PwC, Skadden Say Rule in GILTI, Subpart F Regs Hurts Private Equity Firms

October 22, 2020

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

The Honorable Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

CC:PA:LPD:PR (REG-127732-19)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

RE: REG-127732-19, Notice of Proposed Rulemaking, Guidance Under Section 954(b)(4) Regarding Income Subject to a High Rate of Foreign Tax and TD 9902, Final Regulations, Guidance Under Sections 951A and 954 Regarding Income Subject to a High Rate of Foreign Tax

Gentlemen:

We are writing jointly to submit a comment on behalf of private equity clients on REG-127732-19, Notice of Proposed Rulemaking, Guidance Under Section 954(b)(4) Regarding Income Subject to a High Rate of Foreign Tax and TD 9902, Final Regulations, Guidance Under Sections 951A and 954 Regarding Income Subject to a High Rate of Foreign Tax, as each of them applies to private equity partnerships.

In particular, we are concerned that the consistency requirement of these regulations would improperly and unfairly prevent separate portfolio companies owned by a private equity partnership from electing the high-tax exclusion in respect of its controlled foreign corporations unless all other portfolio companies in which the private equity partnership had a majority ownership interest made such an election in respect of all their controlled foreign corporations. We do not believe this result is appropriate because portfolio companies owned by a private equity partnership are typically separate US taxpayers, are engaged in different lines of business, have different management teams, are in different stages of their life cycle, and are targeted for sale to different buyers at different times. Thus, portfolio companies owned by a private equity partnership do not implicate Treasury's policy concerns underlying the consistency requirement. Further, this result would impose a substantial undue administrative burden on private equity managers and put businesses owned by private equity funds at a commercial disadvantage relative to their publicly-traded competitors.

Subpart F High-Tax Election and GILTI High-Tax Exclusion Election Regulations Overview

The Subpart F regime under Section 951 of the Internal Revenue Code of 1986, as amended (the “Code” or “IRC”) imposes current taxation on a US Shareholder's portion of Subpart F income earned by a controlled foreign corporation (“CFC”), including insurance income and foreign base company income. The Global Intangible Low-Taxed Income (“GILTI”) regime under IRC Section 951A imposes a minimum tax on a US Shareholder's portion of most income earned by a CFC over a routine return (defined as 10% of the CFC's qualified business asset investment), other than Subpart F income.

IRC Section 954(b)(4) provides that insurance income and foreign base company income do not include any item of income received by a CFC if a taxpayer establishes to the satisfaction of the Secretary that the income was subject to an effective rate of income tax imposed by a foreign country greater than 90% of the maximum tax rate specified in IRC Section 11. IRC Section 951A(c)(2)(A)(i) provides that certain income items of a CFC are not subject to GILTI treatment, such as income that is excluded from foreign base company income or insurance income treatment as a result of the high tax-exception under IRC Section 954(b)(4).

Final regulations issued in July 2020, and which became effective on September 21, 2020, provide for a GILTI high-tax exclusion (“GILTI HTE”) to all high-taxed income of a CFC (other than income that is already otherwise excluded), on an elective basis. Taxpayers are permitted to make an election for a CFC to exclude income that is subject to an effective rate that is greater than 90% of the maximum tax rate specified in IRC Section 11 (18.9% based on the current rate of 21%) from GILTI treatment. Proposed regulations issued in July 2020 would conform the rules for the Subpart F high-tax exception (“Subpart F HTE”) to the final regulations for the GILTI HTE.

However, the final regulations also include a consistency requirement under Treas. Reg. §1.951A-2(c)(7)(viii)(E)(1), which provides that, if a CFC is a member of a CFC group, the GILTI HTE election must be made for all members of the CFC group. The proposed regulations under Prop. Treas. Reg. §1.954-1(d)(6)(v) would expand this consistency requirement by requiring a single unified election applicable to all members of a CFC group for purposes of both Subpart F and GILTI.

