In what will no doubt be viewed by practitioners as welcome relief, new guidance on the global intangible low-taxed income provision allows for a broader high-tax exclusion.
Proposed and final regs on GILTI were released June 14. The IRS also released temporary and proposed regs on section 245A that relate, in part, to GILTI. All told, the guidance comes in at more than 500 pages.
Under section 951A, each U.S. shareholder of a controlled foreign corporation is subject to tax on GILTI, defined as the excess of its pro rata share of tested CFC income over a 10 percent return (reduced by some interest expense incurred by CFCs) on its pro rata share of the depreciable tangible property of each CFC (qualified business asset investment).
Unlike subpart F income, the proposed regs (REG-104390-18) released in September 2018 made no allowance for a high-tax exception to GILTI, as section 951A was only deemed to exclude from tested income high-taxed income that is otherwise subpart F income. Practitioners who had requested relief from this provision have noted that this can result in counterintuitive results to the point that some taxpayers were considering making more income subpart F — a planning tactic previously unheard of.
The proposed regulations provide for an expanded high-tax exclusion that would apply on an elective basis to all tested gross income subject to a minimum rate of effective tax. According to the preamble of the new proposed sections 958 and 951A regulations, many comments received in response to the 2018 proposed regulations argued that Congress intended GILTI inclusions only for gross income taxed at a low effective rate.
In response, the proposed regulations would allow domestic shareholders of a CFC to elect to exclude from gross tested income amounts that have been subject to foreign tax at an effective rate that exceeds 90 percent of the U.S. rate. According to the preamble, using an effective rate test is more consistent with legislative intent and would eliminate unintended incentives created by the approach taken in the final regulations.
“An election to exclude a CFC’s high-taxed income from gross tested income allows a U.S. shareholder to ensure that its high-taxed non-subpart F income is eligible for the same treatment as its high-taxed [foreign base company income] and insurance income, and thus eliminates an incentive for taxpayers to restructure their CFC operations in order to convert gross tested income into [foreign base company income] for the sole purpose of availing themselves of section 954(b)(4) and, thus, the GILTI high tax exclusion,” the preamble states.
The 90 percent effective tax rate test would be applied at the CFC level by allocating and apportioning foreign taxes to the CFC’s gross income. The election would be made by the controlling domestic shareholders of the CFC and would be binding for all shareholders for the tax year to which it relates.
The final regs, however, adopted the previously proposed GILTI regs' version of the high-taxed exception without change, as Treasury felt that those rules reflect “a reasonable interpretation” and that it did not have the authority under section 951A(f)(1)(B) to make changes. The preamble further states that existing 1.954-1(d)(1) did “not provide the necessary framework for applying the exception under section 954(b)(4) to income that would be gross tested income.” It therefore relies on the new proposed regs to offer that framework.
Under the high-tax exception of section 954(b)(4), subpart F income is subject to exclusion if it faces a foreign tax rate equal to at least 90 percent of the U.S. rate, or 18.9 percent.
The proposed regulations would also adopt an “aggregate” approach to partnerships for purposes of sections 951 and 951A. Accordingly, domestic partnerships would not be treated as independent entities capable of owning a foreign corporation’s stock for purposes of section 958(a). This approach is necessary to ensure consistent treatment of foreign and domestic partnerships and to carry out the intent of the GILTI regime, the preamble says.
Antiabuse Rule Changes
The final regs also bring some much-needed clarity for practitioners concerning antiabuse rules.
Under prop. reg. section 1.951-1e(6), a transaction or arrangement that is part of a plan with a principal purpose of tax avoidance, including through a reduction of a U.S. shareholder's pro rata share of the subpart F income of a CFC, is disregarded in determining the pro rata share of the subpart F income of the corporation. The antiabuse provision applies to GILTI rules, including for purposes of determining the pro rata share of QBAI based on the pro rata share of tested income.
Treasury previously acknowledged practitioners’ complaints about the rule’s breadth, and some had interpreted the rule as requiring a U.S. shareholder disposing of CFC stock to be required to indefinitely include its pro rata share of the income.
“The Treasury Department and the IRS agree that the scope of the pro rata share anti-abuse rule should be clarified. Accordingly, the final regulations clarify that the rule applies only to require appropriate adjustments to the allocation of allocable [earnings and profits] that would be distributed in a hypothetical distribution with respect to any share outstanding as of the hypothetical distribution date,” the final regs’ preamble states. “Adjustments will be made solely to the allocation of allocable E&P in the hypothetical distribution between shareholders that own, directly or indirectly, stock of the CFC as of the relevant hypothetical distribution date.”
Proposed regs also addressed transactions designed to reduce GILTI from a stepped-up basis in CFC assets from related-party transfers occurring between December 31, 2017, and the beginning of a taxpayer’s next fiscal year (disqualified period) when determining QBAI.
The final regs allow taxpayers to elect to eliminate disqualified basis by “reducing a commensurate amount of adjusted basis in the property.” The preamble labels this the simplest of the options Treasury considered.
“It results in the property only having a single tax basis for all purposes of the Code such that different bases need not be tracked for different purposes,” the preamble states. “This approach permits taxpayers to decide whether the benefit of the additional adjusted basis associated with the disqualified basis outweighs the cost of complexity in applying the rule or, alternatively, whether the value of simplicity outweighs the benefit of the additional adjusted basis.”
Limiting the Section 245A Deduction
Released the same day, a separate 105-page package of temporary regulations limits the availability of the dividends received deduction under section 245A, which permits U.S. corporate shareholders holding at least a 10 percent interest in a “specified 10-percent-owned foreign corporation” to deduct the foreign-source portion of dividend income received from the foreign corporation. A notice of proposed rulemaking cross-references to the temporary regulations, noting that the text of the temporary regs also serves as the text of the proposed regs.
According to the preamble, the temporary rules restrict the section 245A deduction and the section 954(c)(6) exception (look-through rule for related CFCs) in select cases in which the deduction or exception effectively eliminates subpart F income or GILTI income.
“However, consistent with the broad application of section 245A, the temporary regulations apply only to certain well-defined circumstances in which subpart F or tested income earned by a CFC would otherwise escape taxation to its U.S. shareholders as a result of the unanticipated interaction of section 245A and certain rules applicable to the inclusion of subpart F income and GILTI under sections 951(a) and 951A, respectively,” the preamble states.
It further provides that “to prevent the avoidance of U.S. tax in these specific and narrow circumstances, the temporary regulations limit the section 245A deduction only for certain dividends received by a domestic corporation in connection with specific transactions that facilitate the avoidance of taxation of subpart F income or tested income and that, in many cases, may have been entered into with a purpose of avoiding the consequences of the new international tax regime as adopted by Congress in the [Tax Cuts and Jobs Act].”
Restraining the scope of the section 245A deduction, the temporary rules generally provide a formula to determine the “ineligible amount,” which is the portion of a dividend carved out from the permissible deduction. The ineligible amount is calculated as the sum of the “extraordinary disposition amount” and the “extraordinary reduction amount,” which the rules technically flesh out, but respectively define as:
50 percent of the portion of a dividend attributed to select earnings and profits arising from related-party transactions during a period following the section 965(a)(2) (transition tax) measurement date, in which the specified 10-percent-owned foreign corporation was a CFC, but was not covered by the GILTI regime; and
the portion of a dividend attributed to select E&P generated during any tax year ending post-December 31, 2017, in which the domestic corporation reduces its CFC-ownership.