News Analysis: Tax Cuts Chaos

In 1864 General William Tecumseh Sherman’s army marched from Atlanta to Savannah, carrying out a scorched-earth campaign that eviscerated much of the landscape along the way. The Tax Cuts and Jobs Act (P.L. 115-97) is having a similar effect on large areas of the U.S. international tax regime. It has wreaked havoc by layering new concepts on old, and the two don’t mesh well. Whether Treasury and the IRS will be able to use regulatory guidance to restore a system that was already a wobbly house of cards is unclear.

Legislative Purpose and GILTI

According to Republican lawmakers, the TCJA was intended to promote economic growth, increase jobs, and level the global playing field for U.S. multinationals. In December House Ways and Means Chair Kevin Brady, R-Texas, said the act would “create more opportunities for workers to find that next new job, earn that long-overdue raise, and get ahead” and revitalize the U.S. economy “so American businesses can once again compete and win anywhere in the world.”

The legislative history behind new section 951A, the global intangible low-taxed income (GILTI) provision that imposes current taxation of most of the earnings of foreign subsidiaries of U.S. companies, is sparse. In their statements about the international tax changes in the TCJA, lawmakers have been mostly silent about a minimum tax on foreign earnings, instead touting the benefits of the supposed transition to a territorial system.

One of the few references to the adoption of a minimum tax on foreign earnings appears in Treasury’s unified framework for tax reform released last September, in which Republican leadership promised to end “the perverse incentive to keep foreign profits offshore by exempting them when they are repatriated to the United States.” It said that “to prevent companies from shifting profits to tax havens, the framework includes rules to protect the U.S. tax base by taxing at a reduced rate and on a global basis the foreign profits of U.S. multinational corporations.”

Also relevant to the legislative intent behind section 951A is an excerpt from the final conference report:

The September 2017 framework is one of only a few sources that connect the idea of a minimum tax on foreign earnings with the conference report’s explanation of the intent of sections 951A and 250 (providing the associated deduction).

The Foreign Tax Credit

Broadly speaking, the foreign tax credit — enacted in 1918 — is intended to make U.S. taxpayers neutral in their decisions whether to invest in the United States or overseas. That foreign taxes paid by a U.S. person or its 10-percent-owned subsidiaries should be creditable against U.S. taxes owed on the same income is a basic principle of the U.S. international tax system. Daniel Shaviro of the New York University School of Law has suggested that “foreign tax creditability is virtually on a par with the idea that ordinary business expenses must generally be deductible, so that income taxes will fall on net rather than gross income” (see generally “The Case Against Foreign Tax Credits,” NYU Law P.L. Research Paper No. 10-12 (Mar. 2010)).

But throughout the past century, lawmakers have remained concerned that taxpayers could use the FTC to offset U.S. taxes that were otherwise due on U.S.-source income or engage in cross-crediting of taxes incurred in high-tax jurisdictions against income earned in low-tax jurisdictions. The Tax Reform Act of 1986 reflected that concern by enacting section 904(d), which created separate baskets of income that limit the FTC according to those categories.

Since 1986, the rules to limit taxpayer ability to access the FTC have become extremely complex, and Congress has regularly tinkered with them. Periodic amendments to the code and numerous regulatory rewrites have sought to prevent FTC planning perceived as abusive. In just the last decade, Congress has enacted section 901(m) to prevent FTC planning associated with acquisitions of foreign stock and section 909 to prevent FTC splitter transactions, while the IRS and Treasury have been even busier, promulgating multiple regulatory iterations to prevent FTC planning in structured transactions.

Added to the ordinary complexity of government rules to prevent taxpayers from using foreign taxes paid to annually offset U.S. tax liabilities on U.S.-source income are rules to prevent cross-crediting over multiple years. The overall foreign loss rules of section 904(f), along with the separate limitation loss rules in that section, require taxpayers that have incurred an overall foreign loss (or its counterpart, an overall domestic loss) to track those amounts.

Much of the complexity of the FTC system stems from the fact that the credit limitation requires a computation of net foreign-source income, which means that an affiliated group’s deductions must be allocated between U.S.- and foreign-source income, as well as to the different categories of income in section 904(d). The most important expense allocation rules in the section 861 regulations (that allocate interest expense) generally operate to allocate expenses based on assets, which are categorized according to the types of income they produce. Those regulations have also been revised numerous times, with several versions — including some proposed as far back as the 1980s — never being finalized. Here, the look-through rules of section 904(d)(3), which mandate looking through specific items of income paid by a controlled foreign corporation to determine which basket they belong in, are relevant. In allocating interest, the regulations generally treat money as fungible.

