Deloitte Tax Seeks Reg Changes for GILTI Deduction Purposes

November 19, 2018

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, D.C. 20220

The Honorable Charles P. Rettig
Commissioner of Internal Revenue
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
U.S. Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, D.C. 20220

William M. Paul
Acting Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Request for Guidance Under Section 962 To Take the GILTI Deduction Into Account

Dear Messrs. Kautter, Rettig, Harter and Paul:

The Tax Cuts and Jobs Act or TCJA (Pub. L. 115-97) has rendered the regulations under section 962 partially obsolete. As you know, the TCJA added sections 951A (global intangible low-taxed income included in gross income of U.S. shareholders) and 250 (deduction for foreign-derived intangible income and global intangible low-taxed income) to the Code. Section 951A provides for a new category of gross income inclusion under subpart F (the “GILTI inclusion”). Where the U.S. shareholder is a corporation, the TCJA inextricably links the GILTI inclusion with a deduction (section 250(a)(1)(B), the “GILTI deduction”) for the purpose of achieving a reduced effective rate of corporate tax (10.5 percent) on the inclusion. However, in the case of an individual who elects under section 962 to be taxed on his or her subpart F inclusions at the corporate rate, the existing section 962 regulations, which long pre-date the TCJA, take no account of any deduction. If the regulation is not amended to take the GILTI deduction into account in computing an electing individual's tax on the GILTI inclusion, then as we describe more fully below, the effective rate of tax imposed on his or her GILTI inclusion will be neither the individual nor the corporate rate, contrary to the mandate of section 962.

On behalf of Deloitte Tax LLP, a subsidiary of Deloitte LLP,¹ we respectfully request that Treasury and the IRS amend the regulations to provide for a reduction in “taxable income” (as that term is used in Treas. Reg. § 1.962-1(b)(1)(i)) to take into account the GILTI deduction allowed by section 250(a)(1)(B). The purpose of this letter is to explain why we believe such a change is necessary to restore the compatibility of the section 962 regulations with the Code.

This letter has five parts. Part I explains relevant aspects of the regime that was in place before the TCJA was enacted, and summarizes the interaction of the TCJA provisions with the existing regulatory framework of section 962. Part II makes the case for amending the section 962 regulations. Part III makes the case for providing that in all cases the full amount of GILTI inclusion and GILTI gross-up is the correct base for computing the 50-percent GILTI deduction that goes into computing the tax that would be imposed under section 11 if the electing individual's GILTI inclusion were received by a domestic corporation. Part IV explains the consistency between the recently proposed amendment to the section 962 regulations and the amendment requested in this letter. Part V summarizes our recommendations.

I. Background

When an individual is a section 958(a) U.S. shareholder in a CFC, the Code generally imposes tax once on any CFC income included in the individual's income under subpart F. When the individual owns the CFC through a domestic corporation, the Code generally imposes tax twice on that income — first at the level of the domestic corporation, and a second time when the individual receives a dividend of earnings attributable to that income from the domestic corporation.

One level of U.S. tax certainly seems better than two. To assume that is so in every case, however, would be to oversimplify reality. There are tax advantages and disadvantages associated with each of these two ways for the individual to invest in a CFC — i.e., investing directly (resulting in a single level of U.S. tax) versus investing through a domestic corporation (potentially resulting in two levels of U.S. tax). For one thing, the individual and/or corporate income tax rates imposed on the income subject to the subpart F inclusions in the two-levels-of-U.S.-tax arrangement can be lower (at one or both levels) than the individual income tax rate imposed on an individual's own subpart F inclusions. In fact, when subpart F first took effect, the highest marginal tax rate on individual income under section 1 was 91 percent, the highest marginal tax rate on corporate income under section 11 was 52 percent, and dividends were taxed differently than they are today. In the two-level model, credits for the foreign income taxes imposed on the CFC can reduce or eliminate the first level of U.S. tax; no credit for such taxes can be claimed in the single-level model. Moreover, in the two-level model the individual can defer the second level of tax through the expedient of delaying the ultimate distribution.

