Check-the-Box Regulations After Pillar 2

Carol Wang

Carol Wang is legislation counsel at the Joint Committee on Taxation in Washington, where she is a member of the passthrough and foreign teams. She thanks Thomas Barthold, Tim Dowd, David Lenter, Kristine Roth, Mindy Herzfeld, Stephen Shay, and Kristi Crabtree for their comments. However, any errors are the author’s.

In this article, Wang examines how the global intangible low-taxed income regime, the corporate alternative minimum tax, and pillar 2 affect the use of disregarded entities for international tax planning.

The views expressed in this article are solely the author’s and do not necessarily reflect those of the JCT or any other organization.

Copyright 2023 Carol Wang.
All rights reserved.

Since December 1996, domestic and foreign eligible entities have been able to elect their tax classification for U.S. federal income tax purposes.¹ As a result, eligible entities may elect to be a corporation that is subject to entity-level tax, a partnership that is not subject to entity-level tax but rather passes through its income and loss to its owners, or an entity that is disregarded as separate from its owner (a disregarded entity or DRE). DREs that are owned by individuals are treated as sole proprietorships, and DREs that are owned by corporations or partnerships are treated as branches or divisions of that corporation or partnership. They are ignored for U.S. federal income tax purposes and deemed to be the same taxable entity as their regarded owner.

This article focuses on foreign DREs (referred to more colloquially as branches) and how their use in tax planning, traditionally to mitigate subpart F consequences, has been affected by the passage of the tax on global intangible low-taxed income and the corporate alternative minimum tax, as well as how they would be affected under pillar 2.

Using simplified examples, this article shows that it continues to be important to include foreign branches in multinational enterprise structures under the GILTI regime and the corporate AMT. Because GILTI is taxed at half the rates of subpart F income, and because GILTI applies only if subpart F does not apply to a category of income, taxpayers find it important to continue to qualify for an exception from subpart F. This has traditionally been managed with the use of foreign branches.

In addition, the corporate AMT could subject more foreign income to U.S. tax because its tax base is determined by financial accounting concepts, so there is no longer different tax treatment of foreign income that is “active” GILTI income (taxed at lower rates) versus “passive” subpart F income (taxed at higher rates). However, the corporate AMT continues to treat earnings differently if it is earned by a branch versus a corporation, in that the financial statement income of branches owned by controlled foreign corporations would continue to be treated as aggregated with the CFC’s financial statement income. This consolidation of foreign branch income and loss, as well as of foreign branch income subject to high foreign tax versus low foreign tax, can be helpful to minimize corporate AMT liability.

Pillar 2 also uses financial accounting concepts and thus eliminates the distinction between passive and active income, but it goes further than the corporate AMT by also removing the distinction between the earnings generated by a corporation versus a branch. A constituent entity’s earnings would be required to be taxed at 15 percent, regardless of its U.S. tax classification.

JCT Data Analysis

A recent Joint Committee on Taxation study of large U.S.-headquartered corporations showed an increase in the number of foreign branches per taxpayer from 2016 to 2020.² The growth of foreign branches indicates that their importance in tax planning did not change with the implementation of the 2017 Tax Cuts and Jobs Act.

The study examined large, publicly traded U.S.-headquartered corporations with positive pretax income from foreign operations that had at least $100 million in assets in 2016. These corporations also reported gross income of $200 billion to $450 billion per year on their tax returns between 2014 and 2020.

After the passage of the TCJA, the number of foreign DREs used by these U.S.-headquartered corporations markedly increased from 2017 to 2019. The JCT study examined the number of Forms 8832, which are forms required to be filed to elect tax treatment as DREs. In 2017, about 80 forms were filed for each of these U.S.-headquartered corporations; in 2019 about 128 forms were filed. In particular, pharmaceutical companies saw a jump in the use of foreign DREs, from about 40 Forms 8832 filed per company in 2017 to about 70 Forms 8832 filed per company in 2019.

In contrast, the number of CFCs that these U.S.-headquartered corporations reported on Forms 5471 stayed flat, indicating that these U.S.-headquartered corporations were increasing their usage of foreign branches, not simply converting existing CFCs to DREs. (See Figure 1.)

