Final regs issued in July under section 951A contain guidance on how to make an election to apply the section 954(b)(4) high-tax exception to global intangible low-taxed income. Proposed regs issued the same day under section 954 generally conform the subpart F high-tax election to the GILTI high-tax election.
They also modify the GILTI final regs by adding income groupings and changing deduction allocation and apportionment rules when calculating the effective foreign tax rate (EFTR). The new proposed section 954 regs call for withdrawal of the new section 951A regs when the proposed regs are finalized.
The GILTI high-tax election rules and examples are in final reg. section 1.951A-2(c)(7) and (8), while the GILTI and subpart F integrated rules and examples are in prop. reg. 1.954-1(d)(1)-(9).
The GILTI final regs (T.D. 9902) are the subject of four previous articles that focused on the tested unit concept, disregarded payments, interest expense deductions, and timing and manner of electing the high-tax exclusion. (Prior coverage: Tax Notes Int’l, Sept. 14, 2020, p. 1421; Tax Notes Int’l, Sept. 21, 2020, p. 1541; Tax Notes Int’l, Sept. 28, 2020, p. 1673; and Tax Notes Int’l, Oct. 5, 2020, p. 7.)
The new proposed regs (REG-127732-19) contain guidance on the treatment of income subject to a high rate of foreign tax under the subpart F income and GILTI regimes. Historically, reg. section 1.954-1(d) has implemented the section 954(b)(4) subpart F high-tax exception; and the new proposed regs relating to the high-tax exception for both regimes are in new prop. reg. 1.954-1(d).
Section 954(b)(4) allows the exclusion of a controlled foreign corporation’s high-tax income items from foreign base company income (FBCI) and insurance income, or subpart F income. The subpart F high-tax exception is generally governed by regs originally issued in 1988 and updated in 1995. As part of the Tax Cuts and Jobs Act, Congress enacted the section 951A GILTI regime, incorporating the section 954(b)(4) high-tax exception.
Subpart F high-tax regs and the new GILTI final regs each contain guidance for high-tax income that would otherwise be included in subpart F or tested income, but these rules do not conform to each other. The proposed regs integrate these two high-tax exclusions and provide a single election to exclude high-tax income under section 954(b)(4) for both GILTI and subpart F purposes.
The new proposed regs carry over GILTI high-tax provisions to subpart F income, but also modify some of the new GILTI provisions. The proposed regs:
provide a single high-tax election for both subpart F and GILTI;
include the GILTI regs’ CFC group rules in lieu of a separate election for each CFC;
require that the GILTI regs’ determination of whether income is high tax be made on a tested unit basis;
simplify the EFTR determination with new rules grouping together some income that would otherwise be subpart F and tested income;
introduce a new method for allocating and apportioning deductions to gross income;
include the GILTI regs’ per country tested unit combination rule and introduce a new de minimis tested unit combination rule;
introduce a new antiabuse rule;
replace the GILTI regs’ reference to books and records with a new reference to applicable financial statements and add substantiation requirements; and
introduce new coordination rules and modify full inclusion rules.
This article is the first in a series addressing how the new proposed regs change the high-tax election rules for both GILTI and subpart F income. It will focus on the new income groupings and the new deduction allocation and apportionment rules that modify how the GILTI regs calculate the EFTR inputs.
Prop. reg. section 1.954-1(d)(1)(i) provides the general rule warranting the guidance in paragraphs (2)-(9). It is conceptually identical to the GILTI final regs, although it replaces “tentative tested gross income” in the GILTI regs with “item of gross income” and “tentative tested income” with “tentative net item.” A CFC’s inclusion year item of gross income qualifies for the high-tax exception described in section 954(b)(4) only if two requirements are met:
a CFC election to apply the high-tax exception must be in effect in the CFC inclusion year; and
the tentative net item related to the item of gross income must be subject to an effective rate of foreign tax that is greater than 90 percent of the section 11 maximum tax rate (18.9 percent, or 90 percent of 21 percent).
High-Tax Income Exception
Section 952(a)(2) defines subpart F income to include FBCI as defined in section 954. Section 954(b)(4) and 951A provide an exception to FBCI and tested income for some income subject to high foreign taxes, and these provisions are restated in reg. section 1.954-1(d) — that is, FBCI and tested income do not include a CFC’s income if the income was subject to an effective rate of foreign income tax greater than 90 percent of the maximum rate of tax specified in section 11.