A. Election into the double-level model of subpart F taxation

1. Section 962

In acknowledgement of the above reality, subpart F has included section 962 from its inception. Section 962(a) provides, in part:

Under regulations prescribed by the Secretary, in the case of a United States shareholder who is an individual and who elects to have the provisions of this section apply for the taxable year . . . the tax imposed under this chapter on amounts which are included in his gross income under section 951(a) shall (in lieu of the tax determined under sections 1 and 55) be an amount equal to the tax which would be imposed under section 11 if such amounts were received by a domestic corporation.

Section 962(a)(2) provides that, for purposes of applying section 960 (relating to foreign tax credits), the amounts described above shall be treated as if they had been received by a domestic corporation.

Section 962(d) provides that the earnings and profits (“E&P”) of a foreign corporation which were included in the gross income of a U.S. shareholder under section 951(a), and with respect to which a section 962 election applied, shall, when such E&P are distributed, be included in gross income (notwithstanding section 959) to the extent that the E&P so distributed exceed the amount of tax paid under chapter 1 of the Code on the amounts to which the section 962 election applied. Thus, any benefit of a section 962 election comes at the price of forgoing the normal exclusion of such distributions of previously taxed income (“PTI”) from gross income under section 959. The election lands the individual in a world of double-level U.S. tax, not unlike where he or she would have been had he or she held the CFC stock indirectly through a domestic corporation.²

The Senate Finance Committee, which added section 962 to the version of subpart F that had first appeared in the House version of the Revenue Act of 1962, described section 962 as a “relief provision” and explained that

[t]he purpose of this provision is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. This provision gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.

S. Rep. No. 1881, 87th Cong., 2d Sess. 92 (1962) (emphasis added).

2. The Section 962 Regulations

The regulations under section 962 were promulgated in 1965 and amended in 1976. Treas. Reg. § 1.962-1(a), after restating the statutory rule in its first two sentences, describes the effect of the section 962 election in its third sentence as follows: “[t]hus, an individual United States shareholder may elect to be subject to tax at corporate rates on amounts included in his gross income under section 951(a) and to have the benefit of a credit for certain foreign tax paid with respect to the earnings and profits attributable to such amounts” (emphasis added). Treas. Reg. § 1.962-1(b)(1) goes on to provide that, for purposes of applying section 11 for a taxable year as provided in Treas. Reg. § 1.962-1(a)(1) in the case of an electing U.S. shareholder,

(i) Determination of taxable income. — The term “taxable income” as used in section 11 shall mean the sum of —

(a) All amounts required to be included in his gross income under section 951(a) for such taxable year; plus

(b) All amounts which would be required to be included in his gross income under section 78 for such taxable year with respect to the amounts referred to in (a) of this subdivision if such shareholder were a domestic corporation.

For purposes of this section, such sum shall not be reduced by any deduction of the United States shareholder even if such shareholder's deductions exceed his gross income.

Treas. Reg. § 1.962-1(b)(1) (emphasis added).

An electing individual thus determines the amount of tax to be paid on a section 951(a) inclusion by hypothesizing a corporation that has no income or deductions other than the income on which the relevant tax is imposed, and applies the corporate rate to the resulting hypothetical corporate taxable income.

B. TCJA amendments to subpart F that are relevant to section 962

1. Section 951A

The TCJA expanded the scope of section 962 to encompass the TCJA's newly enacted category of subpart F gross income inclusions: the inclusion of global intangible low-taxed income (“GILTI”) (“section 951A(a) inclusions” or “GILTI inclusions”). Like section 951(a)(1)(A) inclusions generally, section 951A(a) inclusions represent current-year CFC income subject to immediate U.S. taxation in the hands of U.S. shareholders who own (within the meaning of section 958(a)) stock in the CFC.³ In light of this similarity between sections 951 and 951A, section 951A(f)(1)(A) provides generally that any GILTI included in gross income under section 951A(a) shall be treated in the same manner as an amount included under section 951(a)(1)(A) for purposes of applying sections 959 and 962.⁴

