Firm Comments on Proposed GILTI Regs

8 October 2018

David J Kautter
Assistant Secretary for Tax Policy, and Acting Commissioner, Internal Revenue Service
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

William M Paul
Acting Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20220

Re: 2017 Tax Cuts and Jobs Act (P.L. 115-97) (the "TCJA")/Request for Guidance Concerning IRC¹ § 962 Election for Income Inclusions of an Individual under IRC § 951A (GILTI), and Availability of 50% Deduction under § IRC § 250(a)(1)(B)

Dear Messrs Kautter and Paul

We refer to Notice of Proposed Rulemaking REG-104390-18 recently published by the Treasury Department, setting out proposed regulations implementing new IRC § 951A (Global Intangible Low-Taxed Income ("GILTI")) of the controlled foreign corporation ("CFC") rules. The preamble to the Notice states that rules relating to the deductions under IRC § 250 will be the subject of a future notice of proposed rulemaking.

We are writing concerning IRC § 250(a)(l)(B) (the "§ 250 deduction"), which allows to a domestic corporation a "special" deduction equal to 50% of the sum of (a) its GILTI inclusion under § 951A and (b) associated IRC § 78 "gross-up", and, specifically, the availability of the § 250 deduction in the case of an individual who elects under IRC § 962 to be subject to the tax on a GILTI inclusion in the amount that would be imposed on such inclusion in the hands of a hypothetical domestic corporation owning the relevant CFC shares. For reasons discussed below, in our submission the language of IRC § 962 (and the interpretation of § 962 reflected in existing regulations) clearly calls for the § 250 deduction to be offset against GILTI in the application of § 962, and the legislative history of IRC § 962 clearly supports this result.

This is an issue which will have a disproportionately large impact on American citizens residing overseas, given the much greater frequency with which they will find foreign corporate structures appropriate to their commercial activities.

As illustrated below, § 962 will be a crucial mitigating factor in the taxation of U.S. individuals subject to Inclusions under the new GILTI rules. Availability of the § 250 deduction in the application of § 962 is an essential element of such mitigation, yet published commentary reflects that this is regarded as an area of uncertainty. Given our analysis that § 962 as currently written clearly permits the § 250 deduction to be claimed in determining the taxable income of the hypothetical domestic corporation, there is no need for the Treasury Department to await technical corrections legislation or any other form of additional Congressional guidance before confirming this. Treasury Department/IRS guidance is urgently needed to eliminate uncertainty for affected individuals and to permit adoption of appropriate planning to mitigate their exposures.

I. Background — Comparative Impact of GILTI Inclusions on Corporate and Individual CFC Shareholders

A. Corporate United States Shareholders

Under new IRC § 951A(a), a domestic corporation owning more than 10% of the shares of one or more CFCs is obliged to recognize in its income a pro rata share of the GILTI attributable to those holdings. However, § 250(a)(1)(B) allows to a domestic corporation with a GILTI inclusion a deduction equal to 50% of such inclusion, while § 960(d)(l) allows a domestic corporation to claim as a credit against U.S. tax on its GILTI inclusion 80% of the foreign corporation tax paid by the relevant CFCs in respect of the GILTI. Given the current domestic 21% rate of corporation tax, it follows that tax on GILTI attributed from one or more CFCs to a domestic corporate shareholder will be fully offset by credits if the income suffers an effective rate of foreign corporation tax of 13.125% or more.²

The mechanism by which a domestic corporate shareholder receives an indirect foreign tax credit on a Section 951A inclusion is the following.

For example, where a domestic corporation includes in its income GILTI of $100 (net after foreign corporation tax) from a CFC which has paid an average rate of foreign corporation tax of 20% (and is therefore not low-taxed), there is no U.S. liability as per the following computation.

Income inclusion Deemed paid foreign tax/§ 78 gross-up Gross Inclusion Less section 250 deduction Net inclusion Tax on above (21%) Less 80% of deemed paid foreign tax Tax after credit

100 25 125 (62.5) 62.5 13.125 (20) Nil

B. Individual United States Shareholders

Absent the § 962 election discussed at II. below, individual 10% or greater U.S. shareholders of one or more CFCs can pay far more tax on GILTI inclusions than corporate shareholders because, in addition to the potentially higher marginal rate of tax, individuals can claim neither the § 250 deduction nor the indirect credit for foreign taxes imposed on the relevant CFCs, as both of these are available only to domestic corporations. Assuming the same facts as in the example at A. above but for a U.S. individual shareholder taxable at top marginal rates (and that the GILTI is not distributed by the relevant CFC(s) in the year of inclusion), the tax computation is as follows.

Income inclusion tax on above (37%)

100 37

This is commonly referred to as a "dry" tax charge, i.e. tax imposed on income which the taxpayer has not received and for which the taxpayer may therefore lack the liquidity to pay the tax.³

II. The Section 962 Election for Individuals

Mitigation of the harsh treatment of U.S. individuals with GILTI inclusions may be obtained under IRC § 962(a), which provides that in the case of an individual United States shareholder of a CFC who elects to have that section apply:

IRC§ 951A(f)(1)(A) provides that § 962 applies to GILTI inclusions "in the same manner" as it applies to § 951(a) inclusions. The legislative history of the GILTI rules simply repeats this language and so adds nothing to the plain meaning of the words used in the statute. H. Rept. 115-466, p. 637.

§ 962 was enacted by the 87^th Congress as part of the original CFC legislation in 1962. According to the legislative history of § 962, its purpose was:

"to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. This provision gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad."

S. Rept. No 1881, 1962-3 C.B. at 798. Thus, recognizing that liability on § 951(a) inclusions was a significant dry tax charge for individual U.S. shareholders of CFCs, Congress made available the tax mitigation afforded domestic corporations in the form of a lower rate of tax and the availability of an indirect credit for foreign tax imposed on the CFC, albeit at the cost of future income recognition when the CFC's profits were distributed.⁴ As post-1962 individual marginal rates of tax have declined relative to the corporate rate, the attractiveness of § 962 relief has diminished, but the TCJA re-introduces a significant gap between individual and corporate marginal rates of tax.

Under § 962(a)(1), the tax imposed on an electing individual shareholder in respect of § 951(a) inclusions is an amount equal to the tax which would be imposed under § 11 if the inclusions were recognized by a hypothetical domestic corporation.

Determination of tax liability under § 11 is not the end of the § 962 computation because IRC § 960 allows a domestic corporation to claim the foreign tax credit for indirect foreign taxes attributable to a § 951(a) inclusion. § 962(a)(2) states that "for purposes of" applying § 960, the subpart F inclusion will once again be deemed received by the hypothetical domestic corporation.

A threshold issue in applying § 962 is what assumptions should be made about the hypothetical domestic corporation which is treated as having "received" the individual's § 951(a) inclusion. Those assumptions, although unstated, appear clear, i.e.

• In applying the CFC rules the domestic corporation is presumed to own the CFC shares belonging to the electing individual;

• The domestic corporation is presumed to have no tax items (e.g. income, expenses or credits) other than those inherent in its ownership of CFC shares; in other words, it is taxed on a "stand-alone" basis relative to its notional CFC holding;

• Despite the "received by" language used in both § 962(a)(l) and (2), the tax is computed on the § 951(a) inclusion that would have been attributed to the domestic corporation based on the presumption that it was the actual owner of the CFC shares.

This is confirmed by the regulations under § 962. Treas. Regs. § 1.962-1. Consistent with the second assumption above, i.e. that the tax on the domestic corporation is determined on a stand-alone basis, the regulations under § 962 provide that the § ll(a) taxable income of the hypothetical domestic corporation arising from its deemed CFC shareholding:

"shall not be reduced by any deduction of the [individual] United States shareholder even if such shareholder's deductions exceed his gross income."