The term “CFC Group” is defined under Treas. Reg. §1.951A-2(c)(7)(viii)(E)(2)(i) and Prop. Treas. Reg. §1.954-1(d)(6)(v)(B)(1) by referencing the affiliated group definition under IRC Section 1504(a) but with a reduced ownership threshold of “more than 50% of vote or value” (instead of at least 80%).¹ Furthermore, the constructive ownership rules of IRC Section 318(a) are applied for the purposes of determining stock ownership with certain modifications, including:

• “Downward” attribution to partnerships and trusts under IRC Section 318(a)(3)(A) and 318(a)(3)(B) does not apply for the purposes of this provision; and

• The ownership threshold for “upward” attribution from a corporation under IRC Section 318(a)(2)(C) is changed from 50% to 5% for the purposes of this provision.

In particular, IRC Section 318(a)(3)(C) imposes “downward” attribution from shareholders to corporations if the shareholder owns 50% or more of the corporation's stock. For example, if an individual or partnership owns 100% of the stock of Corporation A and Corporation B, each of Corporation A and Corporation B is treated as owning 100% of the stock of the other.

Policy Intent of the Consistency Requirement

The preamble of the final GILTI HTE regulations notes that the Treasury Department and the IRS determined that the consistency requirement is necessary in order to mitigate the potential negative impact on the allocation and apportionment of deductions if the GILTI HTE election can be made on a CFC-by-CFC basis (or tested unit-by-tested unit basis). The preamble of the proposed Subpart F HTE regulations notes similar concerns with respect to the Subpart F HTE.

Specifically, the Treasury Department and the IRS were concerned that if the regulations were to allow the selective use of the GILTI HTE and/or Subpart F HTE, taxpayers would have the opportunity to manipulate their IRC Section 904 foreign tax credit limitation by including certain high-taxed income in GILTI or Subpart F income in order to claim foreign tax credits up to their IRC Section 904 limitation, while electing to exclude the remainder of their high-taxed income under the GILTI HTE and/or Subpart F HTE. Deductions and expenses allocated and apportioned to the excluded high-taxed income would not be taken into account for purposes of determining the taxpayer's IRC Section 904 limitation under IRC Section 904(b)(4)(B).

The consistency requirement ensures that taxpayers cannot cross-credit against low-taxed income foreign tax imposed on some of their high-taxed income without taking into account all deductions attributable to other high-taxed income.

By including attribution rules under IRC Section 318 in the definition of “CFC group,” it is apparent that the Treasury Department and the IRS believe the consistency requirement should apply not only to CFCs within the same corporate chain, but also to all CFCs that are closely held by the same interests. The preamble makes this intent clear by stating that a U.S. individual directly owning two foreign corporations would be subject to the consistency rule. As a result, taxpayers that have the ability to separate operations into multiple corporate chains are not advantaged in their ability to avoid application of the GILTI HTE and Subpart F HTE consistency requirement.

Potential Application of the Consistency Requirement to Private Equity Structures

The GILTI HTE and Subpart F HTE consistency requirement outlined above adversely impacts companies held within private equity investment structures, as private equity funds are often organized as partnerships that invest in a number of different companies with separate and unrelated operations.

The CFC group provision as currently written in the final GILTI HTE regulations and proposed Subpart F HTE regulations could result in such separate investments being considered as part of a single CFC group as a result of the common ownership by a private equity fund. This is because the application of the attribution rule under IRC Section 318(a)(3)(C) results in separate portfolio companies owned by the same private equity fund each being deemed to own the stock of the other portfolio companies owned by such fund. The formation of such a CFC group would prevent US portfolio companies from making the GILTI HTE and Subpart F HTE election individually for their own respective CFC subsidiaries and would require consistency across companies that are separate US taxpayers under separate and independent management, and that in most cases are engaged in unrelated businesses, have material differences in ownership, and have no practical ability to move CFCs between the groups (or to select whether a new acquisition is made by one portfolio company rather than another).

We have included below a basic illustrative example of a typical private equity fund structure that is adversely affected based on the current rules of Treas. Reg. §1.951A-2(c)(7)(viii)(E)(2)(i) and Prop. Treas. Reg. §1.954-1(d)(6)(v)(B)(1).

Under this example structure, a private equity fund (“PE Fund”) holds two US portfolio companies (“US PortCo A” and “US PortCo B,” respectively, and each a “PortCo”) that were acquired separately, are managed and operate separately from one another, usually have different minority investors (including management and co-investors) and often operate in different industries.