2. Section 250(a)(1)(B)

While section 951(a) inclusions of a domestic corporation (other than section 965(a) inclusions) are generally subject to the same income tax rate as most other income, the TCJA provides for a reduced corporate income tax rate on GILTI inclusions of a domestic corporation. Section 250(a)(1)(B) provides a domestic corporation with a deduction (the “GILTI deduction”) generally equal to 50 percent of the sum of the GILTI inclusion and the amount attributable to the GILTI inclusion that is treated under section 78 as a dividend received by the corporation (the “GILTI gross-up”). Section 250(a)(2) reduces the amount of the GILTI inclusion taken into account in computing the GILTI deduction if the sum of the foreign-derived intangible income (“FDII”) and the GILTI inclusion exceeds taxable income (determined without regard to the section 250 deduction).⁵ In the case of a domestic corporation with taxable income (without regard to the section 250 deduction) equal to or greater than its GILTI inclusion and FDII, the GILTI deduction is 50 percent of the GILTI inclusion plus the GILTI gross-up. For example, a corporation whose only items of gross income or expense are its GILTI inclusion and its GILTI gross-up is allowed a deduction (and has taxable income) equal to 50 percent of its gross income.

The conference report on the TJCA explains the conference agreement as follows:

Under a 21-percent corporate tax rate, and as a result of the deduction for FDII and GILTI, the effective tax rate on FDII is 13.125 percent and the effective U.S. tax rate on GILTI (with respect to domestic corporations) is 10.5 percent for taxable years beginning after December 31, 2017, and before January 1, 2026.¹⁵²⁵. . .

For domestic corporations in taxable years beginning after December 31, 2025, the effective tax rate on FDII is 16.406 percent and the effective U.S. tax rate on GILTI is 13.125 percent.

____________
¹⁵²⁵ Due to the reduction in the effective U.S. tax rate resulting from the deduction for FDII and GILTI, the conferees expect the Secretary to provide, as appropriate, regulations or other guidance similar to that under amended section 965 with respect to the determination of basis adjustments under section 705(a)(1) and the determination of gain or loss under section 986(c).

H.R. Conf. Rep. No. 115-466, at 426–27 (emphasis added).

3. Proposed amendment to the section 962 regulations

The TCJA provides for not only a reduced effective rate of corporate income tax on GILTI inclusions, but also a reduced effective rate of corporate and individual income tax on section 951(a)(1)(A) inclusions by reason of section 965 (“section 965(a) inclusions”).⁶ As in the case of the GILTI inclusion, this reduced effective rate was achieved via deduction (the section 965(c) deduction). This aspect of the TCJA (like the enactment of the GILTI inclusion and GILTI deduction) partially superseded the current section 962 regulations. The section 962 regulations are thus obsolete to the extent that Treas. Reg. § 1.962-1(b)(1)(i) provides that “taxable income” includes only amounts that are to be included in “gross income,” without reducing taxable income by the section 965(c) deduction.

In August 2018, the Treasury Department acknowledged this obsolescence by proposing to define taxable income in Treas. Reg. § 1.962-1(b)(1)(i) as an amount reduced by section 965(c) deductions.⁷ However, the preamble to this proposed regulation states that absent “future guidance,” “taxable income” as used in Treas. Reg. § 1.962-1(b)(1)(i) is not reduced by any amounts or deductions other than the section 965(c) deduction. 83 Fed. Reg. at 39,524-25. As explained below, further guidance is needed to harmonize the “taxable income” definition in the regulations with the enactment of the GILTI deduction. Only if the GILTI deduction is taken into account by an electing shareholder in determining taxable income on the GILTI inclusion can the regulations satisfy section 962's requirement that a taxpayer pay “an amount equal to the tax which would be imposed under section 11 if such [GILTI inclusion] were received by a domestic corporation.”

