David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. This week: GILTI, or not GILTI. On September 13th, the Treasury Department released highly anticipated regulations interpreting the global intangible low-taxed income, or GILTI provisions. Now, GILTI is one of the most complex provisions of the Tax Cuts and Jobs Act, so practitioners have been eagerly awaiting guidance on how it will work, and fair warning to our listeners, we're going to get into the weeds on this one. Here to walk us through those weeds on what we've learned, and also what we haven't learned, from the proposed regulations are Worldwide Tax Daily Legal Reporter Alexander Lewis and Worldwide Tax Daily Senior Legal Reporter Andrew Velarde. Alex, welcome to the podcast, and Andrew, welcome back.
Alexander Lewis: Thanks for having me, Dave, I'm happy to be here.
Andrew Velarde: Thanks, Dave. It's good to be back.
David Stewart: Andrew, let's start with an overview of what GILTI is and what sort of guidance is needed.
Andrew Velarde: Speaking broadly, GILTI operates like a minimum tax on U.S. multinationals' foreign profits. Each U.S. shareholder of a controlled foreign corporation is subject to tax on GILTI. GILTI is defined as the excess of pro rata share of tested CFC income over a 10 percent return, which is reduced by some interest expense incurred by CFCs on its pro rata share of the depreciable tangible property of each CFC. This last term is referred to as its qualified business asset investment, or QBAI. A 50 percent deduction is then allowed on GILTI income, effectively resulting in a 10.5 percent tax. Since GILTI only provides for an 80 percent allowance for foreign tax credits, the minimum tax is supposedly set at 13.125 percent. But practitioners have been griping nearly since the law's enactment that the provision may be a poor approximation for a minimum tax at that rate because of the potential for allocation of expenses, mainly related to interest in research and development.
David Stewart: From what I understand from your reporting on this, this guidance was, we'll say, incomplete?
Andrew Velarde: That's correct, Dave. With GILTI now subject to its own FTC limitation category, and devoid of carryforwards or carrybacks, it is this area of expense allocation where guidance was most eagerly sought, but it wasn't forthcoming in this initial package. Much to the disappointment of practitioners, the IRS and Treasury also punted on issues related to the 50 percent deduction and how the GILTI rules interact with other provisions, including the foreign-derived intangible income provision, interest limitation provision, and the antihybrid rule. Issues related to the previously taxed income and elections for individual shareholders to get corporate treatment likewise weren't discussed. Now, practitioners shouldn't get too discouraged. Treasury has promised two more packages related to GILTI before the year is out — one broader set of regs on foreign tax credits that will answer the expense allocation question and another that will address the operation of the 50 percent deduction.
David Stewart: So, we know what wasn't there. Did anything noteworthy come out of these regs?
Andrew Velarde: Almost certainly. This package was complex, a total of 157 pages. It was mostly dedicated to definitional and computational guidance, or decisions that were fully expected, such as the adoption of the aggregate approach for determining GILTI inclusions in consolidated groups. There were, however, a few surprises. I'll let my colleague, Alex, explain a little more about one of those provisions.
Alexander Lewis: Thanks, Andrew. One notable provision in the proposed regs that has caused quite a bit of controversy among practitioners we've spoken to is the approach taken for purposes of computing tested income and tested loss.
On the question of what constitutes gross income and allowable deductions, the proposed regs adopt subpart F reg section 1.952-2 with no exceptions. The proposed regs also provide that allowable deductions are allocated and apportioned to gross tested income under the same 954(b)(5) principles that apply in allocating and apportioning deductions for subpart F. The proposed regs’ adoption of subpart F makes sense for many items of gross income and deductions, but, notably, practitioners have commented the approach has the effect of disallowing deductions for net operating losses, or NOLs, and capital loss carryovers in computing tested income and tested loss. By completely adopting the 952 regs — including the NOL and capital loss carryover disallowance rules — for purposes of computing tested income and tested losses, some practitioners believe Treasury is trying to fit a square peg into a round hole.
David Stewart: Now, how do subpart F and GILTI differ in this context?
Alexander Lewis: Well, under subpart F, the statute specifically allows what amounts to a substitute for NOL and capital loss carryover benefits by virtue of a reduction to subpart F income for an item that section 952 refers to as a “qualified deficit.” Therefore, it makes perfect sense that the 952 regs would disallow deductions for NOL or capital loss carryovers, since those deductions would amount to a duplication of the qualified deficit allowance. However, in the GILTI context, the argument goes, the language of the statute allows NOL and capital loss deductions by virtue of the fact that it allows deductions — specifically, “the deductions properly applicable to such gross income.” Unlike the subpart F context, where the statute allows qualified deficits as a substitute for NOL and capital loss carryover deductions, the GILTI statutory provisions do not allow a substitute for NOL and capital loss carryover deductions. They allow actual NOL and capital loss carryover deductions to the extent properly allocable to the gross income. Therefore, in the GILTI context, the NOL and capital loss disallowance by the 952-2 regs does not operate to disallow an unintended double benefit but may have the effect of disallowing a single intended benefit.