In the case of inclusions of subpart F income under § 951(a), the effect of the § 962 election is clear. The individual shareholder determines his tax liability in respect of a § 951(a) inclusion as if he or she were a domestic corporation whose sole activity was holding the relevant CFC shareholding, first determining the "taxable income" of the hypothetical foreign corporation under § 11(a), which is the sum of the § 951(a) inclusion and § 78 gross-up (if the indirect foreign tax credit is claimed) less allowable deductions (in the case of a § 951(a) inclusion nil), then computing the liability on the taxable income at the rate specified in § 11(b), and finally offsetting against this figure indirect foreign tax credits that would be available to a corporation under § 960. Treas. Regs. § 1.962-1(b).

III. Application of the § 962 Election to GILTI inclusions

Inclusions of GILTI under new § 951A are treated "in the same manner" as income included under § 951(a) for purposes of the application of § 962. IRC § 951A(f)(l)(A). Accordingly, where an individual United States shareholder makes a § 962 election, according to § 962(a)(l) the tax imposed on his GILTI inclusion should be

"an amount equal to the tax which would be imposed under section 11 if such amounts were received by a domestic corporation."

As noted, § 11(a) provides that tax is imposed on the "taxable income" of the domestic corporation, i.e. gross income less deductions.

Tax would be imposed on the taxable income figure ((GILTI + § 78 gross-up) - § 250 deduction) at the 21% rate now specified under § ll(b). Against this liability would be offset any indirect foreign tax credit under § 960, which in the case of GILTI would be 80% of the actual foreign liability attributable to the inclusion. § 960(d).

Suppose, for example, an individual U.S. shareholder of a CFC recognized a GILTI inclusion of $100 from a company paying an average 20% rate of foreign corporation tax. If the individual elected § 962, his or her liability, i.e. the tax imposed under section 11 if such amount were received by a domestic corporation, would be as previously illustrated:

Income inclusion Deemed paid foreign tax/§ 78 gross-up Gross inclusion Less section 250 deduction Net inclusion Tax on above (21%) Less 80% of deemed paid foreign tax Tax after credit

100 25 125 (62.5) 62.5 13.125 (20) Nil

This straightforward interpretation of the language of § 962 clearly achieves the legislative intent of the election, i.e. to place a tax burden on individual United States shareholders of a CFC which is "no heavier" than they would have suffered had they invested in an American corporation doing business abroad (via the CFC). In view of the lack of any substantive amendment to § 962 in the TCJA (the only change was to drop the cross-reference to the corporate alternative minimum tax of IRC § 55, which was repealed in the TCJA), the original legislative history of § 962 should continue to inform how it is interpreted.

IV. There is No Valid Argument for Denying the § 250 Deduction in Applying § 962 to GILTI Inclusions

Notwithstanding the above analysis, some commentators have suggested that there is considerable doubt whether an individual making the § 962 election may offset the § 250 deduction in determining his or her liability on GILTI inclusions. Were the deduction not available, then significantly less relief would be afforded by the election. On a GILTI inclusion of $100, the liability would be as follows.

Income inclusion Deemed paid foreign tax/§ 78 gross-up Inclusion Tax on above (21%) Less 80% of deemed paid foreign tax Tax after credit

100 25 125 26.25 (20) 6.25

This imposes a dry tax charge that would not have applied if the CFC investment had been held "by an American corporation doing business abroad" and so is inconsistent with the legislative intent of the 87^th Congress in enacting § 962. A rate of foreign corporation tax of at least 26.25% would be needed to fully eliminate liability in this case (assuming the U.S. and foreign tax bases of the corporation were the same), in contradiction of the apparent intention of the 115^th Congress only to charge "low-taxed" income.

We have identified five arguments (set out at A. to E. below) that have been or could potentially be raised against the allowance of the § 250 deduction in the application of the § 962 election to GILTI inclusions, but for the reasons stated in our view none of these cast any legitimate doubt on this issue.

A. "The tax which would be imposed under section 11", within the meaning of § 962, means a tax at the rate of 21% which is specified in section 11, and no other provisions applicable to the taxation of corporations are relevant.

