Company Supplements Comments on Expense Apportionment to GILTI

April 23, 2018

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

The Honorable David J. Kautter
Acting Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable William M. Paul
Principal Deputy Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

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

Douglas L. Poms
International Tax Counsel
Department of the Treasury

Re: Request for Guidance on Expense Apportionment to Global Intangible Low-Taxed Income

Dear Sirs:

We submitted on April 4, 2018 a request for guidance with respect to the apportionment of certain expenses to global intangible low-taxed income (“GILTI”) for purposes of the foreign tax credit limitation under section 904(a). We wish to supplement that submission in order to examine in a bit more depth two issues pertinent to the requested guidance. Both issues are addressed in the initial submission, but we think it would be useful to expand the discussion.

The two supplementary considerations we wish to address are:

I. GILTI as a Special Purpose Anti-Income Shifting Regime Separate from the General “Territorial” Exemption System

Allocation of taxing jurisdiction between residence and source countries has, since 1918,¹ been effected by one of two methods:

This alternative approach has been generally accepted by the principal developed countries that account for a very large proportion of cross border trade and investment in the global economy.² From 1916 until 2017, the United States applied the worldwide system and from 1918 allowed a foreign tax credit against its “residence country” tax on foreign source income. Such foreign source income included not only dividends from after tax income of foreign subsidiaries,³ but also other foreign source income often subject to low or no foreign tax, such as interest, rents, royalties and income from foreign sales of goods and services. Interest and royalties are commonly deductible by the payer in the source country, but under the old system, excess credits from dividends could offset U.S. residence country tax on such items of foreign source income. The ability of a U.S. corporate taxpayer to reduce its U.S. tax otherwise due by such excess foreign taxes associated with dividends was frequently referred to as “cross-crediting.”⁴

In recent years, the United States began to examine the possibility of moving to, or at least towards, a territorial system. In 2005 the Staff of the Joint Committee on Taxation produced the Options Report. That same year, an Advisory Panel appointed by President Bush also rendered a report on tax reform alternatives and included a discussion of the considerations that adopting a territorial system would entail.

In important part, the considerations described in both Reports were:

In 2011 and 2014 another exercise in tax reform study produced the “Camp proposals.”⁵ The Camp proposals addressed expense disallowance (consideration 3) in part by proposing a proxy “excess leverage” test in lieu of specific tracing (or arbitrary formulary apportionment) of expenses that would be disallowed as deductions. The “French model” was also discussed by tax policy enthusiasts: in lieu of allocation and apportionment to exempt income, rough justice could be accomplished by reducing the exemption percentage from 100 percent to 95 percent (or some other percentage meeting the test of substantial equivalence in the eye of the beholder).⁶

The Act built upon these discussions that date back at least to 2005. In conceptual framework, the Act comprised most importantly the adoption of a dividend exemption system, including the repeal of the worldwide/foreign tax credit regime that allowed cross crediting of high foreign taxes against low taxed foreign income.⁷ Thus, it

Unlike the Options Report, Bush Panel and Camp proposals, however, no measure in the Act was explicitly aimed at denying expenses that might actually or constructively be deemed to be incurred to generate exempt income.

The Act did, however, replace former section 163(j) with a new and much broader section 163(j) that establishes a substantial reduction in all interest expense deductions. That comprehensive reduction at least very substantially reduces, or perhaps even eliminates, the perceived problem associated with allowing deductions for interest expense associated with an actual or deemed leveraged investment in an asset producing tax exempt income.

The territorial system after enactment of new section 245A, the repeal of section 902, and the reduction in deductibility of interest, leaves intact, and without any possibility of cross crediting, U.S. residence country tax on other kinds of foreign source income:

Thus, the elimination of cross crediting for foreign taxes imposed on foreign corporations operating in high taxed jurisdictions is a fundamental component of all proposals for a territorial system. The Act achieved that goal in enacting 245A and repealing section 902. In addition, the lockout problem, with respect to earnings accumulated abroad by foreign affiliates paying low or no foreign taxes was also achieved by enactment of section 245A. This is the low-taxed income leg of the territoriality “stool” in the ongoing discussions of the benefits of a territoriality system. Moreover, a rough proxy for a Camp-style approach to leveraged investments in exempt territorial stock is provided by amended section 163(j).

Viewed in this context, section 951A was not enacted in order to override surreptitiously the adoption of the territorial system established by section 245A and the repeal of section 902. It was, instead, adopted in order to deal with a targeted problem described by the Senate Budget Committee: the risk that adopting the exemption system established by section 245A would result in tax-driven investment decisions to locate direct investment in low tax foreign countries rather than in the United States.⁹

That narrow problem is not present in investments in countries having an effective rate in excess of a rate determined by Congress to be at or below a threshold that would affect direct investment location decisions: 13.125 percent. Nothing in the history of section 951A, or the extended discussion since 2005, would suggest that section 951A was adopted as some sort of stealth measure to eliminate deferral and to end the foreign tax credit, rather than what the drafters said they were doing: avoiding an incentive to invest in low tax foreign direct investment that might otherwise be made in domestic production facilities.

In order to carry out that purpose, and to preserve the integrity of the other territorial provisions of the Act, shareholder expenses, inherently excluded from the tax base of the relevant foreign country, cannot properly be allocated against GILTI. It is the foreign taxes that GILTI was intended to measure. The use of a modified foreign tax credit mechanism to implement that regime was presumably only intended to ensure that there would be no incremental U.S. tax on GILTI subjected to foreign taxes at or above 13.125 percent.