David Stewart: I read something in your story — and it's a great term — about phantom income. Can you tell me more about that?
Alexander Lewis: Sure, one practical effect of the approach taken in the proposed regs is that a company may incur tax on phantom income. The tax on phantom income occurs when a U.S.-based company has a CFC that has tested losses in one year, and tested income the following year. If the U.S. company earned the income itself, or it was treated that way, it would be allowed to net the tested income and losses. However, under the proposed regulations, the inability to carry over the NOL deductions potentially results in taxation of the entire tested income amount.
A quick example illustrates the problem. Assume a U.S. parent owns one CFC that has an $8 billion tested loss in year 1 and $10 billion tested income in year 2. If the U.S. parent had earned the income directly, there would be $2 billion of net U.S. taxable income and $420 million of U.S. tax, by virtue of an NOL deduction in year 2 for $8 billion. However, where the income and losses occur in a CFC, the application of the 952 regs cause the U.S. parent to pay U.S. tax on $10 billion of income, of which $8 billion would be phantom income. In other words, the CFC only earned $2 billion of actual income over the two-year period, resulting in a tax of $1.5 billion.
David Stewart: With any provisions this complex, it would seem that there's always going to be a planning opportunity. So what type of antiabuse provisions have been included in the regs?
Andrew Velarde: Well, the tested income and tested loss section of the proposed regs includes an antiabuse rule. It's also worth nothing that some the strongest consternation from practitioners was saved for several of these antiabuse rules found within the GILTI regs. The statute gives Treasury the regulatory authority to issue guidance to prevent the avoidance of tax on GILTI, and Treasury has seen fit to exercise that authority in several instances. To prevent abuse, the proposed regs disallow a stepped-up basis and specify tangible property transferred between related CFCs during the period before the transferor CFC's first inclusion year when calculating the transferee CFC's QBAI.
Practitioners have decried this rule, which amounts to a per se rule, as overly harsh and not warranted based on the statute or legislative history. It would deny the benefit of amortization deductions in later years arising from current-year transactions, regardless of whether the transaction was motivated by tax avoidance. It is worth noting, however, that Treasury and the IRS have adopted a similar pro se rule in the context of the transition tax. And as much backlash as this rule has received so far, it's still more narrowly tailored than another antiabuse rule hidden away elsewhere in the regs related to pro rata shares.
Under the antiabuse provision related to section 951, a transaction or arrangement that is part of a plan with the 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 rule applies to GILTI rules, including for purposes of determining the pro rata share of QBAI based on the pro rata share of tested income. So, if a CFC, anticipating that GILTI would lead to poor results for its operations because of disallowed credits, decides to sell a business to a third party, it could result in this antiabuse rule catching the transaction. That could mean that the taxpayer is required to track what the third party is going to earn on that business, a result which has left a bad taste in practitioners' mouths.
It is unclear what the reach of this pro rata share antiabuse rule is. For example, how long is the transaction disregarded? What are the collateral consequences of disregarding a transaction, including the impact on subsequent events? Is the rule targeting the allocation of separately determined amounts of subpart F income or GILTI, or is it also addressing the amount of income? Practitioners are begging for answers on these questions in future guidance.
David Stewart: I know partnerships are considered U.S. persons and therefore U.S. shareholders for GILTI purposes, but it's my understanding that the statute failed to provide rules for the treatment of domestic partnerships that are U.S. shareholders of CFCs. Did the proposed regs address that issue?
Alexander Lewis: That's a good question, Dave. The proposed regs do address that directly. The proposed regs adopt a hybrid aggregate/entity approach to U.S. partnerships and their partners for the purposes of the GILTI regime. According to the preamble of the proposed regs, Treasury did consider adopting either a pure aggregate or pure entity approach but found flaws with each.
A pure aggregate approach to the treatment of domestic partnerships and their partners would treat the partnership as an aggregate of its partners so that each partner would calculate its own GILTI inclusion amount, taking into account its pro rata share of CFC items through the partnership.
Under a pure entity approach, the domestic partnership would determine its own GILTI inclusion amount, and each partner would take into gross income its distributive share of that amount.
