to the subsidiary's stock, without the limitations in Prop. Reg. § 1.1502-32(b)(3)(ii)(E). That provision would limit the basis increase for offset tested income to the amount of used tested losses in prior years. A positive adjustment for offset tested income is the flip side of the negative adjustment for used tested losses and should be made for the year in which the offset occurs without limitation. A positive adjustment to the basis of a subsidiary's stock for offset tested income should be the converse of the negative adjustment to the basis of a brother-sister subsidiary's stock for a used tested loss.

Lastly, under Prop. Reg. § 1.951A-6(e) the basis of section 958(a) stock is reduced immediately before a disposition by the owning domestic corporation's net used tested loss. Under Reg. § 1.1502-32(b)(3)(iii)(B), a reduction to the basis of a subsidiary's assets results in a corresponding reduction to the basis of the subsidiary's stock. However, under Prop. Reg. § 1.1502-32(b)(3)(iii)(C), the basis of the subsidiary was already reduced by the amount of the used tested losses with respect to the CFC. The proposed regulations apparently rely upon the general anti-duplication rule described in Reg. § 1.1502-32(a)(2) to prevent duplication of the reduction to the basis of the subsidiary's stock. That provision, however, is a backstop rule and should be relied upon only as a last resort.¹ Accordingly, Reg. § 1.1502-32(b)(3)(ii) and (iii) should be amended to explicitly state that any adjustments to the basis of stock of a CFC by reason of section 951A and the regulations thereunder will not be treated as tax-exempt income or a noncapital, nondeductible expense.

II. Immediate Positive Adjustment for Offset Tested Income

Proposed Reg. § 1.1502-32(b)(3)(ii)(E) provides that a subsidiary (S) may treat as tax-exempt income S's offset tested income, and thereby increase an owning member basis in S's stock. The increase, however, is limited to S's used tested loss amounts in prior years, at least until a recognition event with respect to a share of S's stock. The preamble contains no discussion of the rationale for this limitation and deferral of the basis increase. Offset tested income results when a CFC has a used tested loss that offsets the tested income of another CFC that would otherwise be taken into account in determining the GILTI inclusion amount. A subsidiary that owns the stock of the CFC with tested income will report less GILTI inclusion amount as a result of the offset, and thereby the owning member will have a smaller basis increase to the subsidiary's stock by reason of the positive adjustment for taxable income under Reg. § 1.1502-32(b)(3)(i). The current reduction to the basis of the stock of a subsidiary that owns a CFC with a used tested loss is the yin to the yang of a corresponding basis increase.

The deficiency of the proposed regulations in limiting the current stock basis adjustment to reflect less than the full amount of offset tested income can be illustrated by a simple case involving only a single subsidiary. Consider the following example:

Example. (i) Facts. P owns all the stock of two subsidiaries, S1 and S2, with which it files a consolidated return. S1 owns all the stock of CFC1 and S2 owns all the stock of CFC2. For the year, CFC1 has $100 of tested income and CFC2 has $100 tested loss. S1 does not have any used tested loss amounts from prior years.

(ii) Analysis. CFC2's $100 tested loss offsets CFC1's $100 tested income and the group has a zero GILTI inclusion amount. Under Prop. Reg. § 1.1502-32(b)(3)(iii)(C), P reduces its basis in S2's stock to reflect CFC2's used tested loss. The regulations do not provide for a current increase to P's basis in S1's stock to reflect CFC1's offset tested income because S1 does not have a used tested loss from prior years. See Prop. Reg. § 1.1502-32(b)(3)(ii)(E). Applying the principles of the proposed amendments to Reg. § 1.1502-32 for E&P adjustments, as required under Reg. § 1.1502-33(b) of the current regulations, P's E&P will be reduced by $100.

It should be obvious that the lack of an immediate positive adjustment to reflect S1's offset tested income in P's basis in its S1 stock, coupled with the immediate reduction to P's basis in S2's stock to reflect S2's used tested loss, distorts P's basis in S1's stock by not reflecting the economics of S1's activity for the year. The proposed regulations attempt to ameliorate this distortion by providing for a positive basis adjustment under Prop. Reg. § 1.1502-32(b)(3)(ii)(E), but that adjustment is limited to used tested losses.² The additional positive adjustment in Prop. Reg. § 1.1502-32(b)(3)(ii)(F) immediately prior to a recognition event does not resolve the timing distortion, and has its own unnecessary limitations. Also, if S1's stock is transferred in a nonrecognition transaction, the amount of offset tested income must continue to be tracked. Such tracking creates a recordkeeping burden and the required information may be lost following the stock transfer. Furthermore, Reg. § 1,1502-33(b)(1), governing earnings and profits of subsidiaries and owning members in a consolidated group, cross-references the principles of the investment adjustment rules. Consequently, in the above example S2 would reflect a $100 negative adjustment to its E&P for the year, which would be reflected in P's E&P and potentially allow section 301 distributions to P's shareholders to escape dividend treatment. No amount of positive E&P for S1's offset tested income would tier-up. To prevent distortions of both the basis and E&P results, the final regulations should provide for an immediate positive adjustment to the stock of a subsidiary that owns a CFC by the amount of offset tested income.