Before the enactment of the TCJA, the rules governing taxpayer use of FTCs were complicated and represented a constant tug of war between the government and taxpayers. But at least they were built on concepts around which a common understanding had emerged. The new law has thrown all of that into turmoil.

FTC Chaos Unleashed

In amending many international provisions of the Internal Revenue Code, the TCJA mostly layers new law on top of old, rather than performing a rewrite. In some places the layering leaves gaping holes, and in others, it creates a jumbled mess. In the FTC area, the TCJA has wreaked havoc many ways, largely because the inclusion required by new section 951A has been designated a separate category, or basket, under the section 904(d) FTC limitation rules, while at the same time disallowing a carryforward or carryback for taxes in that basket.

The GILTI inclusion (enacted as part of subpart F of the code) and its associated FTC — allowable under section 960 (the provision that also allows a credit for foreign taxes attributable to subpart F income inclusions) — is in theory based on subpart F and pre-2018 FTC rules. But the inclusion required by new section 951A and the associated deduction allowable under section 250 are different enough from the rules of the pre-2018 system to make attempts to tie the two together often unworkable.

Entity vs. Shareholder

Section 951A requires inclusion of a U.S. shareholder’s GILTI for a tax year. By definition, GILTI is a shareholder-level concept, unlike subpart F income, which is a CFC-level concept. Calculating a U.S. person’s GILTI first requires the aggregation of the net tested income of all a U.S. shareholder’s CFCs with tested income (in excess of those CFCs with tested loss). That distinction has several important ripple effects when applying the section 904 limitation and accompanying regulations to the foreign taxes attributable to GILTI. It also has implications for applying section 960.

Basketing

Congress made the GILTI inclusion different from section 952 subpart F income by requiring it to be a shareholder-level calculation (rather than simply another category of subpart F income). But it also shoehorned it into preexisting FTC limitation rules by declaring in section 904 that the provisions of sections 901 and 960 should be applied separately for income that must be included under section 951A.

An arguable implication of including a reference to GILTI as a separate category of income under section 904(d) is that all relevant rules for section 904(d) basketing of income — such as the section 904(d)(3) look-through rules, the overall foreign loss rules of section 904(f), the overall domestic loss rules of section 904(g), the separate limitation loss rules in section 904(f)(5), and the expense allocation and apportionment rules in the section 861 regulations — also apply to taxes creditable under section 960 as a result of inclusion in section 951A. But none of those rules fit into a regime in which a category of income is determined at the shareholder, rather than the entity, level.

Carryforwards and Pooling

Much of the FTC’s complexity results from the assumption that FTCs a U.S. person can’t fully use in a given year may be carried forward. For example, the overall foreign loss limitation rules of section 904(f) are based on the concept that benefits to a taxpayer from the availability of FTCs should be smoothed out over multiple years. That kind of logic is relevant only when FTCs can be carried forward.

But FTCs that are attributable to income includable under section 951A are available to taxpayers only in the year of inclusion. The reason for disallowing the carryforward for credits associated with GILTI was presumably to minimize FTC planning opportunities. But disallowing a carryforward for a credit for GILTI taxes, while at the same time defining GILTI as a separate section 904(d) basket, makes for an uneasy mismatch. The fundamental paradigm for the overall foreign loss, the overall domestic loss, and the separate limitation loss rules can’t be reconciled with the notion that most foreign-source income of CFCs has already been included in income by U.S. shareholders, with the FTCs associated with that income no longer available after the year of inclusion.

Allocation and Apportionment

The rules that require allocating deductions among types of income also don’t work well under the new regime. While those rules seem to require a separate allocation of deductions to GILTI (section 861 regulations specifically refer to section 904(d) separate limitation categories), the discrepancy between GILTI being a shareholder-level calculation and the expense apportionment rules that imply that a category of income is determinable at the entity level. It’s a mystery how one can apportion an item of deduction to a category of gross income when the amount of that category of income can be determined only at the shareholder level, when the calculation assumes assets can be categorized based on the type of income they produce at the entity level (reg. section 1.861-12T).

Assets and Income

The interest expense allocation rules found in reg. section 1.861-9T generally require apportionment of interest expense based on an asset method: Assets are categorized based on the type of income they generate. But GILTI isn’t derived from assets that generate income at a CFC level. At the CFC level, the only type of income generated is net tested income. There’s no apparent way to reconcile the allocation required by the regulations with the statutory definition of GILTI.