These pharmaceutical companies also reported more royalties as a percentage of gross income than other similarly sized (in terms of assets and revenue) corporations (more than 9 percent, in comparison with 1.8 percent in 2020), more amounts reported as GILTI ($4 billion, in comparison with less than $500 million in 2020), and more foreign tax credits claimed ($400 million, in comparison with less than $100 million in 2020).

Before the TCJA, the number of foreign branches had also been increasing. Before the check-the-box regulations were finalized in 1997, a few hundred foreign branches were reported, but in March 2000, more than 7,800 foreign eligible entities had elected branch/DRE treatment.³

This article explores why the growth in foreign branches continues, in light of the GILTI regime, the corporate AMT, and pillar 2.

U.S. Tax on Foreign Earnings

Beginning in 1962, U.S. persons were subject to tax annually on certain passive and mobile income (subpart F income) earned by a CFC. A CFC is a foreign corporation that is more than 50 percent owned by “U.S. shareholders,” defined as U.S. persons owning a 10 percent or greater interest in vote or value of the corporation.

After the enactment of the TCJA, U.S. shareholders were also subject to tax on the aggregate tested income and tested loss from all of the U.S. shareholder’s CFCs, reduced by a net deemed tangible income return based on the depreciable assets of the CFCs, an inclusion known as GILTI.⁴ GILTI excludes any U.S.-source income that is effectively connected with a U.S. trade or business, as well as any subpart F income. Because subpart F is an exception from GILTI, any analysis of foreign earnings needs to first identify whether the income is taxable as subpart F income before it could qualify as GILTI.⁵

In addition, the TCJA lowered U.S. corporate tax rates from 35 percent to 21 percent, which affects the U.S. tax rate applied on subpart F income and GILTI.⁶ Subpart F income is now taxed at the corporate tax rate of 21 percent, offset by FTCs that may be carried back one year or forward 10 years. It is a calculation made per CFC and is subject to earnings and profits limitations.

GILTI is taxed at the preferential corporate tax rate of 10.5 percent, which is achieved by a section 250 deduction. Its FTCs are more limited in comparison with the FTCs that may offset subpart F (for example, there is a 20 percent haircut, as well as no carryback or carryforward of excess credits).

Last year, the Inflation Reduction Act introduced a new corporate AMT, which imposes a tax on certain applicable corporations’ domestic, as well as foreign, earnings as reported on consolidated financial statements.

Finally, in December 2021 the OECD published the pillar 2 model rules.⁷ An increasing number of countries have now enacted or proposed to enact those rules into domestic legislation. The model rules require covered MNEs to pay a minimum effective tax rate of 15 percent on the global anti-base-erosion (GLOBE) income in each jurisdiction of a constituent entity, a term that includes both branches and permanent establishments.⁸ GLOBE income is financial statement income that would be determined for an entity in preparing consolidated financial statements of the ultimate parent entity.

These changes to how foreign earnings of a CFC are taxed to U.S. shareholders may affect how U.S. MNEs structure their foreign operations, including the CFC’s use of foreign branches. Before discussing how these regimes may affect the use of branches, it may be helpful to summarize how branches have historically been used in subpart F planning.

Subpart F Income

Before the enactment of the TCJA, U.S. shareholders that conducted foreign operations through CFCs had been concerned with two types of subpart F income earned by a CFC: foreign personal holding company income (FPHCI) and foreign base company sales income (FBCSI).⁹ Branches helped minimize the risk that foreign income was classified as either type of subpart F income that would be taxed annually in the United States, regardless of whether the earnings are distributed.

FPHCI

FPHCI targets primarily passive income such as dividends, interest, royalties, rents, and annuities.¹⁰ Exceptions exclude some income from FPHCI, such as income paid to a CFC by a related person organized in the same country as the CFC (the same-country exception), as well as income paid to a CFC by a related person to the extent attributable to the payer CFC’s income that is not subpart F income (the look-through exception).

To illustrate the use of branches, below are a few stylized hypothetical scenarios. Countries referenced are used for illustrative purposes only.

Example 1

Example 1 (which encompasses Figure 2 and Table 1) illustrates how the rules work without tax planning.

Example 2

Example 2 (which encompasses Figure 3 and Table 2) shows that, with tax planning, USP and Irish CFC may instead enter into a cost-sharing agreement in which they agree to share costs of developing intangible property in proportion to each party’s share of reasonably anticipated benefits expected from the use of the intangible property (generally, each party’s share of revenue). Expenses allocated to Irish CFC, here 5, would increase taxable income at USP by the same amount.

