Highlights of the Final and Proposed Regulations on the GILTI High-Tax Exclusion
On July 20, 2020, the US Treasury and IRS released final regulations (the Final Regulations) and new proposed regulations (the 2020 Proposed Regulations) on the treatment of foreign income subject to a high rate of tax under the US global intangible low-taxed income (GILTI) regime under §951A of the Internal Revenue Code (IRC). The GILTI regime was enacted as part of the 2017 US tax reform legislation, referred to as the Tax Cuts and Jobs Act (TCJA) (Pub. L. No. 115-97 enacted December 22, 2017). Proposed regulations were released on June 14, 2019 (the 2019 Proposed Regulations).
This True Insight will highlight the key issues addressed by the Final Regulations. We will also cover the new guidance included in the 2020 Proposed Regulations.
- The Final Regulations provide guidance about the GILTI high-tax exclusion (HTE), which is an election available for US shareholders of a controlled foreign corporation (CFC) to exclude a CFC’s gross income from the shareholder’s gross tested income if the CFC’s effective foreign rate on its gross income exceeds 18.9 percent.
- The Final Regulations add certainty to the use of the HTE by taxpayers, specifically with respect to the scope of the exception, the election mechanics, and the applicability periods. They also, however, add new complexities which will require detailed modeling to determine eligibility for the exception and the benefits and detriments of using it.
- The “Tested Unit” approach was adopted because the IRS believed that taxpayers could blend items of a CFC’s income subject to different foreign tax rates and inappropriately exclude low-taxed foreign income from GILTI. Thus, the Final Regulations introduce complex rules for matching items of income with foreign taxes paid by separating CFCs, their branches, and hybrid entities into individually tested units.
- Taxpayers can decide on an annual basis whether to use the HTE to exclude income subject to high foreign taxes from the computation of GILTI.
- The Final Regulations provide relief to taxpayers who want to retroactively claim the GILTI HTE on previously filed tax returns for tax years beginning after December 31, 2017.
- Because an election to exclude high-tax income from GILTI extends to all CFCs in a CFC Group, taxpayers should consider the applicability of the exclusion to all of their CFCs.
- The threshold effective foreign tax rate for applying the HTE is dependent upon the applicable statutory US federal corporate rate, so that if that corporate rate is increased in the future, the high-tax income threshold would be increased thereby limiting the use of the GILTI HTE.
- The 2020 Proposed Regulations abandon the subpart F high-tax exception rules and adopt the new approach taken under the Final Regulations for GILTI. The new approach is more restrictive and less flexible than the high-tax exception rule under subpart F.
Under subpart F of the IRC, a “US shareholder” is taxed currently on certain, generally passive, income of a foreign corporation if the US shareholders owns more than 50% of the vote or value of the foreign corporation’s stock. For purposes of subpart F, a US shareholder is a US person that owns at least 10% of the vote or value of the foreign corporation’s stock. A foreign corporation with US shareholders who collectively own more than 50% of its stock is known as a controlled foreign corporation (CFC).
Under subpart F, a US shareholder may elect to exclude an item of the CFC’s income from subpart F income if the item qualifies for a high-tax exception from subpart F, which is available with respect to an item of income that is taxed in a foreign country at a rate exceeding 90% of the highest US corporate income tax rate (currently 18.9% with the corporate income tax rate at 21%).
The TCJA added the GILTI, which taxes a US shareholder on the earnings of its CFCs that are not considered subpart F income, and thus would have been tax deferred under pre-TCJA law. The stated purpose of the GILTI provisions are to operate as an anti-base erosion, minimum tax system intended to discourage corporations from using intangible property to shift profits out of the US. US corporate shareholders (and certain US shareholders that have elected to be taxed as corporations with respect to their subpart F income) are permitted a deduction equal to 50% of their GILTI (37.5% for tax years beginning after 2025), which was intended to result in taxing US shareholders at a maximum effective tax rate of 10.5% on their GILTI income (13.125% for tax years beginning after 2025).
A foreign tax credit is also available for up to 80% of the foreign taxes paid with respect to their GILTI. However, the credit is not available for taxes related to the CFC’s income for which the US shareholder claimed the GILTI HTE.
2019 Proposed Regulations
The 2019 Proposed Regulations included an exception from GILTI for CFC income subject to a relatively high rate of income tax in a foreign country, similar to the high tax exception under subpart F. Under this exception, a CFC’s controlling US shareholder could elect to exclude from GILTI a CFC’s gross income that was subject to foreign income tax in excess of 90% of the US corporate income tax rate (i.e. 18.9%).
