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Economic Analysis: More GILTI Than You Thought

POSTED ON Feb. 13, 2018
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The more practitioners study global intangible low-taxed income (GILTI) in new section 951A and the deduction against it in new section 250, the less they like them.

For years they all knew that any move toward a territorial system of taxation would have to be accompanied by a backstop — some sort of minimum tax — to prevent aggressive outbound profit shifting. The key feature they sought was an overall tax that allowed averaging across foreign affiliates rather than the dreaded, vastly more complex per-country approach favored by the Obama administration. With the enactment of the Tax Cuts and Jobs Act (P.L. 115-97), they got their wish. But then once they got past the broad brushstrokes, it seemed to many as if the drafters took pains at every turn to make the provision as unfriendly to taxpayers as possible.

Simplified and stripped of many confounding details, GILTI can be expressed as:

Net CFC Tested Income - 0.1 * QBAI

Net CFC Tested Income is the aggregate of a U.S. corporation’s worldwide foreign profits in all of its controlled foreign corporations modified to remove income already subject to U.S. tax and some income subject to high foreign tax. The second term in the expression represents CFC return on certain tangible property known as qualified business asset investment (QBAI). This may be thought of as a normal return on the corporation’s tangible foreign assets. The whole expression may be thought of as its excess return on tangible foreign assets.

GILTI is an arbitrary measure of high profitability. High profits (relative to tangible assets) could be related to the presence of intangibles, as economists often assume, or may have nothing to do with intangibles at all. Drafters did the public no favors with the GILTI acronym. The “I” in GILTI is understandably confusing to many because there is otherwise no direct reference to intangible assets in the statutory text, and these assets play no direct role in the calculation of tax liability under sections 951A and 250. And, as we shall see, the “LI” is also misleading because in certain circumstances, GILTI can be subject to U.S. tax even when the average worldwide foreign tax rate of a U.S. taxpayer is not low.

GILTI is not subject to the full 21 percent corporate tax because a deduction equal to 50 percent of GILTI is allowed. The deduction is reduced to 37.5 percent of GILTI after 2025. Because many businesses — such as those that provide services and software and those that sell patented and trademarked products — have large profits and relatively small amounts of tangible property, the impact of GILTI on those taxpayers is quantitatively akin to that of a worldwide system with no deferral and a reduced foreign rate.

In addition to the 50 percent deduction, the U.S. tax impact of the GILTI inclusion into gross income is reduced by foreign tax credits. But under the new provision, only credits equal to 80 percent of foreign taxes allocable to GILTI are allowed (section 951A(d)(1)). Making many plain-vanilla assumptions, the tax impact of GILTI can be expressed as the difference, not allowed to go below zero, of:

0.105 * GILTI - 0.8 * (foreign tax allocable to GILTI)

The resulting effective U.S. tax rate and combined U.S.-foreign effective tax rate on GILTI are illustrated in Figure 1. In the figure, the maximum U.S. tax rate on GILTI is 10.5 percent — when the average foreign tax rate is zero — and it declines linearly until it reaches zero when the average foreign tax rate is 13.125 percent.

Wrinkles

That’s the basic stuff. The following sections deal with the details that make computations complex and can result in U.S. tax being applied on excess returns even when the foreign average rate exceeds 13.125 percent.

 
Figure 1
 

But before we get lost in the trees, let’s make some critically important observations about the forest. First and foremost, businesses that are not C corporations, as well as individual taxpayers that are CFC shareholders, are treated harshly relative to C corporation shareholders. Non-C-corporation shareholders are ineligible for the 50 percent deduction (under section 250) and, as the tax credit is a deemed paid credit under section 960, they may be ineligible for foreign tax credits against liability for GILTI (for example, if they do not make an election under section 962.) (See Raymond M. Polantz, “Sec. 962 to the Rescue,” The Tax Advisor (Aug. 1, 2015); and Sandra P. McGill et al., “GILTI Rules Particularly Onerous for Non-C Corporation CFC Shareholders,” McDermott Will & Emery (Jan. 30, 2018).)

Second, GILTI is in its own separate basket for foreign tax credit purposes. There is no carryforward or carryback of tax credits. If the foreign tax allocable to GILTI exceeds 10.5 percent of GILTI, those foreign taxes may never be credited against U.S. tax.

Third, there is a limitation on the 50 percent deduction. The deduction is reduced (or eliminated) to the extent the GILTI deduction plus the new deduction for foreign-derived intangible income (FDII) drive the shareholder’s regular tax liability below zero.

Fourth, if any creditable foreign taxes are owed by a CFC with a tested loss, those taxes are not creditable (section 951A(d)(1)(B) only allows credits for “tested” foreign income, which in this context only means income from CFCs with positive amounts of tested income).

The calculations below will show that the exclusion of tangible returns to qualified business investment for unprofitable CFCs under the new rules can lead to unequal treatment of corporate shareholders with the same net foreign income and subject to the same rate of foreign tax. The calculations will also show that allocation of expenses under the rules of section 861 can limit the foreign tax credit and thereby subject some foreign income to U.S. tax even when the U.S. shareholder’s aggregate foreign tax rate exceeds 13.125 percent.

Lost Property

The first column of the table provides calculations more detailed than those above for determining the effects of the new GILTI provisions for a 100 percent shareholder of a single CFC. In this example, the CFC has $900 of pretax foreign income subject to a foreign tax rate of 5 percent. This leaves $855 of tested income. The return to $5,000 of depreciable property is $500, and there is no interest addition (as required under section 951A, but assumed to be zero here), so GILTI is $355 (= $855 - $500).

GILTI is not subpart F income, but it is treated like it, which means taxable income will include a section 78 deemed dividend gross-up of GILTI. The section 78 gross-up is the product of the inclusion percentage and income tax allocable to CFCs with positive tested income. The inclusion percentage (0.4152) is the ratio of GILTI to the tested income of the CFC. (More generally, only the tangible returns to CFCs with positive tested income would enter into these calculations.)

The deduction for GILTI ($186.84) is equal to 50 percent of the sum of GILTI ($355) and the section 78 gross-up ($18.68). U.S. tax before foreign tax credits is $39.24 (= 0.21 * $186.84). The deemed paid foreign tax credit for this income is $14.95, equal to 80 percent of the section 78 gross-up described above. Net U.S. tax after the foreign tax credit is $24.29 (= $39.2 - $14.95). The effective tax rate on the new additions to gross income (GILTI plus the section 78 gross-up) is 6.5 percent. Note that this corresponds to the calculation shown in Figure 1.

Now let’s suppose all the facts are the same except instead of the corporate shareholder owning only one CFC with $900 of foreign taxable income, $45 of foreign tax, and $5,000 of depreciable property, the taxpayer owns two CFCs, one profitable and one not, that nevertheless together provide the shareholder with the same aggregate foreign taxable income ($900), the same aggregate foreign tax liability ($45), and the same aggregate amount of depreciable property ($5,000). In this alternative case, the taxpayer is subject to a much larger tax liability. The basic parameters for the two CFCs are shown in the second and third columns. The calculation of tax (performed in the aggregate for each shareholder) is shown in the fourth column.

GILTI is larger in this case because the $2,000 of QBAI in the CFC with a loss (shown in the shaded cell) is disregarded. Technically, the draft provides for this by only including “specified tangible property” (used to calculate QBAI) used in the production of tested income. In this context, tested income without a “net” in front of it means income only from CFCs with positive amounts of tested income. It is unclear (to this author) what policy purpose this exclusion of QBAI of loss CFCs accomplishes. This disregard of certain QPAI also results in a larger inclusion percentage. U.S. tax in the two-CFC case is $37.97, compared with $24.29 in the single CFC case. The effective U.S. tax rate on the $373.68 of income subject to tax in the single CFC case increased from 6.5 percent to 10.2 percent.

The quantitative significance of this incongruity depends on the amount of QBAI in CFCs with losses relative to the overall profitability of the corporate shareholder’s CFCs. It also depends on the shareholder’s average foreign tax rate. If overall profitability is high, but there is a loss CFC with lots of depreciable property, and the average foreign effective tax rate is low, the effect can be large. On the other hand, the effect disappears entirely if the average foreign effective tax rate exceeds 13.125 percent (in this example).

Example Showing How Disregarded Tangible Assets Can Increase GILTI and U.S. Tax on CFC Income

 

Single CFC

CFC A

CFC B

Two CFCs

Example parameters:

Net foreign taxable income

$900

$1,000

- $100

$900

Foreign tax rate

5%

5%

5%

5%

Foreign tax

$45

$50

- $5

$45

Tested income (or loss)

$855

$950

- $95

$855

Qualified business asset investment (QBAI)

$5,000

$3,000

$2,000

$3,000

10% of QBAI

$500

$300

$200

$300

Interest expense subtracted from QBAI

$0

$0

$0

$0

Net deemed tangible income return:

GILTI [= net tested income - (10% of QBAI - interest)]

$355

 

 

$555

Taxable section 78 gross-up (foreign tax * inclusion percentage)

$18.68

 

 

$29.21

Calculation of U.S. tax before FTC:

GILTI + section 78 markup

$373.68

 

 

$584.21

50% deduction

$186.84

 

 

$292.11

Net income subject to 21% U.S. tax

$186.84

 

 

$292.11

U.S. tax (before FTC)

$39.24

 

 

$61.34

Deemed paid credit:

Inclusion percentage = GILTI / (tested income > 0)

0.4152

 

 

0.6491

Foreign tax on positive tested income

$45

 

 

$45

Deemed credit limitation percentage

80%

 

 

80%

Deemed paid credit

$14.95

 

 

$23.37

Summary calculations:

U.S. tax after FTC

$24.29

 

 

$37.97

Total U.S. tax as percentage of (GILTI + section 78 gross-up)

6.5%

 

 

6.5%

Total U.S. tax as percentage of single CFC’s taxable income

6.5%

 

 

10.2%

Combined U.S.-foreign tax rate on grossed-up GILTI

11.5%

 

 

15.2%

Source: Author’s calculations.