Both PortCos hold their own respective CFC subsidiaries (“CFC 1” and “CFC 2,” respectively). US PortCo A and US PortCo B are subject to Subpart F income and GILTI inclusion with respect to their own respective CFC subsidiaries.

The ultimate US investors participating in the PE Fund are not subject to any Subpart F income inclusion or GILTI inclusion as a result of their interest in CFC 1 or CFC 2 even if they hold a 10% or more interest in the PE Fund, because such inclusions are already recognized by US PortCo A and US PortCo B, respectively. See Treas. Reg. §1.958-1(b).

However, under a literal reading of Treas. Reg. §1.951A-2(c)(7)(viii)(E)(1) and Prop. Treas. Reg. §1.954-1(d)(6)(v)(B)(1), both CFC 1 and CFC 2 may be considered members of a CFC group due to the application of IRC Section 318(a)(3)(C), pursuant to which the PE Fund's stock ownership in US PortCo A is attributed to US PortCo B and vice versa. Accordingly, a CFC group is formed that includes both CFC 1 and CFC 2.

The application of the GILTI HTE and Subpart F HTE consistency requirement would prevent US PortCo A from making the GILTI HTE and Subpart F HTE election with respect to CFC 1, its subsidiary, without the same election being made for CFC 2, the subsidiary of US PortCo B, notwithstanding that US PortCo A and US PortCo B are separate US taxpayers, are engaged in completely separate businesses with separate management teams, have no practical ability to move CFC 1 or CFC 2 to the other portfolio company, and have no insight into or oversight over the overall tax profile, tax affairs or tax elections being made by each other.

The application of the consistency requirement to the CFC group formed in this example does not achieve the policy intent of this provision. Specifically, allowing US PortCo A to make the GILTI HTE and Subpart F HTE election with respect to CFC 1 would not impact the IRC Section 904 foreign tax credit limitation for US PortCo B (and vice versa), because, as noted, these two entities are separate US taxpayers. These PortCos do not have the ability to select which CFCs would be under each PortCo with a view to maximizing their foreign tax credit position, given that the PortCos are separate businesses and often have different economic interest holders (including management). Furthermore, applying the broad interpretation of the CFC group rule would place private equity-owned US portfolio companies at a significant commercial disadvantage to their publicly-traded competitors.

Rationale for Modifying the GILTI HTE and Subpart F HTE Consistency Requirement

There are several rationales supporting the position that the GILTI HTE and Subpart F HTE consistency requirement should not apply to separate portfolio companies in private equity investment structures, including the following:

Policy Intent: As highlighted above, applying a literal reading of Treas. Reg. §1.951A-2(c)(7)(viii)(E)(1) and Prop. Treas. Reg. §1.954-1(d)(6)(v)(B)(1) to private equity fund structures would result in the formation of CFC groups that include CFCs owned by separate US taxpayers, usually in separate, distinct industries. Applying the consistency requirement to such a CFC group would adversely impact the relevant US taxpayers but would not advance the goal of protecting against the potential concerns identified by Treasury Department and the IRS in the preamble to the GILTI HTE regulations because, as noted, the different portfolio companies do not have the flexibility to select which CFCs would be under each portfolio company with a view to maximizing their foreign tax credit position. Unlike a single business enterprise conducted through multiple affiliates, separate portfolio companies owned by a private equity fund do not present the opportunity to manipulate the allocation and apportionment of deductions across portfolio companies. Except in rare cases, separate portfolio companies, though often majority-owned by the same private equity fund, are engaged in different lines of business, have different management teams, are in different stages of their life cycle, and are targeted for sale to different buyers at different times. There is no practical opportunity or incentive for these separate companies to coordinate in order to manipulate their IRC Section 904 limitations. In fact, there would likely be substantial domestic and foreign tax costs, and other legal and business costs, considerations, and impracticalities to doing so that would substantially reduce any benefit of restructuring among separate portfolio companies to manipulate their respective IRC Section 904 limitations using the GILTI HTE and Subpart F HTE. Similarly, business (and often legal) considerations would invariably preclude a private equity fund from diverting the add-on acquisition of a target company from one portfolio company to another with a view to enhancing their overall foreign tax credit positions.

