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The Proposed GILTI High-Tax Exclusion: A Good Start, but Changes Are Needed

Posted on Sep. 16, 2019

Lewis J. Greenwald and Joseph A. Myszka are partners with DLA Piper LLP. They are based in New York and Silicon Valley, respectively.

In this article, the authors review the recently proposed global intangible low-taxed income regulations, consider flaws in the GILTI high-tax exclusion included in the regs, and suggest how those flaws might be addressed.

Copyright 2019 Lewis J. Greenwald and Joseph A. Myszka. All rights reserved.

The last 18 months have been extraordinarily busy for Treasury and the IRS: Among other things, they have promulgated over 1,000 pages of proposed, temporary, and final regulations to implement provisions of the Tax Cuts and Jobs Act (P.L. 115-97). On June 14 the government released three important regulatory packages: (i) final regulations on the global intangible low-taxed income regime under section 951A (T.D. 9866) (the final GILTI regulations); (ii) proposed GILTI regulations (REG-101828-19) (the 2019 proposed GILTI regulations);1 and (iii) temporary (T.D. 9865) and proposed (REG-106282-18) section 245A regulations.

This article focuses on the 2019 proposed GILTI regulations, wherein Treasury and the IRS propose a high-tax exclusion for the section 951A GILTI regime. While we applaud the government’s efforts to draft an expanded GILTI high-tax exclusion, work is necessary before the exclusion can truly be workable for most multinationals. Comments and requests for a public hearing regarding the proposed regs are due September 19, so interested taxpayers should not delay.

GILTI — An Overview

Through section 245A, the TCJA established a participation exemption system from U.S. taxation for some foreign income by allowing a domestic corporation a 100 percent dividends received deduction for the foreign-source portion of a dividend received from a specified 10-percent-owned foreign corporation. The TCJA’s legislative history expresses concern that section 245A could increase the incentive for U.S.-based multinationals to shift profits to low-tax foreign jurisdictions or tax havens absent base erosion protections.2 Said differently, a U.S.-based multinational might be encouraged to shift income to low-taxed foreign affiliates, and that low-taxed income could potentially be distributed back to domestic corporate shareholders without the imposition of any U.S. tax. To prevent that type of base erosion, the TCJA retained the subpart F regime and enacted section 951A, which applies to tax years of foreign corporations beginning after December 31, 2017, and to tax years of U.S. shareholders in which or with which those tax years of foreign corporations end.

Section 951A

Section 951A requires a U.S. shareholder of any controlled foreign corporation for any tax year to include in gross income the shareholder’s GILTI in a manner similar to a subpart F inclusion.3 Similar to a subpart F inclusion, the determination of a U.S. shareholder’s GILTI inclusion begins with the calculation of relevant items of each CFC owned by the U.S. shareholder: gross tested income, tested income, tested loss, and qualified business asset investment (the “tested items”). The U.S. shareholder then determines its pro rata share of each of those CFC-level tested items.

In contrast to a subpart F inclusion, the U.S. shareholder’s pro rata shares of a CFC’s tested items are not amounts included in gross income, but rather are amounts taken into account by the U.S. shareholder in determining the amount of its GILTI inclusion. According to the 2019 proposed GILTI regs, the U.S. shareholder does not compute a separate GILTI inclusion for each CFC for a tax year, but rather computes a single GILTI inclusion amount by reference to all its CFCs.

High-Tax Gross Tested Income

Under section 951A, a CFC’s gross tested income for a tax year is all the CFC’s gross income, determined without regard to specific items. In particular, section 951A excludes from the definition of gross tested income any gross income excluded from a CFC’s foreign base company income (FBCI) (as defined in section 954) or insurance income (as defined in section 953) because of the GILTI high-tax exclusion.

Under the 2018 proposed GILTI regulations, the high-tax exclusion applied only to income excluded from FBCI and insurance income solely because of an election made to exclude the income under the high-tax exception of section 954(b)(4) and Treas. reg. section 1.954-1(d)(5).