In addition, as our initial request for guidance explains, GILTI was enacted as part of a package with FDII to neutralize taxation as a motive for choosing the location of assets and activities that produce high-profit income. The GILTI effective rate was intended to align with the FDII effective rate on the same type of income. For FDII, any U.S. expenses of a type that would be apportionable and that could conceptually be viewed as driven in part by the FDII activity will produce a deduction at the normal 21 percent U.S. rate, while the FDII gross income is taxed at a reduced 13.125 percent effective rate. In order to tax-neutralize location decisions with regard to both the high-profit income and the apportionable supportive costs, the same treatment must apply to GILTI (subject to higher taxation if the source countries choose to impose tax at an effective rate above 13.125 percent). This prevents the FDII provisions from providing a tax location subsidy, as opposed to merely eliminating a tax distortion.

II. Coordination Between Section 864(e)(3) and Section 904(b)(4)

Inasmuch as section 951A is a special purpose exception to the comprehensive territorial approach, section 864(e)(3) authority should be exercised to ensure that interest and other expenses incurred by the United States shareholder are not taken into account in calculating the available foreign tax credit for foreign taxes on GILTI. As discussed in the initial submission, the reference to apportionment to section 951A(a) in section 904(b)(4)(B) does not mean that Congress intended that pre-Act expense apportionment applies to section 951A(a).

There are two possible approaches to sequencing the application of section 904(b)(4) and section 864(e)(3). As discussed further below, section 904(b)(4) suggests that section 864(e)(3) should be applied before section 904(b)(4). However, if the sequencing were reversed, and section 904(b)(4) were applied before section 864(e)(3), that result would also not be inconsistent with the guidance requested in the initial submission.

The Act added section 904(b)(4),¹⁰ which states:

Thus, section 904(b)(4) provides that, for purposes of section 904(a), the U.S. shareholder's taxable income is determined without regard to the amounts described in section 904(b)(4)(A) and (B).

In terms of sequencing, the statutory language suggests that section 864(e) is applied before section 904(b)(4). That is, the reference to “properly allocable or apportioned” deductions in section 904(b)(4) suggest that existing apportionment rules, including the exempt asset rules, apply to determine what is “properly” apportioned, and then the U.S. shareholder's taxable income is determined without regard to the amounts set forth in section 904(b)(4)(A) and (B). This is based on the logic that taxable income is determined after properly allocable and apportioned deductions are determined. See e.g., section 863(b).

However, if Treasury and the Service were to determine that the sequence should be different, and that section 904(b)(4) should apply before section 864(e)(3), that sequence would not be inconsistent with the proposed guidance requested in the initial submission to treat GILTI as exempt income under Treas. Reg. § 1.861-8T(d)(2). More specifically, if Treasury and the Service were to decide that the sequence should be as follows, that sequence would be compatible with the guidance requested: (1) application of expense apportionment, but not treat GILTI as exempt income, (2) application of section 904(b)(4), and (3) application of expense apportionment treating GILTI as exempt income.

The difference between the sequencing approaches described below is illustrated in the following examples. Assume a U.S. shareholder has $1,000 of apportionable deduction and basis of $400 in domestic assets, basis of $100 in foreign branch assets, basis of $100 in the stock of a CFC that generates subpart F income, basis of $200 in the stock of a CFC that generates GILTI, and basis of $200 in the stock of a CFC that generates section 245A income. Based on these assumed facts, apportionment with section 864(e)(3) applying first is shown as well as an alternative apportionment sequence with section 904(b)(4) applying first.

	Domestic	Foreign Branch	CFC SubF	CFC GILTI	CFC 245A	Total
Assets	$400	$100	$100	$200	$200	$1,000
Section 864(e)(3) first
(1) Existing apportionment rules and treat GILTI as exempt income	$500	$125	$125	$-	$250	$1,000
(2) Section 904(b)(4)					$(250)	$(250)
Final apportionment	$500	$125	$125	$-	$-	$ 750
Section 904(b)(4) first
(1) Existing apportionment rules but not treat GILTI as exempt income	$400	$100	$100	$200	$200	$1,000
(2) Section 904(b)(4)					$(200)	$(200)
(3) Treat GILTI as exempt income	$533	$133	$133	$-	$-	$800
Final apportionment	$533	$133	$133	$-	$-	$800

In any case, regardless of the sequence, the following two points hold: As noted in the initial submission, the fact that Congress did not elect to take the approach set forth in section 904(b)(4) with regard to section 951A does not raise any inference that Congress intended to preclude for GILTI the same treatment traditionally accorded to exempt income. In addition, as noted in the initial submission, by excluding deductions properly allocable or apportioned to GILTI, but not specifying how the excluded deductions would be treated, Congress entrusted Treasury with interpreting the approach most suitable for GILTI. There is no need to enact corrective legislation if Treasury applies section 864(e) to carry out the purposes specific to the use of a foreign tax credit mechanism to ensure that the United States shareholder not incur incremental United States tax on foreign affiliate income subjected to foreign income of at least 13.125 percent.

We appreciate your consideration of our request and we would be happy to discuss with you either in person or by telephone.

Respectfully submitted,

Illinois Tool Works Inc.

By: Kathleen Danakis
Vice President Global Tax
Illinois Tools Works, Inc.
Glenview, IL

Counsel:
Robert H. Dilworth (202) 747 0344
Matthew A. Lykken (630) 244 2751