The timing of adjustments to the basis of subsidiary stock is a separate question from the timing for adjustments to the basis of CFC stock that would be required immediately before a disposition of that stock by Prop. Reg. § 1.951A-6(e). The preamble to the proposed regulations specifically requested comments regarding adjustments that may be “necessary to prevent the duplication of gain or loss resulting from a member's ownership of a CFC.” This question is somewhat analogous to the issue presented by a corporation, S, that owns a pass-through entity when S joins or ceases to be a member of a consolidated group. That issue was resolved in Reg. § 1.1502-76(b)(2)(vi) by treating S as selling its interest in the entity “immediately before S's change in status” solely for purposes of determining the year to which the entity's items are allocated. A similar rule could be promulgated for adjustments to the basis of CFC stock. The adjustment, however, should not be required if the member owning the CFC stock joins a new group as the result of an acquisition of the entire group of which S is a member. See Reg. § 1.1502-13(j)(5).

II. Methodology for Determining Consolidated GILTI and the Allocation of Consolidated GILTI Among Members

As previously stated, the proposed regulations are to be commended for making the ownership of CFC stock by one member of a consolidated group rather than another member irrelevant for purposes of determining the total GILTI inclusion amount of the consolidated group. However, the method used to achieve that result can be made to achieve results that more closely conform to the economic performance of each CFC owned by each member and in a manner that is much more user-friendly. Proposed Reg. § 1.1502-51(b) prescribes the method for “calculating the GILTI inclusion amount for a member of a consolidated group.” The sum of each member's GILTI inclusion amount would then be the total inclusion amount for the group as a whole.

A better method for achieving the desired results would be to determine first a consolidated GILTI inclusion amount for the group as a whole (as if the members owning section 958(a) stock were divisions of a single corporation), and then to allocate that consolidated GILTI inclusion amount based on each member's net tested income. This method can be analogized to the method for calculating a group's consolidated capital gain and loss under Reg. § 1.1502-22. As stated in Reg. §1.1502-22(a), the determination “with respect to members during consolidated return years are not made separately. Instead, consolidated amounts are determined for the group as a whole.” The consolidated net capital loss (if any) is then allocated among the members for carryover and carryback and stock basis adjustment purposes. In the case of GILTI, the last sentence of section 904(c) negates any carryover or carryback of a negative amount for a year, but allocation of the “consolidated GILTI inclusion amount” to members is still necessary for stock basis adjustment purposes. Similarly, if the CFCs were single-member LLCs, losses generated by LLCs with losses as well as income generated by LLCs with income would be taken into account for purposes of increasing or decreasing the basis of subsidiary stock.

Once the consolidated GILTI inclusion amount for the group is determined, it should be allocated among the members based on each member's net tested income. The proposed regulations use tested income, rather than net tested income, to allocate the GILTI inclusion amount among the members; however, that allocation does not conform to the economics. Consequently, the current investment adjustment rules that are cited in the preamble to the proposed regulations, which currently provide for positive adjustments for taxable income, will operate to create noneconomic adjustments. To illustrate the anomaly, one need look no further than the examples provided in the proposed regulations.

The facts in Example 1 in Prop. Reg. § 1.1502-51(f) are:

Example (1). Calculation of consolidated GILTI inclusion amount and allocation among members. (i) Facts. USS1 owns all of the single class of stock of CFC1. USS2 owns all the single class of stock of each of CFC2 and CFC3. USS3 owns all the single class of stock of CFC4. In Year 1, CFC1 has tested loss of $100, CFC2 has tested income of $200, CFC3 has tested loss of $200; and CFC4 has tested income of $600. Neither CFC2 nor CFC4 has qualified business asset investment in Year 1.³

As a result of using tested income rather than net tested income for allocating the group's GILTI inclusion amount, paragraph (ii)(C) of Example 1 concludes that under the facts of Example 1, USS1's net CFC tested income amount is $0. USS2's net CFC tested income is $125, and USS3's net CFC tested income is $375, a 1:3 ratio for USS2 to USS3. That conclusion should be a red light that something is askew. In the example, USS2 owns all the stock of one CFC with tested income and all the stock of another CFC with an equal amount of tested loss, but USS2 is allocated $125 of net CFC tested income. This distortion, however, is not unavoidable. Without altering the total GILTI amount that the group includes, the regulations should provide that a member nets its tested income and tested loss, and the net tested income will be used for the allocation of the consolidated GILTI inclusion amount. The following language could be used:

