24 Companies Tackle Computational, Other Issues Under GILTI Regs

November 16, 2018

Internal Revenue Service
CC:PA:LPD:PR (REG-104390-18)
Room 5203
Post Office Box 7604
Ben Franklin Station
Washington, DC 20044

Re: CC:PA:LPD:PR (REG-104390-18) (Proposed Regulations on GILTI and section 951)

These comments are being submitted by the Working Group for Competitive International Taxation (the Working Group), a group of 24 U.S.-headquartered companies that include industrial companies, manufacturers, financial services companies, and service providers.¹ While from a mix of industries, the companies in the Working Group share a number of characteristics: they are all subject to the new global intangible low-taxed income (GILTI) provisions created by the Tax Cut and Jobs Act (TCJA), they all operate in higher-taxed jurisdictions, and they either have few tangible assets or their tangible assets have low adjusted basis. The Working Group welcomes the opportunity to provide comments on the first set of proposed regulations issued by the Department of Treasury (Treasury) and the Internal Revenue Service (IRS) relating to the GILTI provisions² as part of the implementation of section 951A of the Code.³

The Proposed Regulations focus on the computation of the amount to be included in a U.S. shareholder's gross income as GILTI. The Working Group commends the Treasury and the IRS for issuing these rules in a timely fashion, and we very much appreciate the efforts that have been made to rationalize the most fundamental computations necessary for the operation of statutory rules that raise numerous questions and create significant inefficiencies for U.S. companies operating globally. In particular, the Working Group very much appreciates the clarity provided in the explanation of the Proposed Regulations (the Preamble) relating to the proper treatment of the section 78 gross up as it relates to GILTI.

Our comments address three areas in computing GILTI: relating to taxpayers with subpart F income subject to recapture, controlled foreign corporations (CFCs) that have tested loss, and CFCs with temporarily held assets. Additional comments address issues that relate to or arise out of the new GILTI provisions: relating to foreign-to-foreign dividends, pro rata anti abuse rules, and lower-tier CFC stock basis from previously taxed income. It is notable that the Proposed Regulations do not provide guidance on key aspects of the GILTI provisions that are of most concern to the Working Group, namely: (i) the allocation of U.S. expenses and treatment of certain payments to U.S. shareholders in determining the GILTI foreign tax credit (FTC), (ii) the deduction under section 250, and (iii) the treatment of U.S. shareholders with net operating losses. We look forward to proposed regulations that address these issues and other areas we note in our comments.

I. Subpart F recapture — the nonapplication of the section 952(c) E&P limitation in computing gross tested income

A. Background to Prop. Treas. Reg. § 1.951A-2(c)(4)

Generally, subpart F income of a CFC is included in the income of its U.S. shareholders on a net basis.⁴ Under section 952(c)(1)(A), the subpart F income included by U.S. shareholders is limited to current year earnings and profits (E&P) of the applicable CFC (the E&P Limitation).⁵ When subpart F income exceeds the CFC's current year E&P, the subpart F income inclusion is limited to current E&P and section 952(c)(2) requires E&P to be recaptured as subpart F income in a subsequent year (the Recapture Rule).

Under section 951A, tested income of a CFC is the excess of the gross income of such CFC over the deductions properly allocable to such gross income.⁶ Under section 951A(c)(2), a CFC's gross income is determined without regard to “any gross income taken into account in determining subpart F income of such corporation." Prop. Treas. Reg. § 1.951A-2(c)(4) reiterates this definition and adds, in determining the amount of gross income that is “taken into account” in determining subpart F income, the application of section 952(c) is disregarded. Therefore, in determining whether a CFC's gross income for the year qualifies as subpart F income that is excluded from tested income, neither the E&P Limitation nor the Recapture Rule are taken into account.

In explaining the rationale for disregarding the application of section 952(c), the Treasury and IRS stated in the Preamble:

The [Treasury] and the IRS have determined that any income described in section 952(a) is 'taken into account' in determining subpart F income regardless of whether the section 952(c) limitation applies, and therefore should not be included in gross income. Conversely, the recapture of subpart F income under section 952(c)(2), even if by reason of [E&P] attributable to gross tested income, does not result in excluding any amount from gross tested income. Therefore, the [Proposed Regulations] provide that tested income and tested loss are determined without regard to the application of section 952(c).⁷

Congress also wanted to prevent a tested loss that reduces gross tested income from also reducing subpart F income inclusions. Accordingly, section 951A(c)(2)(B)(ii) coordinates the use of tested losses with the E&P Limitation by requiring tested losses to increase a tested loss CFC's E&P.

The concern addressed by the E&P rule and expressed in the Preamble is that a CFC's subpart F income that is limited by the CFC's E&P might escape U.S. tax. This concern is addressed through the increase in E&P in order to make the E&P Limitation less likely to apply to a CFC with tested loss. It is also addressed in the Proposed Regulation, which treats a CFC's income as both subpart F income and gross tested income in a subsequent year when the Recapture Rule applies.

The example in the Proposed Regulations illustrates how a CFC's income is treated as both subpart F income and gross tested income:

In Year 1, as a result of the E&P Limitation, FS has no subpart F income and A Corp has no subpart F inclusion with respect to FS. Section 951A(c)(2)(B) does not require an increase in FS's E&P because there is no tested loss in Year 1. Under Prop. Treas. Reg. § 1.951A-2(c)(4)(i), gross tested income of FS is determined without regard to the E&P Limitation for subpart F income. As a result, FS's foreign base company income of $100x is excluded from gross tested income for FS in Year 1. Therefore, FS has no gross tested income in Year 1.