The election generally applied on a QBU-by-QBU basis, and either to all or none of each CFC’s items of high-tax income. If certain common ownership and control thresholds were met, the election instead applied with respect to a group of commonly controlled CFCs (CFC Group). The 2019 Proposed Regulations required aggregation of all gross income items attributable to each qualified business unit (QBU) of the CFC to determine whether the income was “high tax” and therefore excludible.
The HTE was elective by a CFC’s controlling domestic shareholders, binding on all US shareholders of the CFC, and once made or revoked, could not be changed for a 60-month period. Foreign tax rates were determined separately with respect to each QBU of a CFC to prevent blending of high-taxed and low-taxed income instead of being applied on a CFC-by-CFC basis.
The elective HTE was intended to be effective prospectively, for a CFC’s tax years beginning on or after the rules were adopted as final regulations.
The Final Regulations generally adopt the GILTI HTE of the 2019 Proposed Regulations with some modifications. The Final Regulations allow taxpayers to elect to exclude GITLI that is subject to an effective foreign income tax at a rate exceeding 90% of the maximum US corporate rate (currently 21%) or 18.9%.
A CFC Group is defined as two or more CFCs that meet the requirements under §1504 for affiliated groups, with certain modifications, including reducing the threshold for including a CFC in the group to greater than 50% common ownership, rather than the 80% required under §1504. A CFC may not be a member of more than one CFC Group.
Tested Unit Determination
In calculating the effective foreign tax rate, the Final Regulations do not apply either the QBU-by-QBU approach of the 2019 Proposed Regulations or a CFC-by-CFC approach that some taxpayers suggested. Instead, the GILTI effective foreign tax rate is determined on a tested-unit-by-tested-unit basis. A tested unit includes a (1) CFC; (2) a branch that has a taxable presence in the country in which it is located; (3) a branch that is not regarded as a taxable presence in the country in which it is located but which is eligible for an exemption or reduced rate of tax in the branch owner’s country of residence; (4) a pass-through entity (including a disregarded entity) that is tax resident in a foreign country; and (5) a pass-through entity treated as a corporation by its owner’s home country.
Also, under a new mandatory combination rule, tested units of a CFC must be treated as a single tested unit if they are located in or residents of the same foreign country, with the exception of a branch that is treated as not giving rise to a taxable presence in the foreign country where it is located under the tax laws of that foreign country. This combination rule applies regardless of whether the tested units are subject to the same foreign tax rate and whether they use the same functional currency.
CFC income items qualify for the GILTI HTE only if the income items belong to a tested unit that is subject to an effective foreign tax rate greater than 90% of the maximum US corporate rate.
The determination is based on books and records, and gross income determined under federal income tax principles with certain adjustments to reflect disregarded payments, which is intended to be a proxy for determining the amount of gross income that the foreign country of the Tested Unit is likely to subject to tax.
With respect to payments from one tested unit to another tested unit that are disregarded for US tax purposes, the Final Regulations provide that gross income be reallocated among the tested units to ensure that the income is properly associated with the tested unit in which such income is subject to tax.
The Final Regulations provide that the election applies on a consistent basis to all CFCs owned by the same domestic controlling US shareholders (more than 50%) and to all of a CFC’s US shareholders. They did not adopt a CFC-by-CFC approach. This “all or nothing” approach creates an annual modeling exercise since taxpayers must compute multiple scenarios (including the impact of foreign tax credits) before determining if claiming the HTE is beneficial.
Repatriation of Excluded Income
A corporate US shareholder can repatriate the excluded income tax free. For an individual US shareholder, the income tax is deferred until repatriated, but then can be repatriated at ordinary income tax rates (i.e., 37% maximum rate or at the qualified dividend rate of 20% if the CFC is treaty-protected).
The Final Regulations eliminate the 60-month waiting period for taxpayers to revoke or make the HTE, and instead provide that a controlling domestic shareholder of a CFC group can determine whether to make the HTE election on an annual basis. If there are multiple CFCs in the same CFC group, the election to exclude high-tax income extends to all CFCs in the group. A controlling domestic shareholder is required to notify the other US shareholders that are not controlling domestic shareholders of any such election (or revocation of such election).
