Group Assails Changes Under Subpart F High-Rate Exception Regs

September 21, 2020

Internal Revenue Service
CC:PA:LPD:PR (REG-127732-19)
Room 5203
Post Office Box 7604
Ben Franklin StationAd
Washington, DC 20044

Re: REG-127732-19) Proposed Regulations under section 954(b)(4) regarding income subject to a high rate of foreign tax

These comments are being submitted by the Working Group for Competitive International Taxation (the Working Group) on proposed regulations issued by the Internal Revenue Service (IRS) and the Treasury Department (Treasury) under section 954(b)(4) that will significantly modify the election that allows U.S. shareholders to exclude income subject to a high rate of foreign tax from the subpart F regime (the subpart F high-tax exception).¹ At the same time, IRS and Treasury issued final regulations (T.D. 9902) that allow U.S. shareholders to apply section 954(b)(4) to high-taxed income otherwise subject to the global intangible low-taxed income (GILTI) rules of section 951A (the GILTI high-tax exclusion).

The Working Group is comprised of 19 companies that include industrial companies, manufacturers, financial services companies, and service providers.² The Working Group welcomes the opportunity to continue to work with the IRS and Treasury as it develops regulations implementing the international provisions of the Tax Cut and Jobs Act of 2017 (the TCJA) in a manner consistent with the intent of Congress, to implement a form of territorial tax system with back-stops to prevent the erosion of the U.S. tax base. It is worth noting, in that context, that the TCJA makes only modest changes to the subpart F rules, and did not amend section 954(b)(4), which is the subject of the Proposed Regulations this comment letter addresses.

The Proposed Regulations will impose a consistency requirement on U.S. shareholders so that those wishing to avail themselves of either the GILTI high-tax exclusion election or the subpart F high-tax election must make a combined election for both high-taxed GILTI and subpart F income, effectively combining two elections into one. The combined election will require all high-taxed foreign income of a controlled foreign corporation (CFC) to be excluded under section 954(b)(4). The Proposed Regulations build on the design of the final regulations for the GILTI high-tax exclusion, and to that extent, the rules finalized for the GILTI high-tax exclusion are relevant to our comments on the Proposed Regulations. The Working Group believes it is inappropriate to require consistency between the GILTI and subpart F high-tax elections; our comments also focus on the far too granular application of the election on a tested unit basis, the scope of the election that relies on a modified section 318 rule to define the CFC group, and the 24-month time limitation imposed for making the elections.

I. Consistency requirement for GILTI and subpart F high-taxed income

The election for the GILTI high-tax exclusion rule finalized the proposed regulation's consistency requirement, pursuant to which the election must be made with respect to all CFCs that are members of a CFC group, preventing elections on a CFC-by-CFC basis. The Proposed Regulations extend the consistency requirement to the subpart F high-tax exception, requiring a joint election for all high-taxed foreign income of CFCs, using the same method to calculate the effective tax rate (ETR), and preventing both the subpart F and GILTI high tax elections from applying on a CFC-by-CFC basis. The Working Group previously commented on the rule preventing the GILTI high-tax election on a CFC-by-CFC basis and continues to assert a CFC-by-CFC election is appropriate for both high-tax elections.³ The comments and recommendations in this letter, therefore, focus on the areas of consistency that would be required by the Proposed Regulations — a mandatory joint election for GILTI and subpart F and the tested unit basis used to measure the ETR for the elections.

A. Mandatory joint election

The explanation to the Proposed Regulations (the Preamble) provides that the broad consistency requirement conforms the elections in order to (i) prevent inappropriate tax planning to convert GILTI into subpart F income, (ii) limit cross-crediting of high-taxed and low-taxed income under section 904, (iii) reduce the complexity of separate elections, and (iv) better implement the TCJA, which now generally allows permanent exclusion (as opposed to deferral) of high-taxed foreign income from U.S. tax if the subpart F exception election is made. This explanation seems aimed particularly at the requirement that an election made under one provision forces an election to be made under the other provision. This requirement seems inconsistent with the plain language of the subpart F high-tax exclusion derived from section 954(b)(4) that reads:

[subpart F income] shall not include any item of income received by a [CFC] if the taxpayer establishes to the satisfaction of the Secretary that such income was subject to an effective rate of income tax imposed by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11 [of the Code].