After promulgating the 2018 proposed GILTI regulations, Treasury received numerous comments regarding the high-tax exclusion that argued that the legislative history to section 951A indicated that Congress intended for a CFC’s income to be taxed as GILTI only if it were subject to a low foreign rate, regardless of whether the income was active or passive.4 Commentators also suggested that the GILTI high-tax exclusion did not require that income be excluded solely because of section 954(b)(4). They argued that the exclusion could be interpreted to exclude any item of income that would be FBCI or insurance income, but for another exception to FBCI (for instance, the active financing exception under section 954(h) and the active insurance exception under section 954(i)). Some commentators recommended expanding the exclusion, suggesting it apply to income taxed at a rate above 13.125 percent, while others suggested that the exclusion apply to income taxed at a rate above 90 percent of the maximum rate of tax specified in section 11 (18.9 percent based on the current rate of 21 percent). They said the high-tax exclusion should be applied either on a CFC-by-CFC or item-by-item basis.

Alternatively, commentators recommended that the scope of the GILTI high-tax exclusion be expanded under section 951A(f) by allowing taxpayers to elect to treat a GILTI inclusion as a subpart F inclusion that is potentially excludable from FBCI or insurance income under section 954(b)(4), or by modifying it to exclude any item of income subject to a sufficiently high effective foreign rate so that the income would be excludable under section 954(b)(4) if it were FBCI or insurance income. Other commentators proposed creating a rebuttable presumption that all income of a CFC is subpart F income, regardless of whether it is of a character included in FBCI or insurance income. Thus, if the taxpayer chose not to rebut the presumption, the income would be excluded from gross tested income either because it was included in subpart F income (and thus excluded from gross tested income because of the subpart F exclusion under section 951A(c)(2)(A)(i)(II)) or because the income was excluded from subpart F income because of section 954(b)(4) (and thus excluded from gross tested income because of the GILTI high-tax exclusion).

Treasury’s Rationale for the Exclusion

In response to the comments, Treasury and the IRS determined that taxpayers should be allowed to elect to expand the GILTI high-tax exclusion to include specified highly taxed income, even if that income would not otherwise be FBCI or insurance income.5 In particular, the government determined that taxpayers should be allowed to elect to apply the exception under section 954(b)(4) for specific classes of income that are subject to high foreign taxes under that provision. Before the TCJA, that kind of election would have had no effect for items of income that were excluded from FBCI or insurance income for other reasons. Even so, section 954(b)(4) is not explicitly restricted in its application to an item of income that first qualifies as FBCI or insurance income; rather, it applies to any item of income received by a CFC. Therefore, any item of gross income, including an item that would otherwise be gross tested income, could be excluded from FBCI or insurance income because of section 954(b)(4) if the provision is one of the reasons for that exclusion, even if the exception under section 954(b)(4) is not the sole reason. Any item thus excluded from FBCI or insurance income because of section 954(b)(4) would then also be excluded from gross tested income under the GILTI high-tax exclusion, as modified by the 2019 proposed GILTI regulations.

The preamble to the 2019 proposed GILTI regulations explains that the legislative history evidences an intent to exclude high-taxed income from gross tested income. It refers to the Senate Budget Committee report on the TCJA, which states:

The Committee believes that certain items of income earned by CFCs should be excluded from the GILTI, either because they should be exempt from U.S. tax — as they are generally not the type of income that is the source of base erosion concerns — or are already taxed currently by the United States. Items of income excluded from GILTI because they are exempt from U.S. tax under the bill include foreign oil and gas extraction income (which is generally immobile) and income subject to high levels of foreign tax.6

Thus, the 2019 proposed GILTI regulations, which permit taxpayers to electively exclude a CFC’s high-taxed income from gross tested income, are consistent with the legislative history. Further, an election to exclude a CFC’s high-taxed income from gross tested income allows a U.S. shareholder to ensure that its high-taxed non-subpart F income is eligible for the same treatment as its high-taxed FBCI and insurance income, and thus eliminates an incentive for taxpayers to restructure their CFC operations to convert gross tested income into FBCI solely to avail themselves of section 954(b)(4) and, thus, the GILTI high-tax exclusion.7

In light of the above, the 2019 proposed GILTI regulations provide that an election may be made for a CFC to exclude under section 954(b)(4) — and thus to exclude from gross tested income — gross income subject to foreign income tax at an effective rate greater than 90 percent of the rate that would apply if the income were subject to the maximum rate of tax in section 11 (18.9 percent). The election is made by the CFC’s controlling domestic shareholders by attaching a statement to an amended or filed return in accordance with forms, instructions, or administrative pronouncements. If an election is made for a CFC, it applies to exclude from gross tested income all the CFC’s items of income for the tax year that meet the effective rate test and is binding on all the CFC’s U.S. shareholders. The election is effective for a CFC for the CFC inclusion year for which it is made, as well as for all subsequent CFC inclusion years of the CFC, unless revoked by the CFC’s controlling domestic shareholders.