Under the asset method of interest expense allocation in reg. section 1.861-9T(g), assets are characterized according to the income they generate, have generated, or may reasonably be expected to generate. At a March 22 luncheon sponsored by the International Tax Institute in New York, Leland Cleland of EY pointed out that assets may generate GILTI in 2018 that historically did not. Absent clarification, taxpayers would rely on the regulatory language to argue that a large portion of their assets shouldn’t be deemed to generate income in the GILTI category, resulting in allocations that allowed more credits against GILTI, which presumably will now be the largest category of CFC income.

CFCs can choose a modified gross income method, rather than an asset method, to apportion interest expense under reg. section 1.861-9T(j). Those rules require a CFC to allocate interest expense based on gross income. Here again, because GILTI is a shareholder-level calculation, the interest expense allocation rules can’t really apply to allocate interest expense at the CFC level.

Gross-Ups

Section 78 provides that if a taxpayer chooses to claim an FTC for a tax year, an amount equal to the taxes deemed paid under section 960 is generally treated as a dividend. If the section 78 gross-up is eligible for look-through as a dividend, the dividend arguably should be allocated to a basket based on the type of income generated in the hands of the CFC to which its earnings are attributable. But because GILTI is a U.S. shareholder-level account, income can’t be categorized as GILTI at the CFC level. That might mean that the section 78 gross-up income could never be allocated to the GILTI basket, potentially reducing taxpayer ability to credit taxes paid by high-taxed CFCs with net tested income.

Marjorie Rollinson, IRS associate chief counsel (international), has suggested that there are good policy reasons for the IRS to write a rule that would essentially apply look-through treatment to the section 78 gross-up that accompanies a GILTI inclusion. But in the absence of guidance, many accounting firms have taken the position that the gross-up associated with a GILTI inclusion belongs in the general (section 904(d)(1)(D)) income basket. When the law is uncertain, auditing firms often become the legal arbiters; the lack of clarity has prompted some attorneys to file a request for expedited guidance.

Circularity

The TCJA has sent financial institutions with foreign branches into a seemingly endless loop when calculating the FTC. The circularity arises because, along with GILTI, section 904(d) created a new category of income known as foreign branch income, defined as any branch income other than passive income. Generally, interest income is passive and therefore excluded from the definition of foreign branch income. But interest income earned by a financial services business is generally recharacterized as general basket income. Recharacterizing that item of income as general basket income returns the taxpayer to the branch income definition.

While the question of what basket the section 78 gross-up belongs in arguably requires IRS clarification, the circularity problem is written into the statute without apparent room for the government to act to rectify it.

Foreign Tax Redeterminations

Like the IRS, foreign tax administrations adjust taxpayer income after returns have been filed. Congress long struggled with how to allow taxpayers to adjust their U.S. tax returns to reflect those foreign tax adjustments, and in 1986 it specified that U.S. shareholders generally shouldn’t reflect a foreign tax redetermination of their CFCs by retroactively recomputing their U.S. tax liabilities. Instead, under section 905(c), a foreign tax redetermination generally was taken into account through prospective adjustments to a CFC’s pools of foreign taxes and earnings and profits. That rule made sense in a section 902 world, based on a concept of tax pools relevant for future dividends. It doesn’t work in a world where most CFC income is includable in U.S. taxable income under section 951A and foreign taxes attributable to that income are creditable only in the year of the inclusion.

Under amended section 905(c), taxpayers must take into account foreign taxes resulting from a foreign tax redetermination in the year to which those taxes relate. That raises a question whether foreign tax redeterminations attributable to income originally included as GILTI simply disappear.

Conclusion

The TCJA changes to U.S. international tax rules contain many flaws, and including GILTI as a separate category of income under section 904(d) while disallowing the carryforward is among the worst. It could be argued that the drafting implies that section 904 should be incorporated into the interpretation of section 951A. But the myriad challenges inherent in reconciling sections 904 and 951A could also suggest that Congress was unaware of the mess it was making when it tried to fit a section 904 limitation concept that applied at an entity level to a shareholder-level characterization of income.

If one makes the reasonable assumption that Congress didn’t think through all the glitches involved in adapting a shareholder-level calculation to an entity-level principle, it’s no longer imperative to try to mold existing expense allocation rules to taxes attributable to GILTI inclusions. The problems that appear when one tries to make the new pieces of the code fit together suggest the government is well-positioned to base any regulations on the conference report language that the GILTI tax should subject U.S. taxpayers to a maximum rate of 13.125 percent on foreign earnings.

Another alternative is for the government to rewrite many of the section 904 regulations as well as the section 861 expense allocation regs — rules that have taken 30 years to figure out how to draft — imperfectly.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, director of its International Tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu