Company Aims to Resolve Problems With GILTI and FDII Regimes

GILTI‐FDII Recapture and Loss Relief Proposal

Hewlett Packard Enterprise

Background

• The purpose of the GILTI provisions is to ensure a minimum (but not maximum) rate of tax (US and foreign) is levied on a US corporate shareholder's GILTI inclusion on an annual basis.

• Assuming no foreign tax is paid on a US corporate shareholder's GILTI inclusion, and disregarding the allocation of expenses under section 861, the section 250 deduction currently allowed against the inclusion results generally in a 10.5% effective US tax rate on that income.

• The purpose of the FDII provisions is to incentivize US corporate taxpayers to own their intangibles domestically by offering a preferential tax rate on sales of goods or services provided for foreign use.

• The section 250 deduction currently allowed against FDII results generally in a 13.125% effective US tax rate on that income.

• The section 250 deduction is reduced, or denied entirely, to the extent the US shareholder's taxable income for a taxable year, determined without regard to the section 250 deduction, is less than the sum of the US shareholder's GILTI and FDII for the taxable year.¹

• A fundamental purpose for permitting NOL carryovers is to equalize the US tax for taxpayers having fluctuating income with the US tax for taxpayer's having stable income (i.e., a business having alternating profits and losses should not pay higher cumulative US tax than a business with stable income).

• Although a reduction/denial of the section 250 deduction, by reason of a current year operating loss or a section 172(a) NOL carryover deduction reducing the US corporate shareholder's taxable income for the year, does not result in additional US tax on a GILTI inclusion (because the current year loss, or NOL deduction, similarly shelters the GILTI inclusion), the limitation on the allowable section 250 deduction can result in additional US tax being paid on income (GILTI and/or non‐GILTI) earned by the US shareholder in subsequent years.

  • For example, a US corporation that generates a <$100x> NOL in Year 1, $100x operating profit in Year 2, and a $100x GILTI inclusion in Year 3, will incur cumulatively $10.50x of US tax (21% of the net $50x GILTI inclusion in Year 3), while if the sequence of operating profit and GILTI were reversed it would incur cumulatively $21x of US tax (21% of the $100x operating profit earned in Year 3).² This result is counter to the policy reason for allowing an NOL carryover deduction.³

• Additional US tax being paid on income (GILTI and/or non‐GILTI) earned in subsequent years by reason of the section 250 taxable income limitation reducing or denying a section 250 deduction in a prior year is arguably inconsistent with (i) the purposes of the GILTI provisions, which, again, are designed to require a minimum rate of tax on GILTI of a specific taxable year, not on income (GILTI or non‐GILTI) earned in a subsequent year, and (ii) the purposes for permitting a deduction for NOL carryovers.

• Similarly, limiting the section 250 deduction allowable with respect to FDII, by reason of a current year operating loss or the NOL carryover deduction allowed in a year, undermines the Congressional intent to incentivize income earned by a US corporation from sales of goods or services provided for foreign use.

• Section 904(f)(5)(C) provides generally that if a loss in a section 904(d) limitation category (a “loss category”) was allocated to income in another section 904(d) limitation category (an “income category”) in a prior year and the loss category has income in a subsequent year, then, for purposes of section 904, that income is instead treated as earned in the income category.⁴

  • For example, if a <$100x> general category loss is allocated against $100x GILTI income in Year 1, and in Year 2 there is $150x of general category income, $100x of the general category income is treated instead as GILTI in Year 2.

  • Treating the Year 2 general category income instead as GILTI does not automatically result in an additional section 250 deduction in Year 2 because the additional GILTI amount is not technically included by the US corporate shareholder under section 951A (which is required by section 250 for a deduction against GILTI to be allowed.)

• Section 904(g) provides rules similar to section 904(f)(5)(C) that apply if a domestic loss is allocated against income in a section 904(d) category, however, in that case there is a limitation on the amount of domestic income earned in a subsequent year that is treated instead as income in the section 904(d) category.⁵ Similar to section 904(f)(5) recapture, however, section 904(g) recapture is only for purposes of section 904 and does not result in an additional deduction under section 250 because the additional GILTI amount is not included by the US corporate shareholder under section 951A.

Regulatory Authority Summary

• Section 250(c) provides: “The Secretary shall prescribe regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section.” Because both sections 172(a)(2) and 250(a)(2) impose deduction limitations based on taxable income, there is a “circularity” between the computations required by these provisions, and when combined with the foregoing policy concerns, Treasury should have authority to promulgate regulations dictating how the provisions interact.

• Section 904(h)(11) further provides broad regulatory authority “as may be necessary or appropriate” and, given the interplay between sections 951A, 250 and 904, Treasury should utilize this authority to provide necessary and appropriate guidance.

• There is precedent for Treasury to issue regulations where necessary that deviate from the literal terms of the Code, to the extent that the literal terms do not accomplish the intended Congressional policies. For example, Treas. Reg. § 1.358‐5(a) provides: “Section 358(h)(2)(B) does not apply to an exchange occurring on or after May 9, 2008”, because Treasury determined that section 358(h)(2)(B) simply does not accomplish the Congressional intent for section 358(h). Thus, Treasury historically has interpreted its regulatory authority broadly, and it should have similar broad authority to address the interplay between sections 951A, 250, 904 and 172, as necessary to accomplish the intended Congressional policies.

• To the extent Treasury determines that regulatory relief should focus on the consolidated group context, section 1502 was amended in 2004 to reinforce Treasury's broad consolidated return regulatory authority, specifically authorizing consolidated return regulations “that are different from the provisions of chapter 1 that would apply if such corporations filed separate returns.” Thus, Treasury should have broad authority to issue regulations applying sections 250 and 951A, including by treating consolidated group members as a single taxpayer, and by addressing the interplay of these rules with sections 172 and 904 in a manner that promotes clearly reflecting the group's income tax liability consistent with the intended Congressional policies.

Recapture Proposal Summary

• One potential solution to the section 250(a)(2) taxable income limitation undermining the purposes of GILTI and NOL carryovers is to permit a US corporate shareholder to recoup the section 250 deduction that is disallowed against that year's GILTI by creating a cumulative “GILTI recapture” account to the extent of the taxable income limitation for the year. A separate “FDII recapture” account could similarly be created to recoup the section 250 deduction disallowed against that year's FDII.

• For example, if in Year 1 the US corporate shareholder has taxable income of $50x (without regard to the section 250 deduction), which includes $80x of FDII, $60 of GILTI and <$90x> of NOL absorption, the section 250 taxable income limitation would reduce the $80x of FDII to $28.6x and $60x of GILTI to $21.4x (i.e., a total of $50x, reflecting the taxable income amount) for purposes of determining the section 250 deduction allowed for that year.

• Under the proposal, as of the end of Year 1, the US shareholder would establish a FDII recapture account of $51.4x and a GILTI recapture account of $38.6x (i.e., a total of $90x, representing the amount of FDII and GILTI superseded by the NOL).

• In a subsequent year in which the US shareholder has taxable income exceeding that year's GILTI and FDII amounts, the excess income would be treated as GILTI and FDII (on a proportionate basis based on the relative account balances) solely for purposes of allowing an additional section 250 deduction in that year.

• For example, if in Year 2 the US shareholder has $200x total taxable income (without regard to the section 250 deduction), which includes $20x of FDII and $60x of GILTI, it would have $120x excess taxable income that becomes subject to the GILTI and FDII recapture accounts created in Year 1.

  • The excess taxable income treated as GILTI or FDII under the proposal would be limited to the lesser of (i) the relevant balance in the recapture account, or (ii) the excess taxable income allocated to that account for this purpose.

  • For example, in Year 2 the $120x excess taxable income would be allocated between the two accounts based on the relative balances (i.e., $51.4/$90 to FDII and $38.6/$90 to GILTI), or $68.5x to the FDII recapture account, and $51.5 to the GILTI recapture account. The actual recapture in Year 2 would be limited to the recapture account balances created in Year 1 — $51.4x FDII and $38.6x GILTI.

• This recapture proposal would apply separately from the existing recapture rules in sections 904(f) and 904(g), which by their terms apply only for section 904 purposes.⁶

  • To the extent that the proposal results in additional section 250 deduction against GILTI, the deduction could be directly allocated against that year's actual GILTI inclusion for purposes of the determining that year's GILTI FTC limitation under section 904(a).

  • However, because the additional GILTI created under the proposal would not otherwise increase GILTI for section 904 purposes, it could be argued that the additional section 250 deduction should not be allocated against GILTI for purposes of determining that year's GILTI FTC limitation.

Expense Apportionment Relief Proposal Summary

• As discussed in the Conference Report to the TCJA, Congress intended that no residual US tax be owed where GILTI income is subject to a minimum foreign tax rate of 13.125%. There is concern that allocation and apportionment of expenses to the section 904 GILTI separate limitation category could undermine this objective.

• A proposed solution to alleviate this concern is to reduce expenses allocated and apportioned to GILTI category income under section 861 by the amount of section 250 deduction allowed.

• For example, if US shareholder has a current year taxable loss (without regard to sections 951A and 250) of <$100x> and a section 951A inclusion of $250x, for total taxable income before section 250 deduction of $150x. The current year section 250 deduction would be limited to $75x under section 250(a)(2), resulting in total taxable income of $75x (i.e., $15.75x US tax before available credits).

  • The computation of US shareholder's GILTI category income for section 904 purposes would start with the section 951A inclusion of $250x, less the section 250 deduction of $75x, for net GILTI category income of $175x. If pursuant to section 861 principles, $150x of expenses were allocated or apportioned to GILTI category income, the net GILTI category income for section 904 purposes would be reduced to $25x (i.e., utilization of GILTI FTCs limited to $5.25x).

  • Even if the GILTI income in this example were subject to a high rate of foreign tax (e.g., 15%) US shareholder would only be able to use GILTI FTCs against $5.25x US tax and would owe residual $10.50x US tax on this high‐taxed GILTI income.

• The expense apportionment relief proposal would reduce the amount of section 861 expenses allocated or apportioned to GILTI category income (i.e., $150x) by the amount of the section 250 deduction allowed (i.e., $75x). This would increase the net GILTI category income from $25x to $100x and allow US shareholder to utilize GILTI FTCs (to the extent available based on the computation under section 960(d)) to offset the US tax which is generally attributable to the GILTI income inclusion.

Other Potential Solutions Considered

• Separate return limitation year (SRLY)‐type provision. Although there are tax policies supporting certain aspects of section 951A being applied in the consolidated group context on a single‐ entity basis (i.e., treating group members as a single taxpayer), there is no reason for the group members to be burdened with tax liability that is substantially different from separate return taxpayers.

  • The dramatic differences that could result from unlimited single‐entity treatment can justify the administrative burden of computing and tracking applicable losses and NOLs on a member‐by‐member basis.

  • For example, if USP generates a current year loss of <$100x>, while its consolidated group subsidiary, USS, generates no loss and has a GILTI inclusion of $250x, USS should be able to claim a section 250 deduction of $125x under section 250(a)(2), unburdened by USP's loss because USP is not the relevant US shareholder for GILTI purposes.

  • The section 250 deduction is a US taxpayer deduction, but it is computed based on the income computations of CFCs. The CFCs are not consolidated group members, they should be respected as separate entities in computing their applicable net tested income, and the section 250 deduction that is a product of the GILTI computations at the CFC level should also apply on a separate‐member basis.

  • The GILTI inclusion required by section 951A operates based on the mechanics under section 951(a)(1)(A) for subpart F income, and subpart F income is determined on a US shareholder‐by‐US shareholder basis even in the consolidated group context.

  • To the extent that Treasury determines that regulatory relief in the consolidated group context should focus on limiting deductions and losses from offsetting GILTI/FDII income, preserving the deductions and losses for other income, there is a long history of case law and regulatory guidance imposing SRLY‐type restrictions as necessary to promote clear reflection of a group's income. For example, the current SRLY regulatory rules originated in the courts, with the Supreme Court in Woolford Realty Cv. Rose, 286 U.S. 319 (1932), determining that a SRLY concept was implicit despite implementing regulations not yet being adopted, based on perceived Congressional intent for consolidated returns, and even after SRLY regulations were adopted, the court in Wegman's Properties, Inc. v. Commissioner, 78 T.C. 786 (1982), followed the lead of Woolford Realty by extending the SRLY principle to an alternative minimum tax attribute not yet addressed by regulations again based on perceived Congressional intent. Thus, Treasury should have similar regulatory authority to adopt SRLY principles for addressing the interplay of sections 250 and 951A with sections 172 and 904.

• Order of applying section 250(a)(2). The language of section 250(a)(2) does not support applying the section 172(a) deduction first, to reduce the taxable income taken into account under the section 250(a)(2).

  • There is no express ordering rule guiding how to apply the taxable income limitation under both sections 172(a) and 250(a)(2).

  • Applying NOL carryovers to reduce taxable income for purposes of applying the limitation of section 250(a)(2) results in treating taxpayers with steady year‐to‐year income different from taxpayers with fluctuating income and year‐to‐year loss. NOL carryovers generally help to equalize the US tax treatment of taxpayers that earn similar cumulative economic profit over a period of multiple years.

  • An ordering rule, applying the section 250(a)(2) limitation without regard to NOL carryovers (similar to section 163(j)(8)(A)(iii)), would allow taxpayers to achieve more uniform benefits from the section 250 deduction, and support policy objectives of section 172 for equalizing the US tax of taxpayers having fluctuating income with the US tax of taxpayers having stable income.

• Even with a SRLY‐type provision, or an ordering rule, to address tax policy concerns, section 172(d)(9) appears to deny the ability for a section 250 deduction to be taken into account for purposes of computing NOL carryforwards.

  • There is precedent for Treasury to issue regulations where necessary that deviate from the literal terms of the Code, to the extent that the literal terms do not accomplish the intended Congressional policies. In order to fully address the tax policy concerns through a SRLY‐type provision or an ordering rule, it will be necessary to also override the literal application of section 172(d)(9). To the extent Treasury has concerns with its authority to apply this approach to all taxpayers, there is clear authority to at least apply it to consolidated groups and there is no reason to not clearly reflect consolidated group income tax liability consistent with the intended Congressional policies.