An election may generally be revoked by the controlling domestic shareholders; however, on revocation, a new election generally cannot be made for any CFC inclusion year of the CFC that begins within 60 months after the close of the CFC inclusion year for which the election was revoked. The IRS will only allow an exception to the 60-month limitation if a CFC undergoes a change of control.

Finally, if a CFC is a member of a controlling domestic shareholder group, the election applies for each group member.

The changes regarding the election to exclude a CFC’s gross income subject to high foreign income taxes under section 954(b)(4) are proposed to apply to tax years of foreign corporations beginning on or after the date that final regulations are published in the Federal Register, as well as to tax years of U.S. shareholders in which or with which those tax years of foreign corporations end.

Making the Exclusion Workable

As mentioned at the outset of this article, we applaud Treasury and the IRS’s efforts to expand the GILTI high-tax exclusion beyond the narrow confines of subpart F income. Unfortunately, some aspects of the proposed exclusion make the proposal simply unworkable for many multinationals by continuing to place those enterprises in the awkward situation of planning into subpart F inclusions or taking other drastic steps to mitigate some of GILTI’s more severe effects (including the 20 percent foreign tax credit haircut and lack of an FTC carryforward mechanism). To make the GILTI high-tax exclusion a more realistic option for more multinationals, we suggest three high-level changes.

First, Treasury should revisit the tax rate threshold for when the exclusion applies. Although it may be rational to set the GILTI high-tax exclusion by reference to the subpart F threshold, we believe Treasury has the authority to adopt a lower threshold, given that the GILTI regime effectively implements a global minimum tax for U.S.-based multinationals. That function stands in contrast with subpart F, which is an anti-deferral mechanism targeted at related-party transactions that may shift income from high-tax jurisdictions to low-tax jurisdictions. Thus, there does not appear to be a substantial policy basis for having a GILTI inclusion for any income over the GILTI threshold. Accordingly, we recommend that Treasury tie the GILTI high-tax exclusion to the effective GILTI rate, taking into account the section 250 deduction.

Second, Treasury should reconsider the mechanics and duration for making an election to apply the GILTI high-tax exclusion. As the preamble explains, through the exclusion, Treasury sought to find at least some parity between high-tax income that was otherwise subpart F income and high-tax income that would not otherwise be subpart F income. Yet the mechanics and duration for electing into the GILTI high-tax exclusion wildly differ from those of the subpart F high-tax exclusion. Specifically, a U.S. shareholder may elect to apply the subpart F high-tax exclusion for each year, so if the election is not made for a particular year, it simply does not apply. In contrast, the GILTI high-tax exclusion is a binding election that may not be changed for 60 months after it is made, except with the IRS’s permission in the limited cases. In today’s highly uncertain and fast-changing business and tax environment, the 60-month restriction is simply too great a commitment for many taxpayers. More fundamentally, there does not appear to be any sound policy basis for creating such a major distinction between subpart F and non-subpart-F income.

Finally, Treasury should allow taxpayers to apply the GILTI high-tax exclusion retroactively to tax years beginning on or after January 1, 2018. That approach would be consistent with Treasury’s determination that an expanded high-tax exclusion is consistent with the congressional intent of section 951A and would enable taxpayers to avoid restructuring some entities and operations to benefit for the one or two years until the exclusion is finalized.

Implementing those three changes would make the GILTI high-tax exclusion a much more practical alternative for multinationals, while respecting the congressional intent of the GILTI regime and removing artificial administrative barriers that would encourage multinationals to spend resources restructuring their operations to avoid GILTI. While other unfortunate aspects of GILTI would still require congressional action to correct (such as the lack of FTC carryforwards), our proposed changes would be a welcome start.

FOOTNOTES

1 The final GILTI regulations finalized proposed section 951A regulations (REG-104390-18), released October 10, 2018 (the 2018 proposed GILTI regulations).

2 See Senate Budget Committee, “Reconciliation Recommendations Pursuant to H. Con. Res. 71,” S. Rpt. 115-20, at 378 (Dec. 2017).

3 See H.R. Rep. 115-466, at 641 (2017).

4 See 2019 proposed GILTI regs.

5 Id.

6 See supra note 2 .

7 See 2019 proposed GILTI regs.

END FOOTNOTES

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