II. Amendment of the Section 962 Regulations Is Necessary to Maintain Their Validity and Harmonize Them with the TCJA

We believe that the regulations under section 962 should be amended to acknowledge that an individual who makes a section 962 election determines the amount of tax on his or her GILTI inclusion by reference to the GILTI deduction (in addition to the GILTI inclusion and the GILTI gross-up). This amendment is necessary to restore the validity of the regulations under the Code. The amendment is necessary to make Treas. Reg. § 1.962-1(b) fully consistent with the third sentence of Treas. Reg. § 1.962-1(a), insofar as it states that an individual “may elect to elect to be subject to tax at corporate rates.”⁸ The amendment is necessary to make the regulations fully consistent with the purpose of section 962 as expressed by its drafters in 1962: to avoid the “hardship” of taxing individuals at “high bracket rates” on amounts they do not receive by ensuring that the tax burdens on undistributed CFC income “will be no heavier than they would have been had [the individuals] invested in an American corporation doing business abroad.” Finally, because an individual who makes the section 962 election is fully taxed on a distribution of “GILTI PTI” (to the extent it exceeds the U.S. tax paid on the related GILTI inclusion), allowance of the GILTI deduction in the context of a section 962 election is fully consistent with the decision of the drafters of the TCJA not to permit a GILTI deduction to individuals who do not make the section 962 election.

The plain language of sections 951A(f) and 962(a) require that the amount of tax to be paid by the electing individual on his or her GILTI inclusion must equal the tax that would be imposed under section 11 if such amounts were received by a domestic corporation. Section 11(a) imposes tax on the taxable income of every corporation, and section 11(b) provides that the amount of such tax be 21 percent of taxable income. Section 250(a)(1)(B) allows a deduction to domestic corporations that turns entirely on the amount of GILTI inclusion and GILTI gross-up properly taken into account in computing taxable income.⁹ It is indisputable that a domestic corporation with positive taxable income and a GILTI inclusion is automatically entitled to the GILTI deduction, such that the amount of tax that would be imposed under section 11 takes the GILTI deduction into account.

Congress was clear that the corporate GILTI deduction enacted to accompany the introduction of “GILTI” as a new type of subpart F inclusion was nothing more than a mechanism for taxing GILTI as “income” under section 11, but at a preferential rate — as opposed to newly creating both GILTI and a separate tax to be imposed solely on GILTI.¹⁰ The passage quoted above from the conference report on the TCJA specifies that the “effective U.S. tax rate on GILTI (with respect to domestic corporations) is 10.5 percent” (emphasis added), not 21 percent.

III. The Revised Definition of “Taxable Income” Under the Regulations Must Take 50 Percent of the Electing Individual's GILTI Inclusion and GILTI Gross-up into Account

Taking the GILTI deduction into account to determine the amount of “tax which would be imposed under section 11 if such amounts were received by a domestic corporation” requires a further specification of the amount of the GILTI inclusion and GILTI gross-up taken into account for this purpose. Section 250(a)(1)(B) generally allows a deduction equal to 50 percent of the sum of these two amounts, but section 250(a)(2) reduces the amounts so taken into account in the event that the corporation's taxable income (before applying section 250) is less than the sum of the corporation's GILTI inclusion and FDII.

Congress designed this reduction of the amount of the GILTI inclusion taken into account in computing the GILTI deduction to preclude the GILTI deduction from reducing the effective U.S. tax rate on GILTI inclusions and gross-ups below 10.5 percent. As an example, consider a domestic corporation (“USCo”) with $100 of GILTI inclusion, no GILTI gross-up, no FDII, $100 of other gross income, and $140 of allowed deductions (other than the section 250 deduction). USCo's taxable income before taking section 250 into account is $60 ($60 = $100 + $100 – $140). Section 250(a)(2) requires reduction of the base on which the 50-percent deduction is computed, reducing it by $40 (the excess of the GILTI inclusion ($100) over taxable income before the section 250 deduction ($60)) from $100 to $60. The 50-percent deduction is applied to the reduced amount, resulting in a deduction of $30, taxable income of $30, and tax of $6.30 (21 percent of taxable income).