This additional tax burden to USP is generally offset by a larger tax benefit of a finite stream of buy-in payments made to USP (in comparison with the tax that would apply to a perpetual, annual royalty payment from CFC to USP for the use of the license).¹¹

Absent some exception, the royalty income to the Irish principal CFC may be FPHCI. However, because the payer, the German manufacturer, is a related-party CFC and because the royalty payment to the Irish principal is attributable to the German manufacturer’s active manufacturing income, the Irish principal may qualify under the look-through exception for its receipt of royalty payments to not be FPHCI. (See Table 2.)

Example 3

U.S. MNEs may find it more reassuring to rely on check-the-box structuring to treat both the German manufacturer CFC and the Irish principal CFC as DREs.¹² In that case, the intercompany royalty between the German manufacturer and the Irish principal disappears and is disregarded for U.S. tax purposes, and there would be no FPHCI. Tax results in Example 3 are the same as Example 2. (See Figure 4 and Table 3.)

FBCSI

FBCSI is intended to address related-party payments that were viewed as inappropriately separating sales from manufacturing income, and reporting sales income in zero or low-tax foreign jurisdictions where they are also not subject to U.S. tax. It consists of income derived by a CFC in connection with:

In each of the situations described in items (1) through (4), the property must be both manufactured outside the CFC’s country of incorporation and sold for use outside of that same country for the income from its sale to be considered FBCSI.¹³

There are two manufacturing exceptions relating to FBCSI:

There is a statutory manufacturing exception from FBCSI for income from the sale of goods that are manufactured in the country where the CFC is incorporated (but it does not require that the CFC itself is taxable in that country in which it is incorporated; see Example 5, where the CFC is treated as a flow-through entity for local tax purposes).¹⁴

There is a second manufacturing exception in the regulations that provides that if the CFC manufactures or constructs the property sold, the income is not FBCSI subject to the branch rule discussed below.¹⁵ Manufacturing is defined by physical manufacturing tests such as the substantial transformation test and the substantial activity test (also referred to as the component parts or major assembly tests),¹⁶ as well as nonphysical activities such as the substantial contribution test, which was added by 2008 regulations and is discussed below.¹⁷

Example 4

Example 4 (which encompasses Figure 5 and Table 4) shows the results without tax planning.¹⁸ USP purchases a product from German CFC, which manufactured the product, which USP then sells worldwide.

However, U.S. shareholders may want to report the sales income in a lower-tax foreign jurisdiction because income earned abroad by a CFC may not be subject to U.S. tax if the CFC conducts manufacturing activities outside the United States.¹⁹

Example 5

To plan to qualify for the first statutory same-country manufacturing exception from FBCSI, USP may form a Chinese business trust (CBT CFC), which would check the box for it to be treated as a corporation for U.S. tax purposes, but as a flow-through entity for Chinese tax purposes. CBT CFC would form Chinese Procurement DRE, which would check the box for it to be treated as a DRE for U.S. tax purposes, but it would be regarded as a corporation for Chinese tax purposes.

Chinese Procurement DRE would find the third-party manufacturers on behalf of USP. CBT CFC then buys the product from those third-party manufacturers and sells the product at a significant markup to USP, which then sells to U.S. customers. CBT CFC pays Chinese Procurement DRE 0.1 percent to 10 percent of the gross value of goods procured, which leaves significant profits in CBT CFC. (See Figure 6.)

These profits would not be taxable for U.S. tax purposes because the income would be derived in connection with manufacturing that also occurs in China, the same country as the jurisdiction of CBT CFC, and thus would qualify for the same-country manufacturing exception.²⁰ In addition, CBT CFC would not be a taxable entity under Chinese law, would have minimal activity, and would have no employees that could give rise to a taxable nexus in China.