This takes what is in our opinion an inappropriately narrow view of the reference to § 11 in § 962(a)(1). This reference clearly encompasses both § ll(a), which imposes a corporation tax on the "taxable income" of every corporation (and, in the case of GILTI, will reflect the § 250 deduction), and § 11(b), which specifies the rate of such tax. Had Congress intended the reference to § 11 to be read as referring only to the rate of tax, then one might have expected § 962 to have provided that tax would be imposed "at the rates" set out in § 11(b) rather than its broader reference to § 11. However, the language of § 962 is consistent with the legislative history in supporting a broader interpretation, i.e. one which would put an electing individual on an equal footing with a domestic corporation in the computation of the individual's tax liability on § 951(a) (and now GILTI) inclusions.

Furthermore, the argument that the reference to § 11 is only a reference to the applicable rate of tax under § 11(b) and not the entire mechanism for taxing a corporation on its GILTI seems singularly inappropriate when one considers more closely the nature of the Section 250 deduction.

Given Congress' intention to provide a reduced rate of corporation tax for GILTI inclusions, one might have anticipated this would have been achieved by amending § 11(b) to provide for a special rate of tax on GILTI income of 10.5%. Had this been done, there would be no uncertainty over how § 962 applies to GILTI inclusions.

However, it is the customary practice to make this sort of adjustment through a "special deduction", and that is what Congress chose to do here in the furtherance of its expressed intention to impose a "reduced rate" of tax on domestic corporations recognizing GILTI. It is inconceivable that such a choice could have been intended to have any impact on the taxation of individuals electing § 962.

B. Had Congress intended that the § 250 deduction would be available to a taxpayer electing § 962, it would have amended § 962 to say so. This is supported by the fact that § 962(a)(2) specifically states that the indirect foreign tax credit available to a corporation is also available to an electing individual under § 962.

As demonstrated at III. above, the language of § 962(a)(1) that a subpart F inclusion is to be subject to the corporation tax that would be imposed if the inclusion "were received by a domestic corporation" is broad enough to incorporate by reference all the tax provisions that would operate if the inclusion were actually "received by" (i.e. attributed to) the domestic corporation. Pre- the TCJA this would have included the requirement to gross-up the subpart F inclusion by the amount of the indirect credit under IRC § 78 in the determination of the hypothetical domestic corporation's taxable income. Post- the TCJA it would also include the ability to claim the § 250 deduction, which is also an essential element of the determination of taxable income as required under § 11(a).

This is supported by the clear understanding under pre-TCJA law (reflected in the regulations) that § 78 applies in the determination of the "taxable income" of the hypothetical domestic corporation under § 11(a), notwithstanding the lack of any express reference to § 78 in § 962(a). Treas. regs. 1.962-1(b)(1)(i)(b). There is nothing in the language of § 962 that can justify on the one hand applying § 78 in the determination of the taxable income of a hypothetical domestic corporation in receipt of GILTI while on the other hand disapplying the § 250 deduction. Rather, the pre-TCJA interpretation of § 962(a)(1) as placing the electing taxpayer in the shoes of the hypothetical domestic corporation remains appropriate, from which it follows that both § 78 and § 250 must be applied in determining the hypothetical corporation's taxable income.

C. The legislative history of the TCJA states expressly that the § 250 deduction is not available to individuals.

The legislative history of the Senate Amendment, where the GILTI rules were first introduced, states that

"U.S. shareholders that are not domestic corporations are subject to full U.S. tax on their GILTI."

H. Rept. 115-466, p. 622 (footnote 1515).

This statement is not controversial since the § 250 deduction is a special deduction only available to "domestic corporations". However, there is no indication in the legislative history that, in affirming this, Congress intended any reflection on the availability of the § 250 deduction in determining the tax liability of a notional domestic corporation where a § 962 election is made. Such an interpretation would be surprising given the intention of § 962 to place an individual on an equal footing with a domestic corporate shareholder.

Since under § 962 tax is determined as if the relevant income belonged to a domestic corporation, the fact that an individual not electing § 962 could not claim the § 250 deduction is irrelevant.

D. Allowing the § 250 deduction in the computation of liability under § 962 would be inconsistent with provisions of the existing § 962 regulations which, having defined the income on which tax is computed under § 11 as the sum of the § 951(a) inclusion plus the § 78 gross-up, state that this amount shall not be reduced by "any deduction of the United States shareholder". Treas. regs. § 1.962-1(b)(1) (final sentence).