In Year 2, FS's E&P ($100x) would exceed its subpart F income ($0). Pursuant to the Recapture Rule in section 952(c)(2), FS's E&P ($100x) is recharacterized as subpart F income. Therefore, FS has subpart F income of $100x in Year 2, and A Corp has a subpart F inclusion of $100x with respect to FS. Gross tested income of FS is determined without regard to FS's E&P of $100x being recharacterized as subpart F income. Therefore, FS has $100x gross tested income in Year 2.

B. Comments on Prop. Treas. Reg. § 1.951A-2(c)(4)

1. Scope of the rule

From an E&P perspective, over the course of the two years addressed in the example, FS has a net of $100 E&P but A Corp includes $100 as its subpart F inclusion and $100 as part of FS's gross tested income. We believe the double inclusion in Year 2 — once as subpart F income and once as gross tested income — captures too much income from an E&P perspective.

However, we recognize that while section 951A is similar to the subpart F regime, section 951A is not based on E&P. From that perspective, the Year 2 inclusion of $100 E&P taxed under the Recapture Rule is separate from section 951A's determination of the annual income required to be included as gross tested income. Furthermore, it is clear Congress was concerned that a tested loss CFC could cause the E&P Limitation to apply more often and addressed that concern by requiring an increase in the E&P of a tested loss CFC. The increase in E&P does not occur when the CFC is not in a loss position. It seems, therefore, that the example highlights the difficulty with coordinating the interaction of the subpart F regime that is an E&P-based system with the GILTI provisions that are an annual income-based system.

Nevertheless, charging U.S. taxpayers with $200 of gross income when economically there is only $100 E&P in the CFC seems contrary to the statutory definition of tested income. As defined in section 951A, a CFC's income is either subpart F income or tested income, but not both. Gross tested income excludes income “taken into account in determining the subpart F income of such corporation.”⁹ The example in the Proposed Regulations discussed above treats FS's $100 of gross income in Year 2 as both subpart F income pursuant to the Recapture Rule and as tested income under the GILTI provisions.

Separately, the Proposed Regulations also potentially create a double tax issue for insurance companies that elect, under section 952(c)(1)(B), to determine their subpart F insurance income without regard to the same country exception that would otherwise exempt the income from subpart F inclusions.¹⁰ Specifically, the Proposed Regulations apply to the entirety of section 952(c), thus potentially disregarding this election for insurance income to be treated as subpart F income. By disregarding the election, the income would be treated as tested income under the Proposed Regulations and as subpart F income because, outside of the GILTI provisions, the election would be regarded and qualify the income as subpart F income.

2. Foreign tax credit concerns

Assuming, arguendo, the differences between the subpart F regime and the GILTI provisions justify imposing tax on more than the net E&P of the CFC in cases where the E&P Limitation applies, the example raises concerns that there will not be sufficient foreign taxes to credit against both the subpart F and GILTI inclusions.

Suppose in the Proposed Regulation's example FS pays $0 foreign taxes in Year 1 (because there is no taxable income from a local tax law perspective), and $15 in Year 2 on the $100 gross income earned in that year. Corp A has $200 of gross income inclusion but only $15 of foreign taxes. Section 960's “properly attributable” language would not likely attribute the $15 of Year 2 foreign taxes to the Year 1 subpart F income because there were no taxes paid in Year 1. It is more likely that the $15 of Year 2 foreign taxes will be considered “properly attributable” to GILTI income in Year 2. The Year 2 foreign taxes attributable to GILTI will be subject to a 20% haircut under section 960(d)(1), and under section 904(c), any excess GILTI foreign tax credit cannot be carried into a subsequent year.

This would not have been the case prior to the TCJA because under section 902, FS likely would have had accumulated E&P with associated taxes that could have been used as FTCs against the subpart F income recaptured in Year 2. Prior to the TCJA, section 902 provided a “pooling” concept for foreign taxes that generally allowed an indirect foreign tax credit (under former section 960) for taxes related to the portion of the earnings of the foreign subsidiary that were included as a subpart F inclusion under section 951. For both subpart F and GILTI inclusions, amended section 960 provides that the amount of foreign taxes paid by the CFC that will be deemed paid by the U.S. shareholder must be “properly attributable” to the item of income included in the U.S. shareholder's gross income. The repeal of section 902 removes the pooling concept for foreign taxes that might have otherwise been applicable to the subpart F income recaptured in Year 2.

Another uncertainty arises when FS pays foreign tax in Year 1 and there is either no subpart F inclusion (for example, when from a local tax law perspective there is taxable income) or there is a partial subpart F income inclusion (for example, if the FOGEI loss was $99 and not $100). In these instances, it is not clear how the FTC rules will apply “properly attributable” to the carryover of FTCs. In the first instance, where foreign taxes are paid in Year 1 but no subpart F inclusion occurs in Year 1, the Year 1 foreign taxes seem to be “properly attributable” to Year 2 when the subpart F income is recaptured. In the second instance, where foreign taxes are paid in Year 1 and there is a partial subpart F income inclusion, the Year 1 foreign taxes seem to be “properly attributable” to both the portion of subpart F income included in Year 1 and the portion recaptured in Year 2.