Tax results are shown in Table 5.²¹

Example 6

In addition, USP may qualify its structure for the regulatory CFC manufacturing exception from FBCSI, which requires the CFC to conduct manufacturing with its own employees. On December 24, 2008, Treasury released regulations to clarify that a CFC may qualify for the manufacturing exception by making a substantial contribution through the nonphysical manufacturing activities of its employees. Qualifying activities include oversight and direction of manufacturing activities, vendor selection, and quality control.²²

To satisfy these regulations, USP may check the box and elect to treat the German manufacturer and the Irish principal as DREs, and the foreign income would be treated as derived by Luxembourg CFC for U.S. tax purposes. If Luxembourg CFC has employees that oversee the German manufacturing, this foreign income may qualify for the regulatory manufacturing exception. (See Figure 7.)

However, a statutory branch rule may cause the 100 deemed earned by the CFC under U.S. tax law to be taxable in the United States. Branch rules apply if the use of the branch has “substantially the same effect” as if the branch were a subsidiary corporation, which, according to the regulations, is the case if a tax rate disparity test is satisfied. A branch is defined as an establishment through which the CFC carries on activities outside its country of incorporation.²³

Under the branch rule, a tax rate disparity test is applied. If the test is satisfied, then the branch is treated as a subsidiary, and, consequently, a CFC. This treatment would separate the manufacturing income from the sales income into two regarded entities that are related persons, and the income earned by the CFC or the branch (now treated as a subsidiary CFC) would be taxable as FBCSI, so long as the CFC or the branch (now treated as a subsidiary CFC) could not separately satisfy the manufacturing exceptions.

There are at least three versions of the tax rate disparity tests.

For sales branches, the tax rate disparity test looks to whether the ETR of the sales branch jurisdiction is too low in comparison with the CFC jurisdiction. If the ETR that applies to the income of the sales branch is too low in comparison with the hypothetical (or statutory) tax rate that would apply if the income were earned in the CFC jurisdiction by a corporation, the tax rate disparity test is met.²⁴

For manufacturing branches, the tax rate disparity test looks to whether the ETR of the CFC jurisdiction is too low in comparison with the manufacturing branch jurisdiction. That is, if the ETR that applies to the income earned by the CFC is too low in comparison with the hypothetical (or statutory) tax rate that would apply to the income if the income were earned in the manufacturing branch jurisdiction by a corporation, the tax rate disparity test is met.²⁵

Finally, in structures where there is both a manufacturing and a sales branch, the tax rate disparity test would apply only to the manufacturing branch and treat the income earned by the sales branch as if it were earned by the CFC. That is, the test compares the ETR that applies with the income earned by the sales branch, and if that rate is too low in comparison with the hypothetical (or statutory) tax rate that would apply to the income if the income were earned in the manufacturing branch jurisdiction, the tax rate disparity test is met.²⁶

An ETR is too low if it is less than 90 percent of the rate it is being compared against and at least 5 percentage points less than that rate.

In Figure 7, there is both a manufacturing and a sales branch. Thus, we apply the manufacturing branch tax rate disparity test only, by looking to the ETR that applies to the income earned by the sales branch and the rate that would apply to the income if the income were earned by a corporation in the jurisdiction of the manufacturing branch. Because the Ireland sales income is taxed at 12.5 percent, a rate lower than 90 percent of the statutory tax rate of 25 percent in Germany, and is also 5 percentage points less than Germany’s 25 percent rate, the tax rate disparity test is met.

As a result, the manufacturing branch is treated as a subsidiary and a CFC. However, because the manufacturing branch, now treated as a subsidiary, is conducting manufacturing, the 30 that it earns is not treated as FBCSI. In addition, because the 70 deemed earned by Lux Holdco CFC separately qualifies for the substantial contribution manufacturing exception, its income continues to not be taxed as FBCSI.

Tax results are shown in Table 6.

GILTI, Corporate AMT, and Pillar 2

To explain the effects of recent tax developments on the subpart F structures previously illustrated, each of those structures is assessed under GILTI, the corporate AMT, and pillar 2. These examples are simplified with the following assumptions:

• no qualified business asset investment;

• single tax year;

• no dividends actually paid by CFCs; and

• all entities are wholly owned.

FPHCI

For FPHCI, tax liability decreased from 4.2 to 2.925 from the branch structure in Example 3, reproduced as Figure 8.

GILTI

For the tax base, if the 15 of income earned by Lux CFC for U.S. tax purposes is not subject to tax as subpart F income, this income would be subject to current U.S. tax under GILTI. Note that this income would be offset by QBAI and foreign oil and gas extraction income (FOGEI) both assumed for simplicity to not be available here.²⁷ The tax rate applied to GILTI is half that of subpart F because of section 250.