However, Treasury determined that in its view, a pure aggregate approach could be interpreted by taxpayers to exempt small partners of a domestic partnership from the GILTI regime entirely, whereas a pure entity approach could result in dramatically different GILTI inclusion amounts for each U.S. shareholder depending on the legal structure through which the shareholder owns each CFC. That, of course, presents significant planning opportunities, and Treasury deemed that approach inappropriate.
So, the approach Treasury did take effectively splits the baby and adopts a combination of both approaches.
David Stewart: How does this hybrid approach work?
Alexander Lewis: Specifically, the regulations provide different rules for partners of the U.S. shareholder partnership that are also U.S. shareholders of the CFC owned by the partnership and partners that are not U.S. shareholders with respect to the CFC.
Under the hybrid approach, a U.S. shareholder partnership determines its GILTI inclusion amount under the general rules, but generally only for purposes of determining the distributive share of that amount of a partner who is not a U.S. shareholder partner. When the partner is a U.S. shareholder partner with respect to a CFC, the partner takes into account its pro rata share of the CFC's tested items. The partner's pro rata share is determined based on its section 958(a) indirect ownership of the CFC, treating the domestic partnership as a foreign partnership. The same rules apply to tiered domestic partnerships.
We've been told by practitioners that the approach taken by Treasury in the proposed regs creates a somewhat schizophrenic partnership that could create significant complexity in terms of the administrative burdens for taxpayers. But overall, Treasury appears to be trying to do its best to make the statute work as intended here.
David Stewart: Well, it sounds like this could create a lot of administrative issues for domestic partnerships with CFCs. Did the proposed regs address any other surprising issues?
Alexander Lewis: They did. The proposed regs also addressed basis adjustments for use of tested losses when a tested loss CFC is sold or disposed of. The proposed regs provide a complex set of rules that are intended to prevent corporate U.S. shareholders from receiving a double benefit for a single tested loss that could result if a domestic corporation benefitting from the tested loss of a tested loss CFC could also benefit from that loss when the tested loss CFC is sold. The rules apply to a domestic corp that is a U.S. shareholder of a CFC that has a net used tested loss amount. Specifically, a U.S. shareholder must reduce the adjusted basis of the stock immediately before the disposition by the amount of the domestic corporation’s net used tested loss amount with respect to the CFC that is attributable to the stock. Notably, if the basis reduction exceeds the adjusted basis in the stock immediately before the disposition, the excess amount is treated as a gain from the sale of stock and is recognized in the year of the disposition.
The proposed regs provide guidance for tracking and calculating the net used tested loss amount of separate CFCs when those CFCs are held through a chain of CFCs. This portion of the guidance will also likely create a significant administrative burden for taxpayers. Taxpayers were fairly surprised by this section of the guidance, noting that the Supreme Court cases that Treasury cites in the preamble of the proposed regs may not actually provide it the authority to issue this section of the regs that Treasury claims they do. Others said that they thought instead of basis adjustments for used tested losses, Treasury would apply the rules that have developed under section 961 for previously taxed income.
David Stewart: Well, it sounds like there is quite a bit to digest here, and we're also waiting on quite a bit more to digest when the two additional regulation packages come out in the future. I'd recommend that all of our listeners do check out Alex and Andrew's coverage in Tax Notes to get the latest on what we know about these regulations and any additional guidance we're expecting in the future. Andrew, Alex, thank you for being here.
Alexander Lewis: Thanks for having me, Dave.
Andrew Velarde: Thank you, Dave.
David Stewart: And now, Coming Attractions. Each week we preview commentary that will be appearing in the next issue of the Tax Notes magazines. We're joined by executive editor for commentary, Jasper Smith. Jasper, what will you have for us?
Jasper Smith: In Tax Notes, Sarah-Jane Morin discusses how the Tax Cuts and Jobs Act affects the due diligence considerations for merger and acquisitions practitioners. And Scott Swartz examines scenarios when the transfer of ownership interests for estate planning purposes results in a deemed tax shelter.
In States Tax Notes, former New York deputy commissioner for tax policy Robert Plattner launches a new regular column with an article discussing the history of click-through nexus laws. Also, William Hays Weissman argues that California should establish a voluntary worker classification settlement program.
And in Tax Notes International, Barry Larking argues that the EU's amended directive on administrative cooperation goes further than necessary, while H. David Rosenbloom and Fadi Shaheen discuss the base erosion and antiavoidance tax implemented under the TCJA.
David Stewart: You can read all that and a lot more in the October 1st editions of Tax Notes, State Tax Notes, and Tax Notes International. That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. Be sure to us on iTunes or Google Play to make sure you get the next episode of Tax Notes Talk
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