Credit Limitations

Under regulations for section 861, expenses incurred in the United States can be allocated to foreign-source income when calculating the foreign tax credit limitations. These allocated expenses include expenses for research, interest, stewardship, and legal and accounting services. Several commentators — including Calum Dewar of PwC at the February 2 conference held by the International Tax Policy Forum and the Institute of Economic Law at Georgetown University Law Center — have noted that these expense allocation rules could lead to results that seem inconsistent with the outcomes suggested in the legislative history (illustrated in Figure 1). In particular, these added expenses could reduce allowable deemed foreign tax credits (already subject to a 20 percent haircut) and subject GILTI (and the related section 78 gross-up) to U.S. tax even when the corporate shareholder’s foreign effective tax rate exceeds the suggested 13.125 percent benchmark. Figures 2A and 2B show how U.S. tax and combined U.S.-foreign tax can increase as a result of expenses allocated to the GILTI basket.

 
Figure 2A
 

Appendix

GILTI is included in the gross income of a U.S. shareholder that holds stock on the last day of a corporation’s tax year if that corporation at any time during its tax year qualified as a CFC. GILTI is calculated on an aggregate (worldwide) basis across all CFCs owned by a shareholder. Loosely speaking, GILTI is excess profit — the positive difference between modified CFC income less a return on tangible capital. More precisely:

GILTI = Max(0, NTESTEDI - NDTIR)

NTESTEDI is net CFC tested income, equal to tested income of profitable CFCs minus the tested losses of unprofitable CFCs:

max(0, {Formula 1 ai  * Max(0,TESTEDIi) - Formula 2 ai * Max(0,TESTEDLi )}

In this framework, a shareholder has 1 through N1 CFCs with positive tested income and N1+1 through N2 CFCs with tested losses. ai is the shareholder’s pro-rata ownership share of CFCi.

Tested income (TESTEDIi) is the excess (if any) of gross income of a CFC less allocable deductions (including taxes) and less certain adjustments. Those adjustments are: any effectively connected income of the CFC already subject to U.S. tax; any subpart F income subject to U.S. tax; any foreign base company or insurance income excluded from gross income because of the high-tax kick-out that may come into effect when the foreign tax rate exceeds 90 percent of the U.S. corporate rate (which now would be 18.9 percent); any dividend received from a related person; and any foreign oil and gas extraction income whose associated foreign tax credits are limited by section 907. If the excess is negative, the sign is reversed and the amount is a tested loss (TESTEDLi).

 
Figure 2B
 

NDTIR is net deemed tangible income return equal to:

0.10 * Formula 1 ai * QBAIi - NONTESTINT

QBAIi is qualified business asset investment for CFCi and is equal to:

(STPA + STPB + STPC + STPD)/4

STPj is the basis of specified tangible property calculated using straight-line depreciation as specified under the alternative depreciation system (ADS) in the tax year used in the production of tested income (but not of tested loss) at the close of quarter j. There are special rules for dual-use property and partnership property, and there is regulatory authority granted to prevent tax-motivated end-of-period adjustments to any STPj. NONTESTINT is the interest expense attributable to interest income not part of tested income.

Deemed paid foreign tax (DPFT) used to calculate the section 78 gross-up inclusion in gross income (SEC78) is:

DPFT = Formula 1 TDPFTi * INCL%

This expression (when rearranged) can be thought of as the average foreign tax rate multiplied by the grossed-up GILTI. TDPFTi is taxes paid by CFCi with positive tested income. The inclusion percentage (INCL%) is:

(GILTI + Sec78)/Formula 1 aiTESTEDIi

The denominator is the sum of tested income of CFCs with positive tested income. Deemed paid foreign taxes potentially creditable against grossed-up GILTI is 80 percent of the expression for DPFT above.

The deemed foreign tax credit is subject to a limitation so foreign taxes creditable against grossed-up GILTI equals:

Min {[0.8 * INCL% * Formula 1 TDPFTi ], [0.21 * (GILTI + SEC78 - EXP)]}

EXP is any expense that may be allocated to the GILTI basket under the regulations for section 861. The 0.21 assumes U.S. tax is paid at an effective rate of 21 percent before tax credits.