For foreign tax credits, FTC limitations on the GILTI category include: no carryback or carryforward of excess FTCs, and a 20 percent haircut so that only 80 percent of foreign taxes paid can offset U.S. tax. In addition, while not evident in this example (with foreign tax paid in only one jurisdiction, Ireland), GILTI allows credits from a high-tax foreign jurisdiction to offset U.S. tax on income earned in low-tax foreign jurisdictions.

For the calculation of the liability, GILTI liability is offset by the lesser of 80 percent of the FTC attributable to foreign tax paid to Ireland (1.5) or the FTC limitation of 21 percent * (5 + 7.5) * (7.5/5 + 7.5) = (1.575). So GILTI liability of 15 * 10.5 percent, or 1.575, is decreased by 1.5 to equal 0.075.

In summary, GILTI imposed on the 15 of Luxembourg income increases tax liability from 2.925 to 3, a 2 percent increase in tax liability from pre-TCJA tax liability.

Corporate AMT

For the tax base, if USP were an applicable corporation, USP would pay 15 percent on its pro rata share of its consolidated foreign subsidiaries’ applicable financial statement income (AFSI) under the corporate AMT. The corporate AMT tax base is financial statement income, which means that the exceptions available to reduce the GILTI tax base would generally not be available to reduce the corporate AMT (no high-tax exclusion (HTE), no QBAI, no FOGEI). If we assume that taxable income is equal to AFSI for simplicity, USP would include its pro rata share, here 100 percent, of Lux CFC’s income of 15.

In addition, under financial accounting principles such as generally accepted accounting principles, a parent entity consolidates its financial statement income with that of a subsidiary over which it has a controlling interest (for example, a 100 percent owned subsidiary), so Lux CFC consolidates the income of the German and Irish DREs on its financial statement.²⁸

For the foreign tax credits, corporate AMT FTCs are subject to fewer limitations than GILTI FTCs. There is no haircut, and a five-year carryforward of excess credits is allowed. The only FTC limit for indirect foreign taxes is 15 percent of the taxpayer’s share of foreign AFSI.²⁹ Like GILTI, the corporate AMT allows for high-taxed foreign earnings to be grouped with low-taxed foreign earnings, and U.S. tax on both is decreased by aggregate foreign taxes, so that foreign taxes paid on high-taxed foreign earnings can offset U.S. tax on low-taxed foreign earnings.

In addition, like GILTI, the corporate AMT allows for U.S. losses to offset foreign income (although foreign losses are not allowed to offset U.S. income below zero and must be carried forward instead).

For the calculation of the tax liability, the rate imposed on foreign income under the corporate AMT is 15 percent, which is higher than the 10.5 percent GILTI rates, so the total tax is 1.05 + 0.375 + 1.875 = 3.3. This liability is reduced by the lesser of foreign taxes paid on that income (no baskets) (of 12.5 percent * 15), or 15 percent * the AFSI (of 15).

The increase in tax from GILTI is the result of the higher tax rate applied to the corporate AMT. In comparison with pre-TCJA tax liability, taxes have increased from 2.925 to 3.3, an increase of 12.8 percent.

Pillar 2

For the tax base, pillar 2 requires that an ETR of 15 percent is paid on financial statement income in each jurisdiction of each constituent entity, which includes both corporations and branches. Like with the corporate AMT, the tax base is financial statement income, and the tax rate is 15 percent.

For foreign tax credits, unlike the corporate AMT, pillar 2 does not allow high foreign taxes paid on income in one jurisdiction to count toward satisfying the 15 percent ETR requirement on income in another jurisdiction. However, parent jurisdiction CFC taxes are allocated to the CFC.³⁰ Under the February pillar 2 administrative guidance,³¹ GILTI is a blended CFC tax that is allocated down to constituent entities based on each entity’s share of tested income and the difference between that entity’s ETR and 13.125 percent.³² Note there is a limit on passive income allocated to constituent entities, so potentially there is a smaller likelihood for top-up tax to be levied if the income is classified as passive subpart F income (or even passive GILTI).³³

In addition, pillar 2 does not treat excess foreign taxes, carried forward as excess FTC, as a deferred tax expense and thus would reduce ETRs, potentially subjecting the MNE to top-up tax.³⁴

GILTI tax of 0.375 is allocated to Ireland. So top-up tax in Ireland is equal to 15 percent * 15 - 12.5 percent * 15 - 0.075 = 0.3.

