Memo Supports IRS's Authority to Address GILTI Expense Allocation

Treasury and IRS Have Broad Regulatory Authority
to Address GILTI Expense Allocation

This memorandum illustrates that the Treasury Department and the IRS have ample authority to eliminate or significantly limit the allocation of U.S. Shareholder expense to income in the GILTI foreign tax credit (“FTC”) basket.

The GILTI Regime and Its Intended Effects

The Tax Cuts and Jobs Act (the “Act”) includes an entirely new tax regime imposing a residual tax on a U.S. Shareholder with respect to the global intangible low-taxed income (“GILTI”) of its controlled foreign corporations (“CFCs”). The legislative history of the Act discusses the GILTI regime as a protective measure, intended to protect against the erosion of the U.S. tax base by reducing incentives for corporate groups placing highly profitable operations in low-tax jurisdictions. The legislative history shows no concern with profitable operations located in high-tax jurisdictions.

A key element of the GILTI regime is the allowance of a credit for 80 percent of the CFC's foreign tax allocable to its GILTI. The House Report, Senate Explanation, and Conference Report for the Act consistently include language indicating that no residual tax should apply to foreign earnings subject to foreign tax above an effective rate threshold of 13.125 percent or more.

Extensive commentary submitted in connection with the GILTI regime and the related foreign tax credit rules illustrate that the allocation of U.S. Shareholder expenses, not deducted under a CFC's foreign tax regime, to reduce GILTI will frustrate the intended effects of the GILTI regime. This occurs under Section 904(a), which (taking into account the separate GILTI basket under Section 904(d)(1)(A)) limits GILTI foreign tax credits to a proportion of the U.S. Shareholder's U.S. pre-credit tax that is the same as the ratio of its GILTI-basket taxable income to its entire taxable income. Such U.S. Shareholder expenses generally may not be charged to CFCs under arm's length principles.

Preamble Language on Expense Allocation

In the preamble to a Notice of Proposed Rulemaking relating to the foreign tax credit (the “FTC NPRM”), the Treasury Department and the IRS put forth an interpretation of the Act that U.S. Shareholder expenses should be allocated to determine GILTI and the related Section 904(a) limitation, despite commentary pointing out the relevant legislative history and the problems caused by such allocations. As discussed below, other permissible interpretations of the Act would better implement the purposes of the Act.

Possible Regulatory Approaches

There are several possible regulatory approaches that would reduce or eliminate problematic expense allocation to a U.S. Shareholder's GILTI. One approach would provide that no such allocation be made, for example by treating GILTI as exempt income under Section 864(e)(3). Another approach would be to identify CFC income subject to tax rates higher than 13.125%, and use that determination to eliminate distortive effects of expense allocation. Possible uses of such a “high tax exception” include treating such income as exempt income under Section 864(e)(3) or residual income under Section 904(b)(4); or adjusting the determination of “gross tested income” or “net CFC tested income” under the GILTI rules. An additional approach would be to provide for expense allocation in the GILTI category only to the extent necessary to eliminate excess foreign tax credit limitation.

Sources of Regulatory Authority

The Code provides extensive regulatory authority for any such approach. In particular, Section 864(e)(7)(G) specifically authorizes regulations providing that expense allocation under Section 864(e) “shall not apply for purposes of any provision of this subchapter to the extent the Secretary determines that the application of this subsection for such purposes would not be appropriate.” Section 864 is broad, containing provisions entirely unrelated to expense apportionment as well as those relating to the apportionment of interest expense, research and experimental expense, and all other expenses. Section 864(e)(7)(G) expressly authorizes not applying the provisions of Section 864 at all, including those relating to the apportionment of interest expense and other expenses, where appropriate. Moreover, the broad authority granted by Section 864(e)(7)(G) may be exercised for the purposes of “any provision” of subchapter N of the Code, which would include Section 904(d)(1)(A). Thus, Section 864(e)(7)(G) expressly authorizes the Treasury and IRS to modify the apportionment of interest expense and other expenses solely with respect to the GILTI basket, including going so far as to not apportion any expense to the GILTI basket.

The authority granted under Section 864(e)(7) is not limited to the express grant in Section 864(e)(7)(G). Section 864(e)(7) generally authorizes rules necessary or appropriate to carry out the purposes of Section 864. The purposes of Section 864 extend to expense allocation and apportionment generally. In addition, Section 864(e)(7)(C) expressly authorizes regulations for apportioning expenses to Section 904(d) categories in a manner different than for other purposes, which would need to take into account the purposes of Section 904(d) including those articulated in the Act's legislative history with respect to GILTI.