Administrative Burden: Furthermore, it would be difficult for private equity fund managers to enforce the application of the consistency requirement across their portfolio companies (i.e., preventing every US portfolio company from making the GILTI HTE and Subpart F HTE election, or alternatively, “forcing” every portfolio company to make the election). Each portfolio company is a separate taxpayer in its own right, with its own tax and operational management, and the private equity fund may have little operating control over or insight into the tax management of each portfolio company. Although private equity funds could develop oversight procedures in an attempt to ensure compliance with this expansive approach to the consistency rule, this added burden and intrusion into the operations of the separately-managed portfolio companies does not further an identified policy objective of the government. This level of detailed control and interference is contrary to the way that private equity fund managers oversee portfolio companies, which, as stated above, have their own separate and distinct management and operating teams that are in charge of running each business, including with respect to tax planning and compliance.

Competitive Disadvantage: Not only does applying a literal reading of the definition of CFC group produce outcomes that do not achieve the stated policy intent, the consequences will actually be disadvantageous to private equity-owned US corporations that are trying to compete on equal footing with publicly-traded US multinational corporations. The application of the rule may also create uncertainty and unnecessary complexity in the context of mergers and acquisitions involving the buying and selling of portfolio companies to and/or from a private equity fund, which occurs regularly.

Tie-Breaker Rule: The inclusion of the tie-breaker rule suggests an intention that CFCs should not be included in more than one CFC group. However, the tie-breaker rule contains only a narrow set of provisions to alleviate crossover situations. Referring back to the example above, the absence of a controlling corporate entity above US PortCo A and US PortCo B produces the result that CFC 1 and CFC 2 are members of a CFC group of which US PortCo A is the parent, but also that CFC 1 and CFC 2 are members of another CFC group of which US PortCo B is a parent. The general premise of the tie-breaker rule may suggest that overlapping CFC groups as in this example (particularly where, absent the PE Fund partnership, there is no direct or indirect controlling shareholder) was not intended.

While the tie-breaker rule addresses one circumstance where the CFC group definition produces inappropriate results, there are numerous other such cases, as illustrated in the recent New York State Bar Association Tax Section's Report No. 1441 (Sept. 29, 2020). One particular unintended consequence of these rules was addressed in a correction to the GILTI HTE regulations published on October 9, 2020, which provides that a CFC is not a member of a CFC group if the CFC does not have a controlling domestic shareholder. See 85 Fed. Reg. 64040 (Oct. 9, 2020). However, this correction does not address other potential cross-over situations.

Suggested Approaches to Modification

Below we provide several suggestions for modifying the consistency requirement in the GILTI HTE and Subpart F HTE regulations to achieve the government's policy intent without unduly impacting the private equity industry. Each of these suggestions incorporates one or more of the following elements: (i) a requirement that each portfolio company be engaged in a separate business from one another, (ii) a requirement that the partnership be an investment fund, (iii) a “look through” or aggregate approach to the partnership for purposes of applying IRC Section 318(a)(3)(C) and (iv) an anti-abuse rule. While we have organized these elements under three alternative approaches, they can be mixed and matched in other configurations, and further adjusted as deemed appropriate.

Separate Trade or Business Exception

The Treasury Department and the IRS could adopt an approach that treats a partnership as not owning stock for purposes of applying IRC Section 318(a)(3)(C) under the CFC group definition if the partnership holds stock in corporations that are in separate trades or businesses. Rather, where this “separate trade or business” requirement is met, then for purposes of applying IRC Section 318(a)(3)(C) under the CFC group definition, stock owned, directly or indirectly, by or for a partnership would be considered as being owned proportionately by its partners, on a “look through” or aggregate basis.²