If Ireland’s top-up tax is collected via a qualified domestic minimum top-up tax, note that the GILTI tax is ignored and instead the top-up tax would be 2.5 percent * 15 = 0.375. (However, because the United States may credit qualified domestic minimum top-up taxes, the GILTI liability would be reduced to zero, and the overall total tax would still be 3.3.)

For the calculation of the tax liability, the total tax is the same as the corporate AMT, so in comparison with the pre-TCJA scenario, tax liability has also increased by 12.8 percent. The difference between the corporate AMT and a jurisdiction-by-jurisdiction approach under pillar 2 is not shown in this example (there is only a single foreign jurisdiction with income, and it is low-tax).

In comparison with GILTI, the corporate AMT increases the tax liability by raising the rate from 10.5 percent to 15 percent on consolidated income of Luxembourg, Germany, and Ireland. Pillar 2 increases the rate and treats Germany and Ireland as regarded entities separate from Luxembourg. However, because only Ireland generates income in this example, pillar 2’s treatment of income as earned by separate constituent entities in Luxembourg, Germany, and Ireland does not produce incremental tax liability on top of the corporate AMT tax liability. This increased tax liability under pillar 2 can be seen more clearly in the next set of examples relating to the FBCSI structure.

FBCSI

For FBCSI, subpart F planning has reduced tax from 22.2 to 16.25, from Example 6, reproduced here.

GILTI

For the tax base, under GILTI, the United States would tax the 100 of foreign income that it views as being earned by Luxembourg Holdco CFC, but that aggregates foreign income from high-tax Germany and low-tax Ireland. In addition, 30 of that foreign income would be eligible for the GILTI high-tax exception as a result of being taxed at German rates (here, assumed to be 25 percent), and 70 would be subject to tax at 10.5 percent.

For foreign tax credits, GILTI’s FTCs are limited (no carryback or carryforward and subject to a 20 percent haircut). And because GILTI is a separate basket, foreign taxes paid on GILTI can offset only U.S. tax on GILTI category income.

For the tax liability calculation:

In summary, there is an increase in tax because previously exempt foreign income is now subject to U.S. tax, but the high-tax kick-out, the lower tax rate, and the tax credit for 80 percent of foreign taxes paid/accrued lower the incremental tax cost in comparison with pre-TCJA tax.

Corporate AMT

For the tax base, if USP were an applicable corporation, as discussed above, USP would pay 15 percent on its pro rata share of its consolidated foreign subsidiaries’ AFSI under the corporate AMT. The corporate AMT tax base is financial statement income, which means that the exceptions available to reduce the GILTI tax base would generally not be available to reduce the corporate AMT (no HTE, no QBAI, no FOGEI).³⁵ If we assume that taxable income is equal to AFSI for simplicity, USP would include its pro rata share, here 100 percent, of Lux CFC’s income of 15.

In addition, like GILTI, the corporate AMT allows for U.S. losses to offset foreign income (although foreign losses are not allowed to offset U.S. income below zero and must be carried forward instead).³⁶

For foreign tax credits, corporate AMT FTCs are subject to fewer limitations than GILTI FTCs. There is no haircut and a five-year carryforward of excess credits is allowed. The only FTC limit for indirect foreign taxes (there is no FTC limit for direct foreign taxes) is 15 percent of the taxpayer’s share of foreign AFSI.

Like GILTI, the corporate AMT allows for high-taxed foreign earnings to be grouped with low-taxed foreign earnings, and U.S. tax on both are decreased by aggregate foreign taxes, so that foreign taxes paid with respect to high-taxed foreign earnings can offset U.S. tax on low-taxed foreign earnings. This is accomplished by financial statement consolidation of Lux CFC with its German and Irish branches.

For the calculation of the tax liability, if we assume for simplicity that taxable income is equal to AFSI, corporate AMT paid by USP is 15 percent applied on USP’s pro rata share (here, 100 percent) of Lux CFC’s financial statement income of 100 (assuming consolidation), offset by FTCs attributable to both Germany and Ireland, which would reduce U.S. corporate AMT to zero.