The rules for determining whether the high-tax exception applies to CFC income consist of a seven-step calculation in reg. section 1.954-1(d):
calculate items of gross income (instead of tentative gross tested income items);
assign expenses other than foreign income tax to items of gross income;
assign foreign income tax expenses to items of gross income;
determine tentative net items (instead of tentative tested income);
calculate foreign income tax paid or accrued on tentative net items;
calculate the EFTR for each tentative net item; and
compare the EFTR with the 18.9 percent threshold to determine whether each item of gross income qualifies for the high-tax exception.
The EFTR equals the U.S. dollar amount of foreign income tax related to the tentative net item divided by the sum of the tentative net item and the foreign tax.
Income Groupings
In defining an item of gross income, the new proposed regs introduce three new income groupings in section 1.954-1(d)(1)(ii). An item of gross income is defined as one of three possibilities in prop. reg. section 1.953-1(d)(1)(ii)(A)-(C):
a general gross item;
an equity gross item; or
a passive gross item.
The first possibility, a general gross item, is the aggregate amount of all gross income without regard to items in section 952(c)(2) (income recharacterized as subpart F income) that is attributable to a single tested unit and has four characteristics:
it is in a single separate section 904 foreign tax credit limitation category;
it is not an equity gross item;
it is not passive foreign personal holding company income; and
it is of a type that would be treated as gross tested income, gross FBCI, or gross insurance income without regard to the high-tax exception.
The second possibility, an equity gross item, is the sum of general gross items (without regard to the above second characteristic) that has one of two characteristics:
it is income or gain arising from stock; or
it is income or gain arising from interests in passthrough entities.
Income or gain arising from stock consists of dividends, income from dispositions of stock, and similar items earned by a tested unit and subject to preferential tax treatment under the tax law of the tested unit’s residence country. Preferential tax treatment does not include FTCs. Equity gross income does not include gain from stock dispositions if the stock would be dealer property.
Income or gain arising from interests in passthrough entities is gain from the disposition of, or a distribution related to, an interest in a passthrough entity (including a disregarded entity) attributable to a tested unit and subject to preferential tax treatment under the tax laws of the tested unit’s tax residence. Again, preferential tax treatment does not include FTCs.
The third possibility, a passive gross income item, is the sum of general gross items (without regard to the third characteristic) that constitutes a single item of passive foreign personal holding company income described in prop. reg. section 1.954-1(c)(1)(iii)(B).
Under prop. reg. section 1.954-1(d)(1)(iii)(A), a CFC’s gross income is attributable to a tested unit to the extent that it is reflected (as modified for disregarded payment adjustments) on the tested unit’s applicable financial statement (not separate books and records as in the GILTI regs). All CFC gross income is attributable to only one tested unit. alice
The principles of reg. section 1.904-4(f)(2)(vi) apply to adjust a tested unit’s gross income to reflect disregarded payments taking into account the rules in prop. reg. section 1.954-1(d)(1)(iii)(B)(1)-(5) . These rules basically mirror the disregarded payment rules in the GILTI high-tax exception final regs.
Rationale
Under reg. section 1.954-1(d), the EFTR is determined on the basis of a CFC’s net FBCI. Single items of income to be tested for high-tax exception eligibility are aggregated. For example, the aggregate amount of a CFC’s income from dividends, interest, rents, royalties, and some annuities constitute a single item of income.
In contrast, the GILTI final regs determine EFTR by aggregating gross income that would be gross tested income within a separate category to the extent attributable to a CFC’s tested unit. The tentative tested income items and foreign taxes of multiple tested units that are tax residents of or located in the same foreign country generally are aggregated.
Applying these rules on a tested unit basis ensures that high-tax and low-tax income items are not inappropriately aggregated to determine the EFTR, while still allowing some level of aggregation to minimize complexity. Also, measuring the EFTR on a tested unit basis reflects the likelihood that CFCs will earn more high-tax income given the TCJA’s reduction of corporate federal income tax rates.