In several places, the Code and regulations require consistent elections or other determinations for trades or businesses that are not separate and distinct. For example, IRC Section 446(d) allows taxpayers to use a different method of accounting only for separate trades or businesses. Treas. Reg. §1.446-1(d) generally provides that different methods of accounting may only be used if the trades or businesses are “separate and distinct,” which is generally determined based on all of the relevant facts and circumstances. The regulations provide that, at a minimum, the two businesses must have “a complete and separable set of books and records” and that there be no “creation or shifting of profits or losses between the trades of businesses . . . (for example, through inventory adjustments, sales, purchases, or expenses). . . .” The courts and certain sub-regulatory guidance have identified additional factors to determine whether a taxpayer is engaged in more than one trade or business under IRC Section 446(d). Such factors include (1) whether the two businesses are operated as separate divisions, with separate books of account, employees, management, and other incidents of business; (2) the self-sufficiency of each business; (3) whether the two businesses have different offices or locations; (4) whether the customers of the two businesses are the same or are mutually exclusive; (5) whether the two businesses are part of an interdependent or integrated supply chain; (6) whether one business is a branch operation of the other business; (7) whether each business has the requisite assets and employees for the production of income; and (8) whether items in common between the two businesses could be shared by any two dissimilar businesses owned by the same taxpayer. See, e.g., Gold-Pak Meat Co., Inc., T.C. Memo. 1971-83; Peterson Produce Co., 313 F.2d 609 (8th Cir. 1963); Nielsen, 61 T.C. 311 (1973); and CCA 201430013 (Mar. 24, 2014).

Treasury and the IRS could craft a “separate trade or business” standard based on the standards applied in Treas. Reg. §1.446-1(d) and the guidance thereunder (or in other relevant provisions), adjusted as appropriate for this context.

Additional or different criteria could also be imposed, which criteria would focus on the various portfolio companies being independent business enterprises that merely happen to be majority-owned by a single investment partnership.. For example, the definition of “separate trade or business” could require that each portfolio company owned by the partnership (i) was separately acquired, rather than as part of an integrated plan, (ii) is expected to be sold separately and (iii) has not and will not provide cross-collateralization, guarantees, or other forms of credit enhancement for debts of other portfolio companies.

For a private equity fund, treating partnerships on a “look through” or aggregate basis would result in the CFCs of each of the portfolio companies in different trades or businesses being in a separate CFC group (unless the application of the relevant IRC Section 318 attribution rules at the level of the private equity fund partners would satisfy the requirements for treatment as a single CFC group). Thus, as applied here, unless attribution at the partner level resulted in the creation of a single CFC group, a private equity fund that owns stock in corporations that are not in the same trade or business would not be required to make a consistent GILTI HTE and Subpart F HTE election for such corporations.

This approach could also include an anti-abuse rule, whereby two portfolio companies would be required to be make consistent GILTI HTE and Subpart F HTE elections for their CFCs if a principal purpose for one or more of those CFCs to be owned by a particular portfolio company (rather than the other) is to enhance the utilization of foreign tax credits by avoiding the application of the consistency rule.

Investment Fund Exception

The Treasury Department and the IRS could adopt an approach that treats a partnership as not owning stock for purposes of applying IRC Section 318(a)(3)(C) under the CFC group definition if the partnership is an investment fund. Rather, where this “investment fund” requirement is met, then for purposes of applying IRC Section 318(a)(3)(C) under the CFC group definition, stock owned, directly or indirectly, by or for a partnership would be considered as being owned proportionately by its partners.

There are several possible approaches to defining an investment fund, and multiple approaches could be combined for this purpose. For example, IRC Section 1061 recharacterizes certain net long-term capital gains of a partner that holds one or more “applicable partnership interests” (“APIs”) as short-term capital gains. Under section 1061, for an interest in a partnership to be an API, the interest must be held or transferred in connection with the performance of services in an “applicable trade or business” (“ATB”). An ATB is defined in section 1061(c)(2) as any activity conducted on a regular, continuous, and substantial basis which consists, in whole or in part, of raising or returning capital, and either (i) investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition), or (ii) developing specified assets.

Treasury and the IRS could define “investment fund” in a manner that draws on the API/ATB standard developed under section 1061 and the proposed regulations thereunder, adjusted as appropriate for this context. For example, the exception could apply where a partnership has issued any APIs. Further, rather than referring to investment in, development of, and disposition of “specified assets,” which includes securities, commodities, real estate, cash, options or derivative contracts, the definition of “investment fund” could be limited to activities related to securities.

Additional criteria could also be imposed, which criteria would focus on the independent operating nature of each of the investment fund's assets. For example, the definition of “investment fund” could require that each corporate chain owned by the partnership be engaged in a separate “trade or business” based on the standards applied in Treas. Reg. §1.446-1(d) and the guidance thereunder (or in other relevant provisions), adjusted as appropriate for this context, or other criteria that Treasury and the IRS deem appropriate.³ As applied here, similar to the “separate trade or business” rule suggested above, a private equity fund that is an “investment fund” would not be required to make a consistent GILTI HTE and Subpart F HTE election for CFCs owned, directly or indirectly, wholly or partially, by such fund, unless the application of the relevant IRC Section 318 attribution rules at the level of the private equity fund partners would satisfy the requirements for treatment as a single CFC group.

This approach could also include an anti-abuse rule, whereby two portfolio companies would be required to be make consistent GILTI HTE and Subpart F HTE elections for their CFCs if a principal purpose for one or more of those CFCs to be owned by a particular portfolio company (rather than the other) is to enhance the utilization of foreign tax credits by avoiding the application of the consistency rule.

Aggregate Treatment of Partnerships, Subject to Anti-Abuse Rule

The Treasury Department and the IRS could adopt an approach that generally treats a partnership as not owning stock for purposes of applying IRC Section 318(a)(3)(C) under the CFC group definition. Rather, for purposes of applying IRC Section 318(a)(3)(C) under the CFC group definition, stock owned, directly or indirectly, by or for a partnership would be considered as being owned proportionately by its partners. For a private equity fund, treating partnerships on a “look through” or aggregate basis would result in the CFCs of each of the portfolio companies being in a separate CFC group (unless the application of the relevant IRC Section 318 attribution rules at the level of the private equity fund partners would satisfy the requirements for treatment as a single CFC group).

As highlighted in the recent New York State Bar Association Tax Section's Report No. 1441 (Sept. 29, 2020), pages 37-43, this approach fosters the policy objective of requiring the affected US taxpayers (namely, the US shareholders, as defined in IRC section 951(b)) to take a consistent position in respect of the GILTI HTE and Subpart F HTE.

To prevent manipulation, this rule could be limited by an anti-abuse rule that reinstates downward attribution from a partnership under IRC Section 318(a)(3)(C) in cases in which the corporations owned by the partnership are not engaged in separate trades or businesses. This would prevent partnerships from intentionally breaking up a CFC group engaged in an integrated business, while narrowing the scope of the existing consistency rule so that it only applies in situations where Treasury's policy concerns regarding cross-crediting are present. Treasury and the IRS could craft an anti-abuse rule based on the standards applied in Treas. Reg. §1.446-1(d) and the guidance thereunder as discussed above (or in other relevant provisions), adjusted as appropriate for this context, or other criteria that Treasury and the IRS deem appropriate. Thus, as applied here, an anti-abuse rule could reinstate downward attribution from partnerships if two or more corporations owned by the partnership would not constitute separate and distinct businesses if treated as a single corporate entity.

As under our other suggested approaches, this approach could also include an additional anti-abuse rule, whereby two portfolio companies would be required to be make consistent GILTI HTE and Subpart F HTE elections for their CFCs if a principal purpose for one or more of those CFCs to be owned by a particular portfolio company (rather than the other) is to enhance the utilization of foreign tax credits by avoiding the application of the consistency rule.

We recognize that Treasury may wish to consider other approaches in order to ensure the consistency requirement achieves its stated policy intent, which could also include leveraging existing provisions or concepts in the Code and regulations.⁴ We would be happy to provide further analysis on any of the alternatives outlined above. We would also be happy to consider modifications or alternative approaches that would meet Treasury's policy objectives without requiring separately-managed portfolio companies owned by a private equity fund partnership to be subject to the consistency requirement.

* * * * *

Brenda Zent
Special Adviser
Department of the Treasury

Peter Blessing
Associate Chief Counsel (International)
Internal Revenue Service

Daniel McCall
Deputy Associate Chief Counsel (International — Technical)
Internal Revenue Service

John Merrick
Senior Level Counsel, Office of Associate Chief Counsel (International)
Internal Revenue Service

Melinda Harvey
Branch Chief — Branch 2, Office of Associate Chief Counsel (International)
Internal Revenue Service