In summary, the tax liability under the corporate AMT is 16.25, which is the same as the pre-TCJA tax.

Pillar 2

For the tax base, pillar 2 requires that an ETR of 15 percent is paid on financial statement income in each jurisdiction of each constituent entity, which includes both corporations and branches. Like with the corporate AMT, the tax base is financial statement income, and the tax rate is 15 percent. Unlike the corporate AMT, pillar 2 does allow for a substance-based income exclusion carveout.

For foreign tax credits, pillar 2 does not allow high foreign taxes paid on income in one jurisdiction to count toward satisfying the 15 percent ETR requirement on income in another jurisdiction. However, parent jurisdiction CFC taxes are allocated to the CFC. In addition, pillar 2 does not treat excess foreign taxes, carried forward as excess FTC, as a deferred tax expense and thus would reduce the ETR in the year that the excess FTC offsets U.S. tax.

For the calculation of the tax liability, under pillar 2, GILTI is a blended tax, but the corporate AMT (regarding foreign income) may not be (which does not matter here because the corporate AMT is 0). As a result, we allocate GILTI tax of 0.35 down to Ireland under the administrative guidance. Ireland’s top-up tax is 1.4. Total tax is increased from 16.25 under pre-TCJA rules to 18 under pillar 2, or an increase of 20 percent.

By consolidating Lux CFC with its foreign branches, financial statement income treatment under the corporate AMT respects the U.S. tax classification for the foreign branches as DREs. This allows the U.S. tax paid under the corporate AMT on Lux CFC’s income to be offset by both high foreign taxes paid to Germany as well as the low foreign taxes paid to Ireland. However, under pillar 2, by disregarding the U.S. tax classification of the foreign branches and treating them as separate constituent entities, both the income in Germany and the income in Ireland are subject to tax at 15 percent, and the high tax paid in Germany does not count toward determining whether the income in Ireland has been taxed at 15 percent.

Conclusion

Before the TCJA, the corporate tax rate imposed on subpart F was 35 percent. Because the subpart F rules are designed to tax passive income payments (such as dividends, interest, and royalties), as well as transactions between regarded related parties, using DREs could minimize subpart F by eliminating related parties in the structure. Planning out of subpart F with these CFC branch structures would reduce the tax cost from 35 percent to 0 percent.

After the TCJA, the corporate tax rate was lowered to 21 percent. In addition, income that is not subpart F may be taxed as GILTI at 10.5 percent. Planning out of subpart F meant a decrease in tax cost from 21 percent to 10.5 percent, a smaller differential. However, this 10.5 percent differential may still be significant cost savings. In addition, this differential may be larger if GILTI may be lowered to 0 percent by income qualifying for GILTI exceptions — for example, if the foreign income can be sheltered by QBAI, if the foreign income is subject to sufficiently high foreign tax rates, and if the foreign income is FOGEI.³⁷

Last year’s passage of the corporate AMT subjects certain corporations to a 15 percent tax on a pro rata share of their foreign corporations’ AFSI reported on the parent corporations’ consolidated financial statements. In addition to the higher rate (15 percent instead of 10.5 percent applied to GILTI), AFSI is a financial statement concept, so certain exceptions from GILTI are not available to offset AFSI.

While the financial statement concepts eliminate the distinction between “active” foreign income taxed as GILTI at 10.5 percent and “passive” foreign income taxed as subpart F income at 21 percent, the corporate AMT preserves the current tax treatment of branches as entities disregarded as separate from their owner. In particular, under financial statement rules, income earned by a branch is consolidated with the income of its CFC parent, and thus the CFC can continue to blend low-taxed foreign branch income with high-taxed foreign branch income as well as losses and income between branches to generate tax savings.

Pillar 2 goes further than the corporate AMT. Not only does it eliminate the distinction between active and passive foreign income, its financial statement income base is adjusted to remove the distinction between how branches and corporations are taxed when either entity gives rise to a taxable presence in a separate jurisdiction. So long as they are constituent entities, the U.S. tax classification does not matter, and their foreign income is separately subject to tax at 15 percent. As a result, check-the-box planning and foreign branches may diminish in importance after the passage of pillar 2.

Until the adoption of pillar 2 by the jurisdictions in which the U.S. MNE operates, foreign branches continue to be important in tax planning to minimize taxable subpart F income and make more income eligible for GILTI rates.

In addition, U.S. MNEs with “excess limit” general category foreign-source income (whose related U.S. tax is not offset by FTCs) may also use foreign branches to generate more subpart F income that is subject to high foreign taxes. These foreign taxes may give rise to more FTCs that offset not only the newly generated subpart F income, but also the existing “excess limit” general category foreign-source income. See Appendix A for an example of the advantages of such a structure. Because the factors required for such a structure to be beneficial are context specific (for example, existing general category foreign-source income whose related U.S. tax is not offset by foreign taxes, as well as availability of foreign income that can be restructured as subpart F income whose high foreign taxes can offset both U.S. tax on that additional subpart F income, as well as the existing general category foreign-source income), the use of foreign branches to generate subpart F FTCs is not highlighted in this article as the reason for the increase in foreign branches since the TCJA. (See Appendix A.)

Appendix A. Generating Subpart F for FTCs

Taxpayers may plan into subpart F to generate subpart F excess FTCs, which, unlike GILTI FTCs, are not subject to a 20 percent haircut and can be carried back one year and forward 10 years. This strategy is beneficial when the taxpayer has “excess limit” general category foreign-source income that is taxable in the United States and is not offset by FTCs.

This can be achieved by contributing the regarded sales entity to another CFC, organized in a jurisdiction different from the jurisdiction where the sales occur, and checking the box on the regarded sales entity to be disregarded. In this way, the country of organization of the sales entity, now the CFC, is no longer the same as the country of the customers, and the sales income earned no longer qualifies for the same-country exception from FBCSI. Alternatively, taxpayers may redomicile the sales entity to achieve the same result, although it may be preferable to keep the sales entity in the same country and not modify existing contracts.

Pre-TCJA (Planning Out of Subpart F)

Assume that a U.S. shareholder has excess general category foreign-source income of 10 from an interest payment by Lux Holdco CFC. Assume also that the CFC can qualify for a substantial contribution manufacturing exception and the sales entity is organized in a high-tax foreign country. Assume U.S. Shareholder prefers not to use any branches so as to not be required to satisfy the branch rule’s tax rate disparity tests.

In such a structure, Lux Holdco CFC can earn more income by hiring German CFC as a toll manufacturer and retaining title to (and increased risk in) all property. Australian CFC purchases the property from Lux Holdco CFC, and these payments to Lux Holdco CFC are not subpart F because Lux Holdco CFC qualifies for a substantial contribution manufacturing exception. Australian CFC sells the product to Australian customers, and the sales income to Australian CFC is not FBCSI because of the statutory same-country exception.

Tax results are shown in Figure 10 and Table 14.

Post-TCJA (No Subpart F FTC Planning)

After the TCJA was enacted, the 60 of Lux Holdco CFCs is treated as GILTI and taxed at 10.5 percent.

Neither the 30 earned by German CFC nor the 20 earned by Australian CFC is taxed as GILTI, because of the high-tax exception.

Tax results are shown in Table 15.

Post-TCJA (Subpart F, More Generous FTCs)

To generate subpart F general category FTCs, U.S. Shareholder may decide to structure the 20 earned by Australian CFC to be subject to U.S. tax as subpart F. Because Australia is a high-tax jurisdiction, the foreign tax paid to Australia could offset both the U.S. tax on subpart F and the 10 excess general category income paid by Lux Holdco CFC to U.S. Shareholder.

U.S. Shareholder causes Lux Holdco CFC to form Dutch CFC, contributes Australian CFC to Dutch CFC, and has Australian CFC check the box to become Australian DRE, in a tax-free reorganization.³⁸

As a result, the 20 earned by Australian DRE and deemed earned by Dutch CFC is FBCSI that does not qualify for the same-country exception and is taxed as subpart F at a 21 percent rate, which is offset by 20 * 30 percent of 6 foreign tax. This means 4.2 - 6 = 1.8 of excess FTC.

Because this 1.8 of excess FTC is assigned to the general category, it can offset the U.S. tax on U.S. Shareholder’s 10 of general category sales income.

Tax results are shown in Figure 11 and Table 16. All-in tax is reduced from 16.9 to 15.1.