If instead USCo had been allowed a GILTI deduction of $50 (50 percent of the unreduced GILTI inclusion), USCo would have had taxable income of $10 and paid tax of $2.10, or 2.1 percent of the GILTI inclusion, a rate bearing no relation to the purpose of section 250. The drafters of section 250 had the choice of (a) reducing the base on which the 50-percent deduction is computed, or alternatively (b) allowing the computation to drive the tax rate on the GILTI inclusion below 10.5 percent. They chose the former. In doing so, they demonstrated that their purpose was to cap the rate of tax imposed on GILTI inclusions at a positive 10.5 percent. The statute would have departed from that purpose if losses or deductions could reduce the tax rate on the GILTI inclusion to 2.1 percent, zero percent, or any other rate less than 10.5 percent.

In 1965, the drafters of the section 962 regulations construed the words “tax that would be imposed under section 11 if such amounts were received by a domestic corporation” strictly, in the sense that they allowed none of the individual's deductions to be taken in account in computing that tax. For example, an individual might have a loss for a taxable year, but if a section 962 election is in effect, he or she will still owe income tax for the year on amounts included under subpart F. Thus, the regulations “wall off” the individual's deductions from those that are taken into account in determining the hypothetical section 11 tax. The same approach in the case of the GILTI deduction means that, in all cases before 2026, the applicable deduction will be 50 percent of the GILTI inclusion and GILTI gross-up consistent with section 250(a)(2). This is the result of computing a hypothetical section 11 tax using no gross income or deductions other than the GILTI inclusion, GILTI gross-up, and GILTI deduction. Similarly, if the individual held CFCs through a domestic corporation that held no other assets, carried on no activities and incurred no expenses, the full amount of GILTI inclusion and GILTI gross-up would constitute the base on which the allowed 50-percent deduction was computed. Nor is it permissible under this approach for the regulations to reduce the base on which an electing individual computes the 50-percent deduction by deductions to which the individual is entitled as an individual U.S. taxpayer.¹¹ He or she also remains taxable on distributions of GILTI PTI (to the extent that distributions exceed the U.S. tax paid on the GILTI inclusion), and it is upon that event that any other of his or her personal “tax attributes” (which would of course exclude any section 250 deductions) are taken into account.¹²

IV. The Regulations Proposed in August Are Consistent with the Amendment to the Section 962 Regulations We Advocate for in this Comment Letter

Section 962(a) (as modified by section 951A(f)) specifies the amount of “the tax imposed under this chapter on amounts which are included in his gross income under” sections 951(a) and 951A(a). This reference to “gross income” does not preclude taking into account the section 250 deduction. Treasury and the IRS have already proposed amending the section 962 regulations to permit the individuals to determine hypothetical section 11 tax taking into account the section 965(c) deduction.

It is irrelevant to the applicability of the GILTI deduction in computing the hypothetical section 11 tax that the section 965(c) deduction would, as stated in the preamble of proposed regulations, be “generally available to United States shareholders of DFICs, including individuals.” 83 Fed. Reg. at 39,524. The section 965(c) deduction belongs in the hypothetical section 11 tax computation for the same reason the GILTI deduction belongs there. The mandate of section 962 is that a U.S. shareholder should pay the same tax on its subpart F inclusion that would be imposed by section 11 on the same inclusion of a domestic corporation — and in the case of GILTI, the amount of such tax is 21 percent of the excess of the GILTI inclusion (and the GILTI gross-up) over the GILTI deduction, rather than 21 percent of the GILTI inclusion and gross-up.

Precisely because an electing individual remains liable for a second level of tax on PTI distributions, the question of whether it is beneficial to make the election depends on his or her particular facts and circumstances, including the length of the delay between the year of the GILTI inclusion and the year of receipt of PTI distributions, the individual's ability to influence the timing of distributions, the ability to pay U.S. tax on the inclusion absent receipt of distributions, the foreign income taxes paid by his or her CFCs, the marginal rate of U.S. tax imposed by section 1, and whether PTI distributions taxed under section 962(d) will be “qualified dividend income” under section 1(h)(11). The election applies to the individual with respect to all of his or her subpart F inclusions from all of his or her CFCs. Given the variety of subpart F inclusions that one individual may have in a particular taxable year, a section 962 election for a year in which the individual has a GILTI inclusion may in some cases have a detrimental effect, and in other cases have a beneficial effect. A set of facts illustrating a detrimental effect is set forth as Exhibit 1.

V. Conclusion

In light of the enactment of sections 250 and 951A, the existing final regulations under section 962 are now partially obsolete. Yet Treasury and the IRS are on record stating that absent future guidance, “taxable income” as used in Treas. Reg. § 1.962-1(b)(1)(i) is not reduced by any amounts or deductions other than the section 965(c) deduction. Unless Treasury and the IRS amend the regulations to account for these new Code provisions, individuals will be forced to decide whether to make the section 962 election, and ultimately prepare their tax returns, without the benefit of authoritative regulations addressing the effect of the election on GILTI inclusions. Moreover, the IRS will have to examine those returns sans authoritative guidance as well. We believe that the regulations will conform to the changed circumstances post-enactment of the TCJA only when they treat “taxable income” as used in Treas. Reg. § 1.962-1(b)(1)(i) as including 50 percent¹³ (rather than 100 percent) of the GILTI inclusion and the GILTI gross-up. In order to conform the regulations to the law and provide clarity to taxpayers and IRS examiners, we respectfully request the Treasury and IRS amend the section 962 regulations to make this explicit.

Thank you for your consideration of these comments. We would appreciate the opportunity to discuss them further with you at your convenience.

Sincerely,

David Warco
Tax Partner
Deloitte Tax LLP

Harrison Cohen
Tax Managing Director
Deloitte Tax LLP

Robert B. Stack
Tax Managing Director
Deloitte Tax LLP

Mallory Mendrala
Tax Manager
Deloitte Tax LLP

Washington, DC

cc:
Douglas L. Poms (International Tax Counsel — U.S. Department of Treasury)
Gary R. Scanlon (Attorney-Advisor — U.S. Department of the Treasury)
Brian H. Jenn (Deputy International Tax Counsel — U.S. Department of the Treasury)
Jason Yen (Attorney-Advisor — U.S. Department of the Treasury)
Marjorie A. Rollinson (Associate Chief Counsel (International) — Internal Revenue Service)
Daniel M. McCall (Deputy Associate Chief Counsel (International — Technical) — Internal Revenue Service)

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Exhibit 1

For purposes of this illustration, we have made the following simplifying assumptions:

• A U.S. individual owns two CFCs, each of which has only the items of income, gain, deduction, or loss identified in the table below

• Neither CFC is eligible for the benefits of an income tax treaty with the United States

	CFC 1	CFC 2	Income tax calculation with:
	(GILTI generator)	(subpart F income generator)	§ 962 election	No § 962 election
Pre-tax income	10,000	6,000
Foreign income taxes	—	(900)
Tested income/subpart F income	10,000	5,100	15,100	15,100
Less: Net deemed tangible income return (NDTIR)	—	n/a	—
Net CFC tested income minus NDTIR	10,000
Shareholder impact of § 951A(a)/§ 951(a) inclusions
§951A(a)/§951(a) inclusion	10,000	5,100	15,100	15,100
§78 gross-up		900	900
§250 deduction	—	—	(5,000)
Taxable income			11,000	15,100
Applicable US tax rate			21%	37%
US tax before foreign tax credits			2,310	5,587
Foreign tax credit			(900)
Residual US tax	—	—	1,410	5,587
Shareholder impact of repatriation
Repatriation of E&P			15,100	15,100
Less: exclusion for PTI Taxable income			(1,410) 13,690	(15,100) -
Applicable rate			37.0%	37.0%
Tax on repatriated earnings			5,065	—
Total taxes — full repatriation
Non-US withholding taxes			—	—
Tax on inclusions			1,410	5,587
Tax on repatriation			5,587	—
Total taxes			6,997	5,587