Allocation of consolidated GILTI inclusion amount among members. To determine the portion of the consolidated GILTI inclusion amount that each member must include in its gross income, each member must first take into account its pro rata share of tested income of each controlled foreign corporation for which it is a shareholder and its pro rata share of the used tested loss of each such corporation (net CFC tested income). Each member's portion of the consolidated GILTI inclusion amount that it must include in gross income is determined by multiplying the consolidated GILTI inclusion amount by a fraction. The numerator of the fraction is the member's net CFC tested income, and the denominator is the sum of the net CFC tested income of all members.

Applying this rule to the facts of Example 1 would result in zero allocation of GILTI inclusion to USS2, which is an accurate economic allocation and would have the added virtue of relative simplicity. Accordingly, the second part of Example 1 would read:

(ii) Analysis. (A) Consolidated GILTI inclusion amount. The total tested incomes of CFC2 of $200 and CFC4 of $600 is $800, and the total tested losses of CFC1 of $100 and CFC3 of $200 is $300. Accordingly, the consolidated GILTI inclusion amount is $500.

(B) Allocation of consolidated GILTI inclusion amount among members. USS1's allocable share of CFC1's used tested loss is $100 and is allocated no amount of consolidated GILTI inclusion. USS2's allocable share of CFC2's tested income is $200 and its share of CFC3's used tested loss is $200. Accordingly, USS2's net CFC tested income is zero. USS3's pro rata share of CFC4's $600 of net CFC tested income and it is the only member with net CFC tested income. Accordingly, the full $500 of consolidated GILTI inclusion must be included by USS3.

Unlike the result proposed under Example 1 of the proposed regulations, it is suggested that the used tested loss of CFC3 be first taken into account to offset CFC2's tested income before the consolidated GILTI inclusion amount is allocated. The consequence of this ordering is to more accurately reflect the activities of all CFCs owned by USS2 to USS2's contribution (or lack thereof) to the group's consolidated GILTI inclusion amount. Furthermore, both stock basis adjustments and E&P adjustments will not become distorted. It does not alter the consolidated GILTI inclusion amount for the group as a whole.

IV. Split Ownership Example

If more evidence is needed to demonstrate that the proposed regulations could cause distortive results, consider Example 2 in Prop. Reg. § 1.1502-51(f), which reads:

Example 2. Calculation of net CFC tested income within a consolidated group when ownership of attested loss CFC is split between members. (i) Facts. The facts are the same as in paragraph (i) of Example 1, except that USS2 and USS3 each own 50% of the single class of stock of CFC3.

(ii) Analysis. As in paragraph (ii) of Example 1, USS1 has no aggregate tested income and a GILTI allocation ratio of 0. USS2 has $200 of aggregate tested income and a GILTI allocation ratio of 0.25, and USS3 has $600 of aggregate tested income and a GILTI allocation ratio of 0.75. Additionally, the P consolidated group's consolidated tested loss is $300 (the aggregate of USS1's aggregate tested loss, which is equal to its pro rata share (within the meaning of §951A-1(d)(4)) of CFC3's tested loss ($100); and USS3's aggregate tested loss ($100). As a result, under paragraph (e)(12) of this section, as in paragraph (ii)(C) of Example 1, USS1's, USS2's, and USS3's net tested CFC income amounts are $0, ($0 - $0), $125 ($200 - $75), and $375 ($600 - $225), respectively.

As Example 2 concludes, each member's net tested CFC income is unchanged from the amounts determined under Example 1, notwithstanding that CFC3, which has a used tested loss of $200 in this example, has a 50/50 split ownership between USS2 and USS3, rather than being wholly owned by USS2. Why is it not obvious that something is amiss?

Under the rule proposed by this comment, the analysis would instead be as follows:

(ii) Analysis. Unlike Example 1, USS2's net CFC tested income would be determined by taking into account its $100 allocable share of CFC3's $200 tested loss rather than the full $200 loss, and USS3 would take into account the remaining $100 of CFC3's tested loss. Accordingly, USS2 would have $100 ($200 - $100) of net CFC tested income and USS3 would have $500 ($600 - $100) of net CFC tested income. USS2's allocable share of the group's $500 GILTI inclusion amount would be $83.33 (( $100/$600) x $500), and USS3's allocable share of the group's $500 GILTI inclusion amount would be $416.67 (($500/$600) x $500).

Compared with the result under the proposed regulations, the result described above more accurately reflects the economic contributions that each member makes to the group's consolidated GILTI inclusion amount.