The language refers to “a CFC” and “a foreign country” in determining whether the 90-percent minimum rate of tax threshold is met per CFC and per country, and therefore does not suggest in any way that the exclusion should apply to all CFCs of a taxpayer. Moreover, there is nothing in the plain language of the statute or by the enactment of the TCJA that justifies forcing taxpayers to make a high-tax election for subpart F if an election is made for GILTI. Without more direction from Congress that subpart F and GILTI are linked in the manner adopted by the Proposed Regulations, the plain language of section 954(b)(4) should remain controlling for purposes of the subpart F high-tax exclusion. The plain language under section 954(b)(4) provides taxpayers a choice of how to treat their high taxed income. The statute limits the Secretary's authority to whether income is sufficiently high taxed if the taxpayer offers the evidence to the Secretary to make that determination. Only when the taxpayer proffers the information does the Secretary have authority to exercise its discretion in concluding that income is taxed sufficiently to be excluded from the subpart F rules.

Moreover, concern that the elections must be linked to prevent inappropriate tax planning to convert GILTI into subpart F income and avoid cross-crediting ignores the structure of the two regimes and Congress' clear intent to retain the blending of high- and low-taxed income within the foreign tax credit (FTC) baskets. Congress left the subpart F regime in place largely as it existed prior to the TJCA and thereby created two systems that address how foreign income that is GILTI or subpart F will or will not be taxed. The retention of section 954(b)(4) is significant and evidences Congressional intent to have each regime operate independently. The subpart F and GILTI rules target different types of income and measure the income differently. Section 951A was written to expressly apply as residual to the subpart F regime. Income that is treated as subpart F is not subject to the GILTI provisions. GILTI is based on the aggregate net tested income of all CFCs that does not fall into a few enumerated categories, while subpart F is generally composed of only a few specific classes of income of each CFC. Treasury may find it appropriate to apply consistency within the GILTI high-tax election, but there is no basis for adopting such rules within the subpart F high-tax election or between the two rules. Certainly, the enactment of the TCJA does not justify a mandatory combination of the subpart F regime with the GILTI provisions, even though the TCJA implemented a system that replaces deferral of U.S. tax on foreign income with a system that imposes tax currently or not at all. The IRS and Treasury acknowledged this in the preamble to the final GILTI regulations by preventing losses subject to the GILTI provisions from reducing subpart F income because a CFC's earnings and profits (E&P) could be reduced and trigger the E&P limitation of section 952(c).⁴ “Congress intended for the GILTI and subpart F regimes to act as parallel, and independent systems of taxation with respect to prescribed categories of CFC income, and losses with respect to one regime (or subject to neither regime) should not be permitted to permanently exempt the income subject to another regime.”⁵ Therefore, we don't believe the IRS and Treasury have direction from Congress to inextricably link the two regimes in the manner included in the Proposed Regulations.

Finally, it is not sufficient to assert that taxpayers can choose to forego the elections if they want to retain their high-tax subpart F income for FTC purposes. The subpart F election permits taxpayers to make a choice and the Proposed Regulations remove that choice, putting taxpayers in a worse position than they would have been if Treasury had not provided for the GILTI high tax exclusion. The combination penalizes taxpayers that do not use the GILTI high exclusion by barring the use of the subpart F election. Nothing in the statute justifies such a result.

The Working Group recommends the subpart F high-tax election in the existing final regulations be retained without change and, most importantly, be delinked from the GILTI high-tax election. By keeping the elections separate, taxpayers will not be unduly penalized for making one election at the expense of being required to make the other election. If, in the alternative, there are concerns about having the elections operate differently, consistency should be limited to using the tested unit basis for measuring the ETR and imposing an all-or-nothing election within each election. This is a more appropriate and targeted way to tighten the parameters for which taxpayers can use the subpart F election and disincentivize taxpayers from moving potential GILTI high tax income into the subpart F regime.

B. Measurement of the ETR

The GILTI high-tax exclusion measures whether income is subject to a high rate of foreign tax by looking at the income and taxes paid on that income on a tested-unit basis.⁶ The GILTI high-tax exclusion also relies on the current U.S. expense allocation rules to measure the net income for the ETR and deems negative or undefined ETRs as high tax. The Proposed Regulations would follow the tested unit basis of measurement and the deemed high tax rule for negative or undefined ETRs but rely on deductions (including interest expense deductions) that are reported in the tested units' applicable financial statements. The Working Group supports the use of financial statements in determining the ETR for the election but recommends modifications to the tested unit basis and deemed high tax rules. To the extent the IRS and Treasury seek to promote consistency between the subpart F and GILTI high-tax elections, the final GILTI high-tax election rules would need to be modified. However, as noted above, consistency between the elections is not necessary and different rules could apply within each election.