As already explained, it is implicit in the stand-alone nature of the § 962(a) tax computation that no items can be taken into account other than those implicit in the notional CFC shareholding of the hypothetical domestic corporation. The statement in the regulations that the § 962 notional liability on a domestic corporate shareholder must be calculated without regard to the electing individual shareholder's own deductions is an aspect of this principle which the Treasury Department chose to make explicit.

The deductions denied under the regulations are "any deduction of the [electing] United States shareholder", who by definition is an individual and therefore not eligible to claim "special deductions" that are only available to corporations. Thus the deductions prohibited under the current regulations clearly cannot include the § 250 deduction, nor, given the fundamental difference between special and itemized deductions already referred to at IV.A above, is there any reason to consider them analogous.

Paragraph 5 of Treasury Department Notice 2018-26 concerning the interrelation of the § 965 transition tax (which augments § 951(a) inclusions of United States shareholders in the transition year) and the § 962 election in respect of such inclusions, states that, in accordance with the legislative history of the TCJA, under an amendment to the section § 962 regulations individuals electing § 962 in relation to § 965 inclusions will be allowed the § 965(c) ("application of participation exemption") deduction in the computation of liability. However, the Notice goes on to state:

"These regulations will not apply to any other deductions, and therefore existing § 1.962-1(b)(1)(i) will continue to provide that 'taxable income' as used in section 11 shall not be reduced by any other deductions."

Since, for reasons explained above, the § 250 deduction is not one of the "any other deductions" referenced in the existing regulations, the fact that those regulations are intended to remain unchanged should have no relevance to the availability of the § 250 deduction/reduced rate in the application of the § 962 election to GILTI inclusions.

E. Since the provision which makes § 962 applicable to GILTI inclusions states that § 962 shall be applied "in the same manner" as it would apply to subpart F inclusions under § 951 A, in applying § 962 the GILTI Inclusion should be treated as an inclusion under § 951(a). As there is clearly no Section 250 deduction available to offset a § 951(a) inclusion of a domestic corporate shareholder of a CFC, It follows that the § 250 deduction should not be available in the application of § 962.

Language stating that provisions of § 962 are to be applied "in the same manner" to GILTI as to § 951(a) inclusions (IRC § 951A(f)(1)(A)) leaves open to interpretation what constitutes the same manner when two quite different types of inclusion are involved. It is submitted that the language is certainly broad enough to allow appropriate distinctions to be recognized in the application of § 962 in the case of GILTI inclusions, as opposed to § 951(a) inclusions.

Had Congress intended "in the same manner" to be interpreted as requiring identical treatment for GILTI as for § 951(a) inclusions in the application, inter alia, of § 962, this could have been clearly stated, e.g. "GILTI inclusions shall be treated as inclusions under § 951(a) in the application of sections . . . 962 . . .". Among other things, such an interpretation would not only preclude an individual electing § 962 from claiming the § 250 deduction (however inappropriate this might seem) but also would require that a 100% credit for indirect foreign taxes be allowed under § 960(a), which applies to § 951(a) inclusions, rather than the 80% credit allowed under § 960(d) for GILTI inclusions. This would be a most peculiar result, and one which would place electing individuals that much further from result intended by Congress in enacting § 962, i.e. that

"their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad."

Furthermore, the "in the same manner" language of § 951A(f)(l) governs not only the application of § 962 but also a number of other provisions affecting the taxation of § 951(a) inclusions, for the purpose of providing comparable treatment for GILTI as for § 951(a) inclusions, and it is extremely doubtful the Treasury Department will find a narrow reading of this language appropriate in the application of those provisions.

Thank you for this opportunity to provide our views on this vital issue, particularly for American citizens residing overseas. If you have any questions, please contact Jeffrey Gould at +4420 7833 3500.

Yours sincerely

[signed] Director
Frank Hirth Plc
London, UK

Cc
Mr Lafayette G. "Chip" Harter III
Deputy Assistant Secretary
International Tax Affairs
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Marjorie Rollinson
Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20220

Barbara Felker
Branch Chief, Branch 3, Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20220