Example with QBAI and Specified Interest Expense

Example 3 provides a deeper dive into the mechanics of the proposed regulations by containing facts that include the presence of QBAI and specified interest expense. The facts are as follows:

Example 3. Calculation of GILTI inclusion amount. (i) Facts. The facts are the same as in paragraph (i) of Example 1, except that CFC2 and CFC4 have qualified business asset investment of $500 and $2,000, respectively, for Year 1. In Year 1, CFC1 and CFC4 each have tested interest expense (within the meaning of §1.951A-4(b)(1)) of $25, and CFC1. CFC2, CFC3, and CFC4 have $0 tested interest income (within the meaning of §1.951A-4(b)(2)). CFC1's tested loss of $100 and CFC4's tested income of $600 take into account the interest paid.

The total QBAI of the group is $2,500 ($500 + $2,000) and the group's total specified interest expense is $50. The proposed regulations allocate those amounts among the members based upon their respective GILTI allocation ratios. As described in Example 1, the proposed regulations apply the ratio on a 1:3 basis of USS2 to USS3. The net deemed tangible income return (DTIR) is not an economic expenditure, but rather a reduction to arrive at the GILTI inclusion amount to account for a hypothetical return on tangible assets, reduced by net specified interest expense. If, as suggested, the GILTI inclusion amount is first computed on a single-entity basis, the net DTIR of each CFC will have been taken into account. If the consolidated GILTI inclusion amount is then allocated to each member based upon net tested income, no further allocation of the net DTIR is necessary.

V. One-Sided Basis Adjustments

Subdivisions (F) and (G) of Example 3 describe the amount of GILTI inclusion of each member and reference the negative investment adjustment rule in Prop. Reg. §1.1502-32(b)(3)(iii)(C) for used tested losses. As a result, P's basis in USS1 will be reduced by the $100 used tested loss amount with respect to USS1. That result would not be changed by the proposal contained in this comment letter. The effect on the basis of the stock of USS2 and USS3, however, would be radically different.

Under the proposed regulations, USS2 would have $75 of GILTI inclusion amount and a $200 used tested loss amount with respect to CFC3, for a net stock basis reduction of $125. USS2 would also have $75 of offset test income with respect to CFC3, which would not result in a current basis adjustment. USS3 would have $225 of GILTI inclusion amount and $225 of offset tested income amount, which also would not result in a current positive basis adjustment. The preamble to the proposed regulations specifically requested comments as to whether additional rules under Reg. § 1.1502-33 are necessary. Under Reg. § 1.1502-33, the principles of the investment adjustment rules apply for E&P purposes. Under the proposed regulations the basis of the stock of a subsidiary with offset tested income could be substantially understated and as a consequence there could be substantial understatement of P's E&P. By contrast, if the basis of a subsidiary's stock is increased currently for offset tested income, as this comment suggests, no understatement of E&P would result.

Under this proposal, the initial computation of the consolidated GILTI inclusion amount would take into account any QBAI or specified interest expense as if the members of the group were a single corporation. Allocating the consolidated GILTI inclusion amount among the members based on each member's net tested income would not require the lengthy computations described in Prop. Reg. § 1.1502-51(f) Example 3 (ii) (A), (B), (C), (D), (E), (F) and (G). Under this proposal USS3 would have a current positive adjustment to stock basis for its offset tested income as well as the increase for its taxable income. USS2 would have $0 change because its net tested CFC income would be zero. These results reflect true economic results in the stock basis of each subsidiary more accurately than the results under the proposed regulations, and would not result in under inclusion of E&P by the group.⁴

VI. The Section 250 Deduction

For taxable years beginning before 2026, section 250 provides a deduction equal to 50 percent of the GILTI inclusion amount, plus the section 78 gross-up amount, and a 35 percent deduction for foreign derived intangible income (FDII). The sum of those deductions may not exceed 50 percent of a corporation's taxable income (as adjusted). If the sum exceeds the corporation's taxable income, each deduction is reduced based upon each category's proportion of the total.

In the case of corporations that are members of a consolidated group, taxable income should mean consolidated taxable income. The amount of the deduction for the group as a whole should be determined based upon the group's consolidated GILTI inclusion amount (and consolidated FDII, if relevant) and then allocated among the members based upon each member's proportion of the GILTI inclusion amount.

Thank you for your consideration of these comments on the proposed regulations. If you have any questions regarding these comments, I would be happy to discuss the issues further.

Sincerely,

Lawrence M. Axelrod
Of Counsel
Morgan, Lewis & Bockius LLC
Washington, DC

cc:
Robert H. Wellen
Lisa A. Fuller
Marie Milnes-Vasquez
Kevin M. Jacobs
Austin Diamond-Jones
Katherine H. Zhang