1. Tested unit measurement for the ETR

The tested-unit measurement requires a more granular analysis than the QBU-basis originally proposed for the GILTI high tax election. The Proposed Regulations also rely on the tested unit measurement and would depart from the current measurement of high tax for subpart F purposes, which is based on aggregating a CFC's items of income that are of a single type, creating in substance a CFC-level measurement by type of income.⁷

According to the Preamble, the tested-unit basis is more targeted than the CFC or QBU approach to prevent high-taxed and low-taxed items of income from being aggregated for purposes of analyzing whether the income is high taxed.⁸ At the same time, ostensibly to reduce complexity, mandatory aggregation rules combine the income and taxes of tested units that are tax residents of, or located in, the same country. If there are de minimis tested units — whether in the same country or not — the income and taxes of the tested units are also combined.⁹

In addition to measuring the income and taxes within tested units, grouping of income by category within each tested unit is also required. General category items of income attributable to a tested unit that would otherwise be income available for the high-tax election (i.e., tested income under GILTI or foreign base company and insurance income under subpart F) would be grouped. Another grouping would be made for equity transactions, such as dividends or losses attributable to stock, where the income might be subject to a rate of tax different than the general country tax rate because of preference items applicable to the transaction. Passive foreign personal holding company income would continue to be grouped under the current rule, but the IRS and Treasury are considering changes to the grouping rules for high-taxed passive income that current regulations would treat as general category income. See Reg. § 1.904-4(c).

The grouping rules are provided to accomplish both simplification and prevention of manipulation of the ETR. By grouping all general category income together, IRS and Treasury explain that taxpayers will avoid the need to first determine whether income should be characterized as subpart F or GILTI income. The separate grouping for equity transactions is intended to keep high taxed income from sheltering low taxed income.

The tested-unit basis focuses heavily on income and taxes within a particular jurisdiction and seems to set the stage for a jurisdictional approach to the ETR measurement, despite the fact that Congress eliminated the per-country FTC limitation in the Tax Reform Act of 1976. Moreover, Congress, in explaining the reason for reducing the number of FTC limitation baskets in 2004, maintained that this was necessary to reduce the complexity of the U.S. international tax system and enhance the competitiveness of U.S. multinationals in the global marketplace.¹⁰ Creating a jurisdictional-based ETR measurement seems inconsistent with prior actions of Congress in reforming the U.S. international tax rules and thus is inappropriate without more recent Congressional support.

Moreover, the tested unit concept can have the effect of misrepresenting the ETR. An entity that is transparent for U.S. tax purposes but not transparent under the local tax rules of the CFC country, may have tax assessed in a later year on a distribution from the transparent entity that would be treated as a separate tested unit under the Proposed Regulations. In such a case, the tested unit concept necessarily gives rise to a mismatch between income and taxes paid with respect to such income and misrepresents the ETR on that income.

Furthermore, the complexity imposed by the tested unit measurement will be significant. The Proposed Regulations will require segregation of income, expenses and taxes by jurisdiction, further segregation of business income from subpart F income and, finally, segregation of different types of subpart F income and the associated expenses and taxes. This segregation is not uniformly performed and would require some taxpayers to create new systems to track information and perform calculations that are not currently in place. Many taxpayers have struggled over the past two years to employ systems that track the data to respond to provisions of the TCJA for E&P and GILTI calculations and have yet to find readymade solutions that provide consistent and usable systems. The tested unit measurement and the segregation rules in particular will add to the complexity of the systems required to perform calculations that are not currently tracked.

The Working Group recommends the subpart F high tax election in the existing final regulations be retained without change and, at a minimum, recommends simplifying the tested unit measurement by removing the segregation rules.