The current FTC regulations and the new FTC statutory rules do not confirm these results. Forthcoming regulations on the foreign tax credit rules will be critical to taxpayers understanding how the nonapplication of section 952(c) in the Proposed Regulations impacts the overall taxation of the foreign earnings.

C. Recommendations for Prop. Treas. Reg.§ 1.951A-2(c)(4)

With regard to the scope of the Proposed Regulations, the nonapplication of section 952(c) should be limited to the E&P Limitation and Recapture Rule described in the Proposed Regulation's example and specifically provide that the rule would not apply to taxpayers that may elect to determine their subpart F insurance income without regard to the same country exception.

With regard to FTCs, the meaning of “properly attributable” should be applied to ensure any amount of foreign taxes paid by CFCs on subpart F income that is subject to the E&P Limitation will be creditable in the year the Recapture Rule applies. In other words, U.S. shareholders will trace the foreign taxes paid in prior years to the year in which the subpart F income becomes an inclusion in the U.S. shareholder's gross income. In the Proposed Regulations' example, any foreign taxes paid in Year 1 would be “properly attributable” and therefore creditable in Year 2 when the income is subject to inclusion. Taxes paid in Year 2 would be “properly attributable” to GILTI. If, however, foreign taxes attributable to subpart F income and GILTI are attributed on a current year basis, foreign taxes paid on subpart F income in Year 1 could be unavailable when the income is included in the U.S. shareholder's gross income under the Recapture Rule. Such an interpretation would create double taxation of the CFC's foreign income.

II. Stock basis adjustments of tested loss CFCs

A. Background to Prop. Treas. Reg. § 1.951A-6(e)

Under section 951A, a U.S. shareholder increases its gross income by its pro rata share of GILTI. GILTI is measured, in part, by aggregating the tested income of CFCs, offsetting that amount with the tested loss of CFCs, and reducing the result by an allowance that is based, in part, on the adjusted tax bases in tangible assets held by each CFC (the qualified business asset investment (QBAI) return). Once the U.S. tax owed on the GILTI inclusion is determined, a foreign tax credit is provided. Special rules are provided for tested loss CFCs. Under section 951A(c)(2)(B)(ii), a tested loss CFC's E&P is increased by the amount of its tested loss in determining the E&P Limitation for subpart F inclusions. Under section 951A(d)(2)(A), a tested loss cannot contribute to the U.S. shareholder's QBAI return. Under section 960(d)(3), the foreign taxes paid by a tested loss CFC are not treated as deemed paid taxes for the FTC.

The Proposed Regulations reiterate these section 951A rules,¹¹ and impose an additional rule for tested loss CFCs to prevent the corporate U.S. shareholder from recognizing “a second and duplicative benefit of the loss — either through the recognition of a loss or the reduction of gain — if the stock of the tested loss CFC is disposed of.”¹²

To eliminate the perceived duplicative benefit, the Proposed Regulations require a corporate U.S. shareholder to reduce, prior to the disposition of the tested loss CFC, the adjusted basis of its CFC stock by the amount of the U.S. shareholder's net used tested loss (NUTL) amount. If the reduction exceeds the adjusted basis in the CFC stock, the excess is treated as “gain from the sale or exchange of the [CFC] stock for the taxable year in which the disposition occurs.”¹³ The Proposed Regulations provide guidance when a domestic corporation owns CFC stock directly or indirectly through an interest in a foreign entity or other CFCs.

To determine if a U.S. shareholder has a NUTL, the domestic corporation first aggregates its offset tested income amount for the CFC for every U.S. shareholder inclusion year. The domestic corporation then aggregates its used tested loss amount for the CFC for each shareholder inclusion year. If a CFC has a tested loss in a year that is not matched against any corresponding tested income in that year, the amount is not included in its tested loss amount. A U.S. shareholder's NUTL is therefore the difference between its offset tested income and used tested loss amounts. If no NUTL exists or if the amount is positive, there is net used tested income and no corresponding upward adjustment is made to the basis of the stock.

Example 1 from Section 1.951A-6(e) is illustrative:

In Year 1, USP has GILTI income of $10 (tested income – tested loss = $100 – $90 = $10), resulting in a GILTI tax of $1.05.¹⁴ Without CFC2's tested loss, USP's tax liability would increase by $9.45 from CFC1's tested income at an effective rate of 10.5%.¹⁵

In Year 2 when USP sells CFC2, USP must reduce CFC2's basis by $90 right before the sale. Assuming USP sells the stock of CFC2 to an unrelated third party for $100 and CFC 2's basis ($100 before the adjustment) would be reduced to $10. USP would recognize a gain of $90. USP's benefit from including its tested loss is effectively wiped out by the reduction in basis in Year 2.

B. Comments Prop. Treas. Reg. § 1.951A-6(e)

1. Extending the Ifeld principle to Section 951A is misplaced

The Ifeld principle¹⁶ is rooted in consolidated returns, where separate members of the group are treated as a single economic unit to share income and loss in determining the taxable income of the group. The GILTI provision is not based on this theory. Each CFC computes its tested items separately, which are then aggregated at the U.S. shareholder level. While a U.S. shareholder's inclusion might be reduced when there is a tested loss CFC, this does not equate to treating the CFCs as a single economic unit. Notably, there is no sharing of particular items of a tested loss CFC's items. Congress identified certain items of tested loss CFCs that should be excluded in determining the U.S. shareholder's inclusion. The U.S. shareholder is not permitted to take into account the QBAI of a tested loss CFC or the foreign taxes paid by a tested loss CFC. Instead of applying a single economic unit theory to CFCs, Congress believed measuring the tested items separately and aggregating those items at the U.S. shareholder level was “a more accurate way of determining a U.S. corporation's global intangible income.”¹⁷

The use of tested loss is not related to the stock investments made in the CFC but to the annual computation of the foreign income Congress seeks to tax. Applying the Ifeld principle outside of consolidation to adjust stock basis in tested loss CFCs seems to go beyond the intent of Congress. In section 951A, Congress identified and addressed a potential double benefit between the subpart F regime and GILTI provisions. When a U.S. shareholder's subpart F inclusion is limited by the E&P Limitation, the tested loss CFC's E&P is increased by the amount of tested loss used. This addresses the potential that tested loss will be used to reduce tested income and limit subpart F inclusions. Congress identified no other areas in which tax benefits should be limited.

2. The stock basis adjustment rule might lead to noneconomic results

From an economic perspective, a domestic corporation might be no better off from having a tested loss.

For example, USP owns CFC1 and CFC2 and neither has specified tangible property. In Year 1, CFC1 has tested income of $10 and unrealized loss in its assets of $10. CFC2 has tested loss of $10 and unrealized gain in its assets of $10. Overall the values of CFC1 and CFC2 remain the same. USP includes no GILTI in gross income because, under section 951A(c)(2)(B)(ii), CFC1's tested income is fully offset by CFC2's tested loss. If USP sells CFC1 and CFC2 in Year 2, there is no gain on CFC1 stock (because value is less than basis) but there is a $10 gain on CFC2 stock. For U.S. consolidated groups, the Proposed Regulations provide a similar allocation of each member's tested items to members of the group.¹⁸

If USP adjusts CFC2's stock basis downward for the use of the $10 tested loss from Year 1, the gain on CFC2 stock would increase to $20 of gain even though the net effect of the disposition of CFC1 and CFC2 produced no economic gain to USP.

3. The stock basis adjustment rule makes the location of a CFC more significant

Section 951A's measurement of a U.S. shareholder's GILTI inclusion reduces the significance of a CFC's location by measuring each CFC's tested items and aggregating those items at the U.S. shareholder level. Reducing the significance of a CFC's location is also addressed in section 951A(f)(2) for purposes of how to allocate GILTI that is treated as subpart F income for various Code sections. Aggregating tested items and then allocating these items back to each member or CFC minimizes the significance of each CFC's location within the group.

The stock basis adjustment rule, however, makes the location of tested loss CFCs more significant. Prop. Treas. Reg. § 1.951A-6(e)(1)(ii) allows a CFC's tested income to be offset by tested loss in another CFC in the same ownership chain.¹⁹ The netting is not provided to CFCs in different ownership chains. This will likely cause taxpayers to engage in planning transaction to arrange their CFCs in particular ownership chains to avoid to the impact of the stock basis adjustment rule.

4. The stock basis adjustment rule produces an economically incorrect result

Through the application of the section 250 deduction, U.S. shareholders in many circumstances apply an effective rate of 10.5% to their GILTI inclusion, rather than the full 21% U.S. corporate tax rate. The stock basis adjustment rules can take away this benefit. Furthermore, on disposition of a tested loss CFC, the stock basis adjustment rules can create subpart F income, thereby turning a tested loss into a future income inclusion. Example 7 in the Proposed Regulations illustrates this point:

In Year 1, USP1 has no GILTI income (tested income of $100 – tested loss of $100 = $0), resulting in no GILTI tax liability. Without CFC2's tested loss, USP1 would have $100 of GILTI income, resulting in a $10.50 tax liability.²¹

At the time of the disposition, USP1 has a NUTL amount of $90 with respect to CFC2 due to the fact that CFC2 had tested loss of $100 in Year 1 and USP1 owns 90% of CFC1 which owns all of CFC2. As a result, CFC2's basis is reduced by the amount of its NUTL, $90. Because USP1's ownership in CFC2 is the result of its ownership in CFC1, CFC1 rather than USP1 recognizes a gain of $90 at the disposition of CFC2. This results in USP 1 having subpart F income, specifically foreign personal holding company income, which it must recognize in Year 2. The resulting gain would be taxed at the 21% rate resulting in tax liability for USP1 of $18.90 before foreign tax credits, nearly twice the amount of the tax saved by the presence of tested losses in Year 1.

Note that because the gain from the sale is treated as subpart F income and not as a dividend under section 1248, USP1 is not eligible to reduce its ultimate tax liability by the section 245A deduction and is therefore taxed on the entire amount. As a result, USP1's benefit from including its tested loss in its GILTI calculation in Year 1 is not only effectively wiped out by the reduction in basis in Year 2 but also produces additional tax as the full U.S. tax rate of 21% is applied on the disposition. The perceived benefit of the tested loss — reducing GILTI subject to a reduced U.S. tax rate of 10.5% — produces a result worse than if the tested loss were not used at all.

5. Tracking the stock basis adjustments for used tested losses presents an administrative burden for domestic U.S. shareholders

The NUTL calculation presents significant bookkeeping and tracking inefficiencies for domestic corporations. While the calculation would be relatively simple for a domestic corporation that owns CFCs directly, most structures in place take the form of tiered CFCs where tracking NUTLs would create a significant administrative burden. The two components of NUTL, used tested loss and offset tested income, not only include amounts for the year prior to the sale of a tested loss CFC, but for all years in which the domestic corporation has had a sufficient interest in the CFC. Beginning after the effective date, domestic corporations will be required to track detailed information for each CFC through the ownership period, only to conclude in many instances that an otherwise tested income CFC does not possess a NUTL at the time of a potential disposition and therefore no adjustment is necessary. The examples in Prop. Treas. Reg. § 1.951A-6, while instructive, only account for instances in which a CFC is owned by a domestic corporation for a maximum of two or three years, rather than a situation in which there is long-term ownership.

C. Recommendations for Prop. Treas. Reg. § 1.951A-6(e)

For the reasons explained above, the Working Group recommends that this rule be deleted in the final regulations. In the event Treasury does not remove the rule outright, the Working Group suggests Treasury allow for a 50% rather than a 100% reduction in stock basis, and the option to elect out of using tested losses entirely.

Under the alternative rule, taxpayers would be required to reduce stock basis by only 50% of the NUTL amount. While the Working Group maintains that used tested loss should not be treated as having the potential to provide a double benefit, the haircut would provide at least some relief for taxpayers by taxing any gain from the adjustment at the same 10.5% rate at which GILTI income is generally taxed, rather than the current U.S. tax rate of 21%.

Taxpayers also should be allowed to elect out of using tested losses in their GILTI calculation altogether, eliminating the possibility that a CFC would have a NUTL, and therefore eliminating the need for a corresponding stock basis adjustment. Taxpayers might not have the information necessary to determine whether to waive using a tested loss in the current year but taxpayers could be allowed to waive the loss retroactively, or reduce the NUTL amount at the time of a later disposition to the extent the taxpayer can establish to the satisfaction of the Secretary that the prior tested loss did not provide a double benefit.

III. Temporarily held assets presumed to have a principal purpose to avoid GILTI

A. Background to Prop. Treas. Reg. § 1.951A-3(h)(1)

Under section 951A(b), a U.S. shareholder's share of net CFC tested income is reduced by the QBAI return. The QBAI return is measured with respect to each CFC as the “average of such corporation's aggregate adjusted bases as of the close of each quarter of such taxable year in specified tangible property used in a trade or business of the corporation, and of a type with respect to which a deduction is allowable under section 167.”²² Section 951A(d)(3) provides that the adjusted basis is determined by using the alternative depreciation system under section 168(g). In general, the more QBAI a CFC has, the more net CFC tested income will be reduced by the QBAI return and the less U.S. tax a U.S. shareholder will owe on its share of GILTI. Congress anticipated that the QBAI return might encourage taxpayers to engage in transactions to increase a CFC's QBAI.²³ Accordingly, section 951A(d)(4) directs the IRS and Treasury to issue appropriate guidance to

(emphasis added)

In the Proposed Regulations, the IRS and Treasury exercised this authority in three different rules aimed at specific areas of concern. With respect to property “transferred, or held, temporarily,” the Proposed Regulations would disregard specified tangible property and therefore the adjusted basis of such property for purposes of the QBAI return if the property is (1) acquired by the CFC with a principal purpose of reducing the GILTI inclusion, and (2) held over the close of one quarter.

The Proposed Regulations then provide what appears to be an irrebuttable presumption that these two factors are met when the CFC holds the property for “less than a twelve month period that includes at least the close of one quarter during the taxable year” of the CFC.²⁴

B. Comments on Prop. Treas. Reg. § 1.951A-3(h)(1)

The Working Group believes this anti-abuse rule is too broad. While it is clear Congress was concerned with transactions that increase the adjusted basis in specific tangible property, the Proposed Regulations leave no room for taxpayers to establish that in their normal business operations, tangible property is acquired, held over a quarter, but disposed of before a 12-month period is completed. There very well may be no principal purpose to reduce the GILTI inclusion in these transactions, but the Proposed Regulations make a conclusive presumption that such is the case. For these taxpayers, the QBAI return will be reduced due to their normal business operations.

Taxpayers that acquire specified tangible property as a long-term capital investment can lose credit for a portion of the adjusted basis if acquired in a quarter prior to the 12-month period being satisfied. For example, if a taxpayer acquires specified tangible property on September 15 of Year 1, the adjusted basis attributed to the last quarter will not be available as QBAI because the taxpayer will not be able to establish for Year 1 that the property was held for the 12-month period. In Year 2, adjusted basis allocated to each quarter in Year 2 will be available as QBAI because the taxpayer will be able to establish prior to the close of Year 2 that the property has been held longer than the 12-month period. The anti-abuse rule does not, however, look back to the prior year to give credit for QBAI lost in the last quarter of Year 1.

C. Recommendation for Prop. Treas. Reg. § 1.951A-3(h)(1)

The anti-abuse rule in Prop. Treas. Reg. § 1.951A-3(h)(1) should be narrowed to take into account normal business operations that would otherwise run afoul of the irrebuttable presumption currently proposed. The simplest way to modify the rule would be to provide a rebuttable presumption for taxpayers to demonstrate that the acquisitions have a business purpose.

IV. Foreign-to-Foreign dividends — application of section 245A to determine CFC tested income or loss

A. Background to Prop. Treas. Reg. § 1.951A-2(c)(2)

In the Proposed Regulations, the IRS and Treasury request comments on whether “a CFC could be entitled to a dividends received deduction under section 245A, even though section 245A by its terms applies only to dividends received by a domestic corporation.”²⁵ As explained below, a CFC should be entitled to a dividends received deduction under section 245A in circumstances when the distributed foreign earnings represent the QBAI return that is exempt from U.S. tax. While members of the Working Group are from a mix of industries, the companies either have few tangible assets or their tangible assets have low adjusted basis that results in little to no QBAI return. Nonetheless, to the extent a company has a QBAI return, we advocate for the application of section 245A to such returns.

Section 245A establishes a participation exemption system in which a domestic corporation is entitled to a 100% deduction for the foreign-source portion of a dividend received from a specified 10-percent owned foreign corporation that is a U.S. shareholder.²⁶ The 100% dividends received deduction (DRD) implements the movement of the U.S. tax system towards a territorial tax system that seeks to exempt certain foreign earnings of U.S. shareholders from U.S. tax.

Foreign earnings that are exempt include the QBAI return that reduces or eliminates a U.S. shareholder's GILTI inclusion. Under section 951A, GILTI is measured as the excess of the gross income of a CFC over the deductions properly allocable to such gross income.²⁷ In calculating the allowable deductions, Congress references the subpart F principles in section 954(b)(5) that address the allocation and apportionment of deductions. The Proposed Regulations link this statutory reference to determining a CFC's tested income by applying Treas. Reg. § 1.952-2, which treats a CFC as a domestic corporation.

For purposes of determining whether a DRD applies to a CFC's receipt of a distribution from another foreign corporation, reference to Treas. Reg. § 1.952-2 suggests CFCs are treated as domestic corporations and might be entitled to a DRD. This application is consistent with the Conference Report that suggests “a CFC receiving a dividend from a 10-percent owned foreign corporation that constitutes subpart F income may be eligible for the DRD with respect to such income.”²⁸

In addition, prior to expiration of the look-thru rule provided in section 954(c)(6), distributions between related foreign corporations of foreign earnings that are not characterized as personal foreign holding income are not subject to current U.S. tax under the subpart F regime.²⁹ The potential expiration of section 954(c)(6) raises the issue of whether the receipt of these distributions would also be entitled to a DRD if the look-thru rule is not extended or made permanent.

B. Comments to Prop. Treas. Reg. § 1.951A-2(c)(2)

The DRD should be applied to dividends between foreign corporations to ensure foreign earnings identified as exempt income remain exempt from U.S. tax. Under the GILTI provisions, foreign earnings are exempt to the extent of the QBAI return. Without the application of section 245A to certain foreign-to-foreign dividends, a distribution of these earnings can result in exempt income becoming taxable where the distribution is between foreign corporations and characterized as subpart F income. In contrast, when foreign earnings are not exempt (because they are taxed currently under either the subpart F regime or GILTI provisions), section 959 prevents these earnings from incurring additional U.S. tax by excluding amounts distributed from a U.S. shareholder's gross income. Section 959(a)'s statutory language is limited to subpart F inclusions but pursuant to section 951A(f)(1)(A) the same exclusion from gross income should be extended to GILTI inclusions. While Treasury plans to issue PTI regulations in the near future that would confirm this application, the cross reference in section 951A(f) appears sufficient to extend section 959 to GILTI inclusions until regulations confirm the result.

The DRD would apply to foreign-to-foreign dividends of exempt earnings by providing a deduction that offsets the inclusion of exempt earnings treated as subpart F income as a result of a distribution. Exempt earnings can be characterized as subpart F income as a result of a dividend when either the dividend is made between unrelated CFCs (such as distributions from noncontrolled foreign corporations), or after the expiration of the look-thru rule provided in section 954(c)(6) and the dividend is made between related CFCs that are not in the same country.

When a dividend is made between unrelated CFCs, such as a distribution from a noncontrolled foreign corporation to a CFC, section 245A is necessary to ensure foreign earnings identified as exempt income remain exempt from U.S. tax. For example, assume:

First, in Year 1, USP1 has no subpart F inclusion and, after the QBAI return, no GILTI inclusion (USP1's $100 GILTI is less than the $150 QBAI return (20% of $7500 x 10%)). Next, in Year 2, the impact of CFC2's $100 dividend to CFC1 depends on the application of section 245A. The $100 dividend is FPHCI to CFC1 and no exception applies to exclude the distribution from subpart F income because CFC1 and CFC2 are not related within the meaning of section 954(d)(3). Without the application of section 245A, the $100 of earnings exempt from GILTI in Year 1 (because of the QBAI return) becomes taxable. Further, unless the local taxes paid are deemed “attributable to” CFC1's dividend income under section 960, USP1's subpart F inclusion may not be offset with CFC 2's local taxes paid. If section 245A applies to the Year 2 dividend, then CFC1 can offset the $100 subpart F income with a $100 DRD. The application of the DRD ensures the foreign earnings identified as exempt income remain exempt from U.S. tax.

A similar application of the DRD will be necessary when a dividends is between related CFCs but made after the potential expiration of section 954(c)(6). For example, assume:

First, in Year 1, USP1 has no section 952 subpart F inclusion and, after the QBAI return, no GILTI inclusion (USP1's $200 GILTI is less than the $500 QBAI return ($5000 x 10%)). Next, in Year 2, the impact of CFC2's $200 dividend to CFC1 depends on the application of section 245A. As provided under current law, after 2020, the look-thru rule no longer applies and the $200 dividend is FPHCI to CFC1. No exception applies to exclude the distribution from subpart F income despite CFC1 and CFC2 being related within the meaning of section 954(d)(3). Without the application of section 245A, the $200 of earnings exempt from GILTI in Year 1 (because of the QBAI return) becomes taxable. If section 245A applies to the Year 2 dividend, then CFC1 can offset the $200 subpart F income with a $200 DRD. The application of the DRD ensures the foreign earnings identified as exempt income remain exempt from U.S. tax.

Applying section 245A to these foreign-to-foreign dividends is consistent with Treas. Reg. § 1.952-2 that treats CFCs as domestic corporations. Furthermore, the DRD for the distributions gives meaning to Congress' footnote reference that subpart F income may be eligible for the DRD with respect to such income.

It is not clear that all foreign-to-foreign dividends would benefit from the DRD. Foreign-to-foreign dividends that would not be subject tax, for example through the look-thru rule, might trigger consequences under section 1059 if the distribution were both excluded as subpart F income and permitted a DRD. Section 1059 seeks to tax extraordinary dividends through stock basis adjustments equivalent to the portion of the dividend that was not taxed. If the downward stock basis adjustment exceeds the existing stock basis, gain results.³⁰ In instances where the dividend was intended to be excluded from subpart F income (i.e., under the look-thru rule), the application of section 1059 could trigger gain recognition on income that was excluded from tax.

C. Recommendations to Prop. Treas. Reg. § 1.951A-2(c)(2)

The Working Group recommends that Treasury confirm the DRD will apply to subpart F dividends between foreign corporations to ensure foreign earnings identified as exempt income remain exempt from U.S. tax. Specifically, the Proposed Regulations or further guidance under section 245A should confirm foreign-to-foreign dividends treated as subpart F income will be allowed the DRD. The regulations should take into account that the look-thru rule provided in section 954(c)(6) expires after 2019 and, upon expiration, dividends that otherwise would have qualified as exempt under section 954(c)(6) would be equally entitled to the DRD. In each case, regulations should confirm that the DRD is a deduction that is definitely related to the subpart F dividend income it offsets for purposes of determining net foreign base company income (within the meaning of Treas. Reg. § 1.954-1(c).

An equally important clarification would be a rule that coordinates the DRD with subpart F dividend inclusions that are deferred under the E&P Limitation by applying the DRD in the year the Recapture Rule causes an inclusion of the subpart F dividend.

V. Pro rata share anti-abuse rule under section 951

A. Background on Prop. Treas. Reg. § 1.951-1(e)(6)

A U.S. shareholder's inclusion under section 951A is based on its pro rata share of the excess of net CFC tested income over net deemed tangible income return. A U.S. shareholder's pro rata share is defined by reference to section 951(a)(2).³¹ The Proposed Regulations update the pro rata rules in the pre-existing 951 regulations for purposes of subpart F income and section 951A inclusions.

As part of the pro rata proposed rules, the Proposed Regulations add an anti-abuse rule that reads:

This anti-abuse rule extends to the determination of a U.S. shareholder's pro rata share of CFC tested items.³³

As explained in the Preamble, the anti-abuse rule is concerned with noneconomic allocations of income that reduce or remove inclusions from a U.S. shareholder's gross income.³⁴ These concerns were first addressed by Treasury and the IRS in regulations published in 2005 and 2006 to identify and preclude certain transactions that resulted in non-economic allocations of subpart F income. Treas. Reg. § 1.951-1(e)(3)(v), adopted in 2006, specifically identified certain section 304 transactions that were being used to avoid U.S. federal income tax by allocating income to a tax indifferent party. These concerns persist and Treasury believes these transactions and structures might still provide noneconomic allocations that impact subpart F income and section 951A inclusions. Therefore, the Proposed Regulations broaden the anti-abuse rule in Prop. Treas. Reg. § 1.951-1(e)(6) and extend the application to whether transactions reduce a U.S. shareholder's pro rata share of CFC tested items.³⁵

B. Comments on Prop. Treas. Reg. §1.951-1(e)(6)

As written, it is not clear whether the anti-abuse rule is limited to transactions that reduce a U.S. shareholder's pro rata share of tested items or applies more broadly to transactions that reduce the GILTI inclusion because tested items have been reduced. Particularly, if a transaction changes the characterization of a CFC's income from tested income to subpart F income, the anti-abuse rule potentially could be interpreted to apply. Other elections (e.g., section 338(g) elections, or check-the-box elections pursuant to Treas. Reg. § 301.7701-3) could also change the characterization of foreign earnings without altering a U.S. shareholder's allocable share of foreign earnings. The anti-abuse rule should be limited to transactions that are (i) noneconomic allocations, and (ii) result in a shift in section 951A inclusions or section 952 subpart F income away from the U.S. shareholder. Transactions that change the treatment of the income — from GILTI to subpart F — should not be subject to the anti-abuse rule. These transactions might reduce tested income but do so by increasing subpart F income. Such transactions are not an avoidance of U.S. federal income tax. These types of transaction simply move income from being taxed under one anti-abuse provision (the GILTI provisions) to another anti-abuse provision (the subpart F regime).

C. Recommendation for Prop. Treas. Reg. §1.951-1(e)(6)

The Proposed Regulations should clarify through an example or language that narrows the rule to confirm the anti-abuse rule is not intended to prevent taxpayers from restructuring their foreign income between different types of taxable income.

VI. Lower-tier stock basis adjustments to account for GILTI PTI

A. Background to PTI stock basis adjustments

GILTI inclusions generally are similar to but operate outside of the subpart F regime, except where Congress identified certain Code sections that will apply to GILTI inclusions “in the same manner as an amount included under section 951(a)(1)(A) [i.e., as subpart F income].”³⁶ Congress also provided authority to Treasury to apply other Code sections to GILTI inclusions in the same manner as subpart F inclusions “in any case in which the determination of subpart F income is required to be made at the level of the [CFC].”³⁷

Sections 959 and 961 are among the specifically enumerated Code sections for which GILTI inclusions shall be treated in the same manner as subpart F income. Sections 959 and 961 work together to prevent double taxation of a U.S. shareholder's foreign earnings that have been previously included as subpart F income or, by reference from section 951A(f), as GILTI. The previously taxed income (PTI) is excluded from double taxation under section 959 by excluding such earnings from a U.S. shareholder's gross income when the earnings are actually distributed from a CFC to its U.S. shareholder. Corollary adjustments are made to CFC stock basis. Under section 961(a), stock basis is adjusted upwards when a U.S. shareholder has an income inclusion and downwards, under section 961(b), when a U.S. shareholder receives a distribution from its CFC. Similar adjustments are made to lower-tier CFC stock basis under the direction of section 961(c) to account for inclusions and distributions occurring below a CFC held directly by a U.S. shareholder.³⁸ As provided in section 961(c), however, these stock basis adjustments are made “only for purposes of determining the amount included under section 951 in the gross income of a U.S. shareholder.”³⁹ Treasury regulations address rules for determining stock basis adjustments under section 961(a) and (b), but regulations do not yet address rules for adjusting lower-tier CFC stock basis under section 961(c) or for new PTI created as a result of the GILTI provisions.

B. Comments on PTI stock basis adjustments

We welcome Treasury issuing PTI guidance that updates rules for stock basis adjustments under section 961(a) and (b) and urge Treasury to include in the PTI guidance rules that address issues existing prior to the TCJA under section 961(c) as well as rules to address PTI created under the GILTI provisions. An issue existing prior to the TCJA is the implementation of section 961(c) basis in transactions where lower-tier CFCs become first tier CFCs. For example, assume:

In Year 1, when USP includes $100 GILTI in gross income, USP's stock basis in CFC1 is adjusted upwards by $100 under section 961(a). CFC1's basis in CFC2 stock is also adjusted upwards by $100 under section 961(c). In Year 2, when CFC1 liquidates into USP, USP becomes the direct owner of CFC2. USP's basis in CFC2 is the same as CFC1's basis in CFC2 as determined under section 334(b). Treasury guidance does not address, however, whether CFC2's stock basis, initially determined under section 961(c), converts to basis determined under section 961(a) that would remove the limitation on the use of CFC2's stock basis. This issue existed prior to the TCJA but will become more relevant as more foreign earnings become PTI under the GILTI provisions. In particular, the PTI guidance will be important for taxpayers to determine the U.S. tax consequences to USP on CFC2's subsequent $100 distribution — the distribution will either be a tax-free return of basis or a fully taxable distribution.

After CFC1's liquidation, CFC2 is a first-tier subsidiary of USP and its stock basis should be converted to section 961(a) basis. One of the goals of sections 959 and 961 is to prevent double taxation of foreign earnings that have been previously taxed. In Year 1, CFC2's income of $100 was included in USP's gross income as GILTI. The amount of PTI is knowable and as a result of becoming a CFC directly held by USP, USP's basis — that represents PTI — should be usable for purposes of a subsequent distribution by CFC2 to USP. If the basis is not converted to section 961(a) basis, the stock basis might not be available when CFC2 makes a subsequent distribution of the earnings and could result in those earnings being taxed again.

C. Recommendation for PTI stock basis adjustments

Forthcoming regulations on PTI will be critical to taxpayers understanding the full impacts of the GILTI provisions. Among those impacts are issues that existed prior the TCJA. We recommend the PTI guidance permit the stock basis in lower-tier CFCs to convert to section 961(a) basis in an amount equal to the income previously included by the U.S. shareholder, where lower-tier CFCs become CFCs directly held by a U.S. shareholder.

The Working Group thanks you for the consideration of these comments. Please contact Jeff Levey (Jeff.Levey@ey.com) if you have any questions regarding this submission.

Copies to:

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Douglas L. Poms
International Tax Counsel
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Marjorie A. Rollinson
Associate Chief Counsel (International)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224