Election on Amended Returns
The HTE election can be made on an originally filed tax return or on an amended return by attaching a statement. The Final Regulations allow taxpayers to amend previous years’ tax returns and retroactively elect the GILTI HTE or to revoke previous elections. The retroactive election or revocation may be made on an amended return filed within 24 months of the unextended due date for the controlling domestic shareholder’s original return for the taxable year with or within which the CFC inclusion year, for which the election is made or revoked, ends.
The Final Regulations are effective for tax years of foreign corporations beginning on or after July 23, 2020, and for tax years of US shareholders in which or with which such tax years of foreign corporations end. Taxpayers may choose to apply the Final Regulations for tax years beginning after December 31, 2017, and before July 23, 2020, but the taxpayer must consistently apply the Final Regulations to each such year.
High-Tax Exclusion – Interaction with CARES Act
The change in the Final Regulations that allows for retroactive use of the HTE in 2018 and 2019 could help some taxpayers utilize some of the benefits of the Coronavirus Aid, Relief and Economic Security Act (CARES Act), which has been confirmed by an official from the Treasury Department. The § 250 deduction related to GILTI cannot be carried forward or back, and companies must use it in the year it is earned or they lose it.
Prior to the CARES Act, net operating losses (NOLs) generated in taxable years beginning after December 31, 2017, could be carried forward indefinitely, but could not be carried back. The CARES Act permits NOLS generated in taxable years beginning after December 31, 2017, and before January 1, 2021, to be carried back to each of the five taxable years preceding the taxable year in which the NOL arose.
Being able to exclude the high-taxed income from those prior years is viewed as a benefit so that taxpayers can carry back their NOLS to prior tax years without having to absorb the GILTI. Companies can remove subsidiaries from GILTI calculations entirely, which should give them more flexibility in managing economic losses.
Because the GILTI HTE can now be made on an annual basis, a taxpayer carrying forward NOLs may consider making the GILTI HTE solely in a taxable year that it expects to utilize NOL carryforwards in order to prevent the NOL carryforwards from displacing the 50% GILTI deduction that would have otherwise been available with respect to the taxpayer’s GILTI inclusion.
Issues Not Addressed in the Final Regulations
The Final Regulations do not finalize the parts of the 2019 Proposed Regulations under §§951, 956, 958 and 1502 related to the treatment of domestic partnerships. The IRS has stated that under the current applicable proposed subpart F and §956 regulations, a domestic partnership can be a controlling domestic shareholder for purposes of determining which party makes the GILTI HTE. These issues will be addressed in forthcoming regulations.
2020 Proposed Regulations
On July 20, 2020, the IRS also issued the 2020 Proposed Regulations that modify the subpart F high tax exception income rules to conform that exception to the newly finalized GILTI exclusion rules. The 2020 Proposed Regulations are generally effective for tax years beginning on or after the date that the 2020 Proposed Regulations are finalized. Comments on the 2020 Proposed Regulations are due by September 21, 2020.
Treasury and the IRS agreed with taxpayer comments that they should conform the two high-tax exclusions, but they concluded that the HTE of the Final Regulations better reflects the policies underlying the exception than the current subpart F income high tax exception. Thus, the 2020 Proposed Regulations modify the existing subpart F income high tax exception to conform to the GILTI HTE of the Final Regulations and they provide for a single HTE election to be applied for purposes of both GILTI and subpart F.
The 2020 Proposed Regulations provide a single election to exclude high-taxed income under §954(b)(4) and provide related information reporting provisions for foreign corporations. In alignment with the Final Regulations, the 2020 Proposed Regulations include the requirement that an election is generally made with respect to all CFCs that are members of a CFC Group (instead of an election made on a CFC-by-CFC basis). The determination of whether income is high-taxed is made on a tested-unit-by-tested-unit basis.
The 2020 Proposed Regulations also are designed to simplify the determination of high-taxed income and eliminate a fact intensive analysis by grouping certain income that would otherwise qualify as tested income for the purpose of determining the effective foreign income tax rate. Finally, these new proposed rules modify the method of allocating and apportioning deductions to items of gross income for purposes of the HTE.
TPC Insights and Next Steps
As with many of the TCJA’s new tax rules, determining one’s potential benefit from the GILTI HTE requires annual modeling to determine the net effect of numerous interrelated tax provisions. In particular, the benefit of claiming the GILTI HTE should be considered in conjunction with the potential loss of foreign tax credits associated with the CFC’s high-tax income, since both items will be excluded if a taxpayer claims the election.
If you have additional questions about this topic or to learn more about how we can help you to identify opportunities to maximize your company’s benefits from the GILTI high-tax exclusion, please contact a member of your TPC engagement team.