2. Deemed high-taxed income for negative or undefined ETRs

The ETR calculation can produce a negative or undefined tax rate if either the numerator or denominator zero or less. This can occur, for example, if the amount of expenses and taxes exceeds the gross income item to which they are allocable. When the result of the ETR is negative or undefined, the income of the tested unit is deemed high-taxed. In this instance, the high tax election would cause the tested unit's gross income and deductions, including foreign taxes, to be assigned to the residual grouping. Consequently, the foreign taxes will be unusable and the taxpayer's subpart F or GILTI inclusion will generally increase (by removing losses).

This approach seems wholly unnecessary and creates the potential for double taxation. This is most clearly seen in the GILTI provisions, where if the deemed high tax rule treats tested losses as high-taxed, the rule would (1) preclude tested losses from offsetting tested income in either the CFC or an affiliated CFC and (2) disallow FTCs with respect to taxes paid by the tested unit. Moreover, the taxes associated with the negative or undefined ETR may not be taken into account in determining whether the income of such CFC is high-taxed in a different year in which the CFC has tested income rather than a tested loss. That is a particularly harsh result and at odds with the policy of allowing tested losses to offset tested income. The rule, in effect, removes a loss that would have otherwise, as intended by the statute's calculation of subpart F income and GILTI, reduced shareholder inclusions. In the subpart F context, the rule could turn what otherwise would have been a qualified deficit, available to offset future subpart F income, into a non-subpart F loss that can no longer be utilized in future years to reduce income subject to U.S. tax. This result is incompatible with the current structure of the qualified deficit rules and further supports keeping the GILTI and subpart high-taxed elections separate.

The Working Group recommends this rule be withdrawn, as the current proposal is overly broad and would deem income to be high taxed when a negative or undefined ETR results from an economic loss and not the payment of local taxes. The rule produces a cliff effect when just one dollar of income tax causes a tested loss to be lost and could result from a tax that is not based on net income but treated as an income tax as a result of the in-lieu-of tax rules (e.g., there are a number of gross receipts-type taxes that are creditable for U.S. tax purposes). If the IRS and the Treasury have a particular concern for which this rule is intended to address, the remedy should be a narrowly tailored rule to address that concern.

3. Financial statements to measure the ETR

Section 954(b)(4) is based on foreign income being subject to an effective rate of foreign income tax (the ETR) greater than 18.9%, which requires a measurement of the items of gross income and deductions to arrive at the net item for each grouping within each tested unit.

The GILTI high-tax exclusion rule determines a CFC's item of gross income using U.S. tax principles for each tested unit to the extent that the item is properly "reflected on" on the separate set of books and records of the tested unit, adjusted for disregarded payments between tested units to align the location of the income and incidence of taxation in the same tested unit.¹¹ To arrive at the net item for each tested unit, the final regulations allocate deductions under the general allocation and apportionment rules. However, the preamble to the Proposed Regulations recognizes that this approach may result in deductions not being fully taken into account for purposes of determining an income item under the high-tax exclusion rules.

The Proposed Regulations try to correct this result by moving away from the general allocation and apportionment methods based on income or assets of a CFC and instead rely on deductions reported in the tested units' applicable financial statements.¹² Moreover, the Proposed Regulations would not allocate the interest expense of the upper-tier CFC to lower tier entities unless the interest expense is reflected on the applicable financial statement of those entities. The upper-tier CFC's income would be reduced by interest expense deductions reflected on its applicable financial statement. None of the interest expense is moved to the residual basket, and thus better reflects the foreign tax base of the upper-tier CFC. This change makes it more likely the ETR for high-tax subpart F purposes will be higher than under the final GILTI high tax rule.

The Working Group supports consistency between the calculation of foreign source income and the calculation of local taxable income that follow financial statements. Expanding the use of financial statements for the ETR would promote consistency and in most cases administrability of the rule. However, there are instances (mainly due to timing differences for reporting income and taxes) where the use of financial statements might be problematic in determining taxable income in a way that might prove unreliable from an ETR perspective. For these instances, the Working Group recommends an election be allowed for taxpayers to use either their financial statements or the methods described by the regulations.

II. Scope of the election

A. CFC Group based on constructive ownership

The subpart F high tax-election, as proposed, applies to all CFCs within a CFC group. A CFC group is defined by the final GILTI high tax exclusion rule as an affiliated group within the meaning of section 1504(a), modified to include foreign corporations. It also reduces the 80% ownership threshold to more than 50% of vote or value, and applies modified constructive ownership rules of section 318(a) that reduce the ownership threshold from 50% to 5% for attribution from partnerships and corporations.