The proposed regs calculate the EFTR for both the GILTI exclusion and the subpart F exception on a tested unit basis. The proposed regs also group general-category income items that would otherwise be tested income, FBCI, or insurance income. By grouping these income items, taxpayers avoid the complex analysis required to determine whether income would meet the definition of subpart F income. For example, taxpayers will not be required to determine whether income is foreign-based company sales income versus tested income if the high-tax exception applies.
The proposed regs generally group foreign personal holding company income in the same manner as the existing regs. Future regs may propose conforming changes to the income grouping rules in reg. section 1.904-4(c) and request comments.
Income and deductions attributable to equity transactions are also separately grouped if the income is subject to preferential tax treatment in the tested unit’s tax-resident country. The purpose of this grouping is to separately test for high-tax eligibility income that is subject to foreign tax at a different rate than other general-category income and that is susceptible to timing manipulation.
Under current subpart F regs, EFTRs are determined separately for several different income categories, requiring taxpayers to classify their income items into these categories when making a high-tax election. Moreover, the GILTI final regs require taxpayers to determine whether their income would otherwise qualify as tested income. Both processes require complex factual analysis. The proposed regs, however, modify the income categories to simplify the EFTR determination.
The proposed regs group together income that would otherwise qualify as subpart F or tested income to determine if it is high tax and eligible for the exception. This grouping of income types may eliminate the need for taxpayers to determine to which category an income item belongs. For example, under current regs, the taxpayer may need to determine whether income is foreign base company sales income or tested income. Under the proposed regs, taxpayers can avoid this analysis because the income would fall into the new broader category that includes both foreign base company sales income and tested income.
The proposed regs will also decrease incentives for taxpayers to organize their operations solely to ensure that income will fall into a specific category. For example, taxpayers may have an incentive to generate sales rather than services income to raise or lower the EFTR in those FBCI categories. By manipulating the EFTR of income categories, taxpayers could maximize their tax savings from the high-tax exception. Under the proposed regs, these incentives are diminished since income items are grouped into broader categories.
Deduction Allocation and Apportionment
Reg. section 1.954-1(d)(1)(iv)(A)-(D) contain rules for deduction allocation and apportionment. In general, a tentative net item is an item of gross income in one of the three above groupings determined by allocating and apportioning deductions to items of gross income under principles of reg. section 1.960-1(d)(3). Each item of gross income is treated as gross income in a separate income group, and all other income is treated as assigned to a residual income group.
Deductions (other than taxes) are attributable to a tested unit if they are reflected on its applicable financial statement. In applying the principles of reg. section 1.960-1(d)(3), deductions attributable to a tested unit are allocated and apportioned based on the income and activities related to the expense, but only reduce items of gross income attributable to the same tested unit (including income attributed to the tested unit because of disregarded payments and regardless of whether the tested unit has gross income in the relevant income group during the CFC inclusion year).
In applying reg. section 1.861-9 and -9T, interest deductions attributed to a tested unit are allocated and apportioned only on the basis of the income or assets of that tested unit. No interest deductions attributable to the tested unit are allocated or apportioned to the assets or gross income of another tested unit, or of a corporation owned by the CFC indirectly through the tested unit.
If a tested unit has a loss or deduction (including for taxes) on a transaction involving stock or an interest in a passthrough entity, and income or gain would have been an equity gross item, the deduction or loss is allocated and apportioned solely to the item of gross income relating to the tested unit, regardless of whether there is any gross income included in that item during the CFC inclusion year.
The proposed regs contain guidance on the effect of a potential or actual change in taxes paid or accrued. The amount of current-year tax paid in relation to an item of gross income generally does not take into account any potential reduction in foreign income tax that may occur because of a future distribution to shareholders of all or part of the income. However, to the extent the CFC’s foreign taxes are reasonably certain to be returned to a shareholder by the foreign country on a subsequent distribution to the shareholder, the foreign taxes are not treated as paid or accrued under prop. reg. section 1.954-1(d)(1)(iv) or 1.954-1(d)(5).
Foreign income taxes that have not been paid or accrued because they are contingent on a future distribution of earnings are also not taken into account. If a redetermination of U.S. tax liability is required to account for the effects of a foreign tax redetermination, reg. section 1.954-1(d)(1)(iv) and (5) are then applied in the adjusted year taking into account the adjusted amount of the redetermined foreign tax.