More specific to the context of foreign tax credits, Section 904(d)(7) authorizes regulations to carry out the purposes of Section 904(d), which include the purposes of amended Section 904(d)(1)(A) (i.e., the GILTI basket). This grant can in some ways be more flexible than those under Section 864(e). It contemplates regulations that apply only for purposes of Section 904(d), and it contemplates regulations that can deviate from the general rules prescribed in regulations under other Code sections. One purpose of the new basket under Section 904(d)(1)(A) is similar to a purpose of the baskets introduced in the Tax Reform Act of 1986, which also introduced Section 904(d)(7), to prevent averaging foreign taxes across different categories of income. But another purpose of this new basket, distinctly articulated in the Act's House Report, Senate Explanation, and Conference Report, is to identify whether a U.S. Shareholder's GILTI is subject to foreign tax near or above the identified effective rate threshold and ensure residual U.S. tax is not imposed, or in the case of effective rates near the threshold is imposed smoothly, with respect to that GILTI. Section 904(d)(7) authorizes the Treasury and IRS to promulgate regulations to carry out this additional purpose of Section 904(d)(1)(A).

Lastly, Section 7805(a) authorizes all needful regulations for tax administration, which includes interpreting the term foreign-source taxable income under Section 862(b) to determine the appropriate manner for allocating expenses generally. It also authorizes interpreting the term “global intangible low-taxed income” in a manner consistent with its component term “low-taxed” and with the legislative history that expressly articulates the meaning behind that component of the term.

Based on these grants of regulatory authority, the Treasury and IRS could promulgate a regulation providing that expense allocation does not apply to the GILTI basket based on a determination of appropriateness, a regulation that allocates expense to the GILTI basket only to the extent of a taxpayer's excess limitation in the GILTI basket, or a regulation that addresses in another manner the application of GILTI in the case of foreign earnings subject to foreign tax in excess of the effective rate threshold identified by Congress The grants are sufficiently broad to permit such regulations even if one agreed with the statutory interpretation put forth in the FTC NPRM. The Treasury and the IRS could also re-examine that interpretation, because it is clearly not the only possible interpretation. Indeed, it is not the best interpretation when considered in light of other provisions of the Code and the purposes of the new GILTI regime.

Problems with Preamble Language

One argument in the FTC NPRM is that application of the income limitation for the Section 250 deduction, which prevents creating or increasing net operating losses (“NOLs”), could create a residual tax in excess of 13.125 percent in certain circumstances. The FTC NPRM concludes that this means that the legislative history discussion of the 13.125 percent rate was not intended to limit expense allocation. The Section 250 income limitation, however, is expressly included in the Act, unlike any mandate regarding expense allocation. The income limitation is also better viewed as a distinct feature of Section 250. Tax benefits are often limited by income or tax liability, such as the deductions under former Section 199 and current Sections 199A and 613A and nonrefundable tax credits. In addition, the Section 250 deduction was designed with a strict year-by-year limitation. The income limitation is best viewed as making sure the year-by-year feature of Section 250 is not undercut through application of NOL carryover rules.

Another argument in the FTC NPRM is that the application of Section 59A, or BEAT, could create residual GILTI tax in excess of 13.125 percent in certain circumstances, again drawing conclusions about GILTI expense allocation from such an example. BEAT, however, has its own purposes and specific statutory rules. The BEAT tax base is expressly provided for in the Act, and the BEAT has its own base erosion prevention purposes. Any collateral effect on GILTI speaks more to BEAT design than to any supposed Congressional intention regarding GILTI expense allocation.

The FTC NPRM also points to inaction in the Act with respect to Section 901 rules relating to the creditability of certain foreign taxes and Section 904 rules relating to U.S. or foreign losses in different baskets or different years. The discussion argues that since there is no consideration of a CFC's foreign effective tax rate in those areas, Congress must have intended that there be no consideration of effective tax rate with respect to the consequences of GILTI expense allocation. This seems too aggressive as a matter of statutory interpretation. The failure to act with respect to a separate set of rules can hardly be said to require a particular approach under a different set of rules. And in any event, these other rules serve policies distinct from those of GILTI that Congress simply did not seek to change in the Act. At best, this discussion, and the related discussions of the Section 250 income limitation and BEAT, raise uncertainty and ambiguity, which the Treasury and IRS have the power to address with properly promulgated and reasonable regulations.