The application of the reduced ownership threshold for constructive ownership under section 318(a) could be interpreted as creating a CFC group among separate groups where there is a connection only through minority shareholders. This is especially relevant for general partnerships and joint ventures where the ownership structures can be complex. It will not always be possible to understand where minority interests are held that may trigger the application of the constructive ownership rule. Moreover, even when there is an understanding of the ownership structure, there may be conflicts among shareholders as to whether the election should be made. When the shareholders are connected only through the application of the modified constructive ownership rules, one shareholder should not be permitted to prevent another shareholder from accessing the election it is otherwise entitled to make.

The Working Group recommends that the application of the constructive ownership rules be restricted to prevent shareholders from becoming connected and creating CFC groups that are not economically connected in any significant manner.

B. Time limitation on making the election

The Proposed Regulations rely on the GILTI final high tax rules for the mechanics of the subpart F election because, as proposed, there will only be one, joint election. The joint election, therefore, requires a 24-month time limitation within which the election will need to be made or revoked.

Taxpayers can make or revoke a prior election on an amended federal income tax return. The CFC's U.S. shareholders, however, must file the amended return with an election within 24 months of the unextended due date of the original return with all U.S. shareholders of each CFC filing amended returns within a single six-month period. The 24-month limitation fails to account for the time U.S. taxpayers will need to make tax redeterminations arising from disputes with local tax authorities. There is no general timeframe within which these disputes conclude, making it impossible to recommend how to modify the 24-month limitation.

Taxpayers are required to incorporate into their U.S. tax returns the results of disputes with local tax authorities. In fact, the proposed foreign tax credit regulations (REG-105495-19) will require a U.S. tax redetermination in all cases to account for the effect of a foreign corporation's foreign tax redetermination, including whether a taxpayer is eligible for the subpart F high tax election under section 954(b)(4). The Working Group's comments on the FTC proposed regulations pointed out that foreign tax redetermination can require amending the U.S. return whether or not that determination occurs within a 24-month period and recommended that taxpayers be allowed time after a foreign tax redetermination to reconsider whether the high tax election should have been made and be allowed to amend prior year tax returns in accordance with that reconsideration.¹³ Therefore, the proposed regulations allowance for an election on amended returns is a positive development but the 24-month period is not realistic. Foreign tax audits vary and can take years to finalize. It is not clear why any additional limitation should be imposed on making the election. Therefore, we recommend the election be able to be made on any timely filed amended tax return and that the 24-month limitation be removed.

III. Conclusion

For the reasons explained above, the Working Group recommends that the IRS and the Treasury reconsider the Proposed Regulations in order to eliminate the ill-advised consistency requirement that ties together the GILTI and subpart F high-tax elections. The IRS and Treasury have taken on and successfully addressed numerous implementation issues relating to the TCJA, and we applaud them for their efforts. However, in this case, we do not believe the proposal to dramatically change the subpart F high-tax exception is warranted by the TCJA and, in fact, can be viewed as running counter to Congressional intent in creating the subpart F exception long before the TCJA was enacted.

We also believe the determination at a tested unit level for whether such election can be made is far too granular a mechanism that runs counter to Congressional intent and would create a level of complexity that is unwise and unnecessary.

Finally, we believe the scope of the election should be modified by limiting the application of section 318 when determining the CFC group and removing the 24-month time limitation imposed for making the elections.

* * * * *

The Working Group thanks you for the consideration of these comments. Please contact Jeff Levey (jeff.levey@ey.com) or Rebecca Burch (rebecca.burch@ey.com) if you have any questions regarding this submission.

Copies to:
The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

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

Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury

Douglas L. Poms
International Tax Counsel
Department of the Treasury

Wade Sutton
Senior Counsel
Department of the Treasury

Jason Yen
Attorney Adviser
Department of the Treasury

Michael Desmond
Chief Counsel
Internal Revenue Service

William M. Paul
Deputy Chief Counsel (Technical)
Internal Revenue Service

Peter Blessing
Associate Chief Counsel
Internal Revenue Service Office of Associate Chief Counsel (International)

Jorge M. Oben
Internal Revenue Service Office of Associate Chief Counsel (International)

Larry R. Pounders
Internal Revenue Service Office of Associate Chief Counsel (International)