Reg. section 1.954-1(d)(1)(v) addresses portfolio interest and treatment of some income under the FTC rules. Portfolio interest as defined in section 881(c) does not qualify for the high-tax exception under section 954(b)(4).
For FTC treatment of distributions of passive income that were excluded from FBCI, insurance income or tested income under section 954(b)(4), taxpayers are directed to section 904(d)(3)(E) and reg. section 1.904-4(c)(7)(iii). These rules address FTC treatment of dividends paid out of otherwise passive income that qualified for the high-tax exception, including distributions that cause decreases in foreign tax.
Reg. section 1.954-1(d)(5) addresses foreign income taxes paid or accrued on a tentative net item. This is the amount of the CFC’s current-year taxes allocated and apportioned to the related item of gross income.
Rationale
The TCJA is silent on how to allocate and apportion deductions to gross income for high-tax exception purposes, even though this can affect a tested unit’s EFTR.
Under the final GILTI regs, deductions are allocated and apportioned among separate items of a CFC’s gross income even if the deductions are reflected on the books and records of only one tested unit and are likely only taken into account to compute foreign taxable income for foreign tax purposes in that tested unit’s foreign jurisdiction.
Again, the final GILTI regs use items on the books and records as the starting point for determining gross income attributable to a tested unit. Those regs do not, however, use books and records to allocate and apportion deductions to gross income. Instead, the final regs apply the general allocation and apportionment rules to convert tentative gross tested income items into tentative tested income items.
In other words, deductions are generally allocated and apportioned under the principles of reg. section 1.960-1(d)(3) by treating each tentative gross income item as income in a separate tested income group as defined in reg. section 1.960-1(d)(2)(ii)(C). Under those principles, some deductions (like interest expense) are allocated and apportioned among a CFC’s gross income items based on a specific factor like assets or gross income. The result is that deductions on a single tested unit’s books and records used to compute foreign taxable income may not be the same as those used to determine a tentative tested income item for GILTI high-tax exception purposes.
This result is illustrated by an example in the proposed regs’ preamble. It assumes that a CFC’s only activity is owning interests in TU1 and TU2, two foreign disregarded entities that are both tested units. An equal amount of gross income is attributed to TU1 and TU2. TU1’s and TU2’s income is subject to 30 percent and 15 percent foreign income tax rates, respectively.
TU1 accrues deductible interest expense paid to a third party that is allocated and apportioned to the CFC’s gross income using the modified gross income method in reg. section 1.861-9T(j)(1). This causes interest expense incurred by TU1 to be allocated and apportioned equally between TU1 and TU2 for GILTI high-tax exclusion purposes.
The foreign countries in which TU1 and TU2 are tax resident, however, only allow deductions of interest expense to resident entities that accrue the expense. Therefore, TU1’s residence country allows a deduction for all of the interest expense, while TU2’s residence country does not allow a deduction for any of it. Under the final GILTI regs, the allocation of interest expense for U.S. tax purposes may cause TU1’s gross income to not qualify for the GILTI high-tax exception while causing TU2’s gross income to qualify, even though the tax rate in TU1’s country is higher.
The policy goal of section 954(b)(4) is to identify income subject to a high EFTR. It is better served if the EFTR is determined by reference to income that approximates taxable income as computed for foreign tax purposes rather than U.S. tax purposes. The use of U.S. instead of foreign tax rules to determine the amount and timing of items included in the high-tax exception calculation remains appropriate to ensure that the calculation is not distorted by foreign tax rules that do not conform to U.S. tax principles.
Therefore, the proposed regs generally determine tentative net items by allocating and apportioning deductions to items of gross income under U.S. tax principles to the extent the deductions are reflected on the tested unit’s applicable financial statement. This is consistent with the manner in which gross income is attributed to the tested unit. A tentative net item better approximates the foreign tax base under this method than the allocation and apportionment rules in the section 861 regs.
The proposed regs allocate and apportion deductions to the extent reflected on the appliable financial statement only for section 954(b)(4) high-tax exception purposes and not any other purpose (like determining a CFC’s U.S. taxable income for subpart F or GILTI purposes, or determining its FTCs under section 960). The section 954(b)(4) rules are intended to approximate the foreign tax base, while the subpart F, GILTI, and FTC calculations continue to use the deduction allocation and apportionment rules in the section 861 regs.
Treasury and the IRS are considering whether it would be appropriate in limited cases to allocate and apportion a CFC’s deductions based on the contents of its applicable financial statement, and request comments in this regard. For example, a rule could allocate and apportion deductions (other than foreign tax expense) only up to the amount of a tested unit’s items of gross income and allocate and apportion deductions in excess of that to all of the CFC’s gross income.
Moreover, applying a method based on financial statements to calculate the high-tax exception could affect the allocation and apportionment of deductions to determine the amount of an inclusion related to a CFC’s gross income that is not eligible for the high-tax exception. One approach that addresses this is to provide that deductions allocated and apportioned to an item of gross income based on a financial statement to calculate a tentative net item under the high-tax exception cannot be allocated and apportioned to a different item of gross income that does not qualify for the exception for purposes of calculating a subpart F or GILTI inclusion.
These approaches would be limited changes to the traditional rules for allocating and apportioning deductions. They are intended to address concerns that deductions not allocated and apportioned using a consistent method when the high-tax exception has been elected could be viewed as being double counted. The deductions would reduce tentative net income for purposes of determining eligibility for the high-tax exception, and also reduce the amount of a U.S. shareholder’s subpart F or GILTI inclusions related to a different item of gross income. Comments are requested on this issue.
Examples
Prop. reg. section 1.954-1(d)(9) has six examples, while the GILTI final regs have five examples. The common facts for the examples are identical. The differences in the examples include use of applicable financial statements instead of books and records, item of gross income instead of tentative gross tested income, and tentative net income instead of tentative tested income. Also, the conclusions in the examples speak to the status of the CFCs’ income as FBCI and tested income when comparing the EFTR to the high-tax threshold.
Examples 1 and 2 of the proposed regs address the effect of disregarded interest and the effect of disregarded payments for services, respectively. These illustrate the same concepts as examples 1 and 2 of the GILTI final regs.
Example 3 of the proposed regs addresses application of the tested unit rules and illustrates the same concepts as Example 4 in the GILTI final regs. Similarly, Example 5 in the proposed regs addresses the CFC group rules and mirrors Example 5 in the final GILTI regs.
Examples 4 and 6 of the proposed regs address application of a new de minimis combination rule and a new antiabuse rule, and there is therefore no equivalent in the final GILTI regs. These provisions will be addressed in a future article.
The proposed regs contain no equivalent of Example 3 in the final GILTI regs, which covers interest expense allocated and apportioned to income of a lower-tier CFC. This is because allocation and apportionment of interest expense under the section 861 regs for high-tax purposes was modified in the proposed regs, which offer a closer alignment of income and deductions with the contents of financial statements and therefore the foreign tax base.
Effective Dates
The effective dates of the GILTI final regs are in reg. section 1.951A-7(b). Section 1.951A-2(c)(7) and (8) apply to tax years of CFCs beginning on or after July 23, 2020, and to tax years of U.S. shareholders ending in or with the CFC tax
year-end.
Taxpayers may choose to apply the GILTI rules to tax years that begin after December 31, 2017, and before July 23, 2020, provided they consistently apply the GILTI rules along with rules in the section 954 regs that were finalized with the GILTI regs in T.D. 9902. Those rules align specific GILTI reg provisions with FBCI provisions and have similar effective dates that are set forth in reg. section 1.954-1(h).
The effective dates of the proposed regs are in prop. reg. 1.954-1(h). Prop. reg. section 1.954-1(d) applies to tax years of CFCs beginning on or after the date that final regs are filed for public inspection, and to tax years of U.S. shareholders ending in or with the CFC’s year-end.
The proposed regs recommend that reg. section 1.951A-2(c) be amended by removing paragraphs 1.951A-2(c)(7) and (8), which contain the GILTI high-tax exception rules. As stated in the proposed regs’ preamble, the section 954(b)(4) high-tax exception should apply consistently to all of a CFC’s items of gross income. These proposed regs provide for a single election for purposes of both subpart F income and tested income. As a result, when the proposed regs are adopted as final, the GILTI-specific high-tax exception rules will be withdrawn.