The FTC NPRM also cites the Act's enactment of Section 904(b)(4). Section 904(b)(4) provides that the income ratio underlying a U.S. Shareholder's Section 904(a) limitation is determined without regard to dividends from foreign corporations that are eligible for the Section 245A (participation exemption) deduction and without regard to deductions allocated to the certain income with respect to foreign subsidiaries or stock that gives rise to such income. The disregard of deductions allocated to foreign subsidiary income or stock does not apply to CFC income includible under either the Subpart F or GILTI regimes, or to stock underlying such includible amounts. The FTC NPRM argues that including a reference to GILTI in this new subsection “plainly contemplates” the allocation and apportionment of deductions in determining the U.S. Shareholder's GILTI amount.

Neither Section 904(b)(4) nor its legislative history affirmatively requires any such result. Section 904(b)(4) imposes only one relevant requirement with respect to the apportionment of deductions — it requires, solely for purposes of Section 904(a), foreign source income (and entire taxable income) to be determined without regard to expenses allocated to stock to the extent the income with respect to such stock is neither subpart F income nor GILTI. With respect to expenses that are (or would be) allocable to subpart F or GILTI, Congress simply does not provide a rule, either in the statutory text or in the accompanying conference report. If, by writing rules that apply to expenses that are not allocated to GILTI, Congress intended to prescribe the outcome regarding the allocation of expenses to GILTI, it is reasonable to expect the Conference Report would confirm that Congress intended this interpretation. Because the Conference Report, like the statutory text itself, is completely silent on the allocation of expenses to GILTI, the most appropriate interpretation of this provision is that Congress wished Treasury to use the authority granted to it by Congress to craft appropriate rules in this area.

Both the statutory text of Section 904(b)(4) and the accompanying legislative history indicate that Section 904(b)(4) was not in any way intended to address the appropriate treatment of expense allocation with respect to GILTI. Section 904(b)(4) is simply part and parcel of the Act's scheme for effectively exempting dividends from foreign subsidiaries, and denying the related deemed-paid foreign tax credit. Section 904(b)(4) refers to deductions properly allocable or apportioned to certain income (excluding Subpart F and GILTI inclusions) and stock (except to the extent it gives rise to such inclusions). The language, heading, and legislative history of Section 904(b)(4) indicate it is aimed at addressing the Act's introduction of a Section 245A deduction. In this respect, CFC income that is imputed to a U.S. Shareholder under Subpart F or GILTI cannot form the basis for a Section 245A-eligible dividend from the same CFC, so Section 904(b)(4) limits its disregard of expenses allocable to CFC income and stock to the kind of income and stock that does produce Section 245A-eligible dividends. It does not provide what, if any, expenses should be allocated to the GILTI basket—a determination that necessarily must be made before Section 904(b)(4) becomes relevant. Under the basketing scheme mandated by Section 904(d), GILTI inclusions are already in a basket that is separate from any basket into which a Section 245A-eligible dividend would fall (in most or all circumstances, the general basket). Accordingly, Section 904(b)(4) simply clarifies a detail of the overall basketing scheme while ensuring deductions allocable to Section 245A-eligible dividends and the underlying stock do not give rise to losses in the related FTC basket.

As noted above, Treasury has broad authority to craft appropriate rules with respect to the allocation of expenses to GILTI, and this authority was not limited by Congress in the TCJA, including in the enactment of Section 904(b)(4). Despite this broad authority, the approach taken by Treasury in the FTC NPRM with respect to the allocation of expenses generally applies the pre-TCJA rules to the post-TCJA world. In doing so, this approach effectively ignores the unique nature of the newly-enacted GILTI regime and undermines Congress's expectations regarding the treatment of GILTI inclusions. As indicated in very name of the regime, as well as in the legislative history, Congress intended GILTI to result in the imposition of US tax on low-taxed income earned by foreign subsidiaries. The unique provisions that apply only to GILTI inclusions (e.g., the fact that the foreign tax credit applicable to GILTI inclusions is subject to a 20 percent haircut, and the lack of any carryover or carryback of taxes in the GILTI basket) provide strong indication that Congress's policy goals with respect to GILTI were significantly different than the traditional policy goals of the foreign tax credit of limiting use of foreign taxes to reduce tax on U.S. source income. Within GILTI, the foreign tax credit is simply a means to an end of ensuring current US tax is imposed on excess returns earned by low-tax foreign subsidiaries, based on a simple annual “snapshot” of the earnings and associated taxes in the taxpayer's foreign subsidiaries. There is no indication that Congress intended to increase the economic burden borne by US taxpayers on income earned through foreign subsidiaries that pay significant foreign tax. Indeed, the legislative history of the TCJA as well as the descriptor, “global intangible low-taxed income” strongly indicate otherwise. It is therefore entirely “appropriate,” within the language of Sections 7805(a), 904(d)(7), and 864(e)(7), to gauge foreign tax burden for GILTI purposes without distorting the foreign tax base with expenses that are not deductible against the foreign tax base.