Proposed regulations (REG-104390-18) relating to the “global intangible low-taxed income” (GILTI) provisions under the new U.S. tax law were published this week in the Federal Register.
Read text of the proposed regulations [PDF 389 KB] (40 pages)
The following discussion provides initial impressions and observations about the proposed regulations under the GILTI provisions.
The new U.S. tax law (Pub. L. No. 115-97, enacted December 22, 2017) generally retained the existing subpart F regime that applies to passive income and related-party sales, but created a new, broad class of income—“global intangible low-taxed income” (GILTI).
GILTI is deemed repatriated in the year earned and, thus, is also subject to immediate taxation. GILTI income is effectively taxed at a reduced rate while subpart F income is taxed at the full U.S. rate. In general, GILTI is the excess of all of the U.S. corporation’s net income over a deemed return on a controlled foreign corporation’s (CFC) tangible assets (10% of depreciated tax basis).
The proposed regulations were initially released by the U.S. Treasury Department and IRS on September 13, 2018, and then were formally published in the Federal Register on October 10, 2018. According to an IRS release, the proposed regulations describe new reporting rules requiring the filing of Form 8992, U.S. Shareholder Calculation of Global Intangible Low-Taxed Income (GILTI), but do not include foreign tax credit computational rules relating to GILTI (these rules are to be addressed separately in the future). Read TaxNewsFlash
The proposed GILTI regulations were shorter than many anticipated because Treasury and the IRS limited the scope to address primarily the calculation of the GILTI inclusion amount.
Among those things not addressed in the proposed regulations are:
However, the preamble clarifies an outstanding issue by indicating that “[i]t is anticipated that the proposed regulations relating to foreign tax credits will provide rules for assigning the section 78 gross-up attributable to foreign taxes deemed paid under section 960(d) to the separate category described in section 904(d)(1)(A).”
The GILTI inclusion amount is a formulaic shareholder-level determination described through a series of defined terms. The proposed regulations add more than 20 new defined terms that feed into the calculation. As with the section 965 regulations (which had a large number of defined terms), the trend seems to be to provide rules through definitions.
Net CFC tested income is computed at the U.S. shareholder level, using section 951(a)(2) to determine the pro rata share of a CFC's tested income, tested loss, qualified business asset investment (QBAI), and interest items. The proposed regulations also modify the pro rata share rules in Prop. Reg. section 1.951-1(e), affecting both subpart F and GILTI inclusion calculations.
In a welcome piece of guidance, the proposed regulations aggregate and then allocate consolidated group members’ GILTI items (such as tested income, tested loss, and QBAI) to members in proportion to their share of the group’s tested income. This has the effect of allowing tested losses or QBAI attributable to CFCs owned by one consolidated group member to offset tested income attributable to CFCs owned by another member of the group. The guidance stops short, however, of mandating that all GILTI computations are done as if members of a consolidated group were a single shareholder.
The proposed regulations provide guidance for the CFC-level computations that was absent from the statute itself. In particular, the proposed regulations generally determine income and loss by reference to the section 952 regulations (the existing rules that provide taxable income for subpart F purposes). It is important to recall, however, that unlike subpart F income which is ultimately governed by earnings and profits, all computations related to the computation of tested income of a CFC are driven by taxable income concepts. Because the information currently gathered for Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, is earnings and profits (E&P) driven, taxpayers as a practical matter may generally need to start with E&P and then make appropriate adjustments to get to taxable income. Some examples of necessary adjustments—items which are treated differently for taxable income and E&P purposes—include:
Importantly, the proposed regulations confirm that there is not a general high-tax exception for GILTI for non-subpart F income. Thus, the high-tax exception remains very limited—it includes only subpart F income that is actually excluded from subpart F under the subpart F high-tax exception when a taxpayer makes a section 954(b)(4) election.
Similarly, the proposed regulations confirm the statutory structure that results in the absence of any QBAI benefit for a tested loss CFC. The proposed regulations define tangible property for QBAI purposes by reference to sections 167 and 168. The preamble explains that this was meant to be helpful in determining when tangible property is eligible to be QBAI.
Adjusted basis is determined using section 168(g)’s alternative depreciation system (ADS) rules for QBAI purposes, regardless of whether a different method is used for another Code section. For property placed in service before the new tax law, the basis is calculated as if ADS had applied from the date placed in service. Unfortunately, this appears to mean that the vast majority of companies will need to recompute basis for QBAI purposes.
There is new guidance on the specified interest expense amount. At a high level, QBAI is reduced for interest paid to third parties, related U.S. parties, or related CFCs when the amount is included in the recipient CFC’s subpart F income. As a practical matter, there was no prior guidance on how to determine when interest expense and tested income or loss are attributable to the appropriate interest income. Treasury and the IRS rejected a tracing approach as too burdensome and instead provided that the specified interest expense is determined under a netting approach.
In another nice piece of computational guidance, the foreign currency exchange rate to use for translating amounts for GILTI purposes is the average exchange rate for the CFC’s year. This is the same rate methodology that applies for translating subpart F inclusions.
Compared to the relatively straightforward approach provided in the basic rules above, the proposed regulations also add some less straightforward anti-abuse rules. In particular:
There is some ambiguity in the preamble as to whether section 163(j) will apply for GILTI purposes. Unless and until there is a follow-on regulation that states that section 163(j) does not apply, it will apply for CFC tested income and tested loss, and less explicitly for computing specified interest expense. The preamble signals that Treasury and the IRS may be willing to reconsider this. It is an open question where they will come out, but absent more guidance, it seems that section 163(j) will apply until further notice.
Section 267(a)(3)(B) is a rule that disallows a deduction for a payment to a related person if the deduction isn’t taken into account for U.S. tax purposes. Under the proposed regulations, items—including OID, notwithstanding section 163(e)(3)(B)(i)—are treated as included in income of a U.S. person when taken into account for tested income or tested loss purposes. This helpful rule significantly limits application of section 267(a)(3)(B) to CFC-to-CFC payments. It could also apply to accruals of royalties outbound from the U.S. in certain circumstances.
Generally, a U.S. shareholder takes into account a CFC’s QBAI based on its pro rata share of the CFC’s tested income. A limitation applies for preferred shareholders when QBAI exceeds 10 times the tested income of the CFC, in which case the excess QBAI gets allocated to common stock. This is a favorable rule.
Instead of following regulations under section 861, the proposed regulations create a stand-alone rule for allocating income from dual use property—Prop. Reg. section 1.951A-3(d). Among other provisions, the QBAI dual use property rule is expanded to include property that does not produce any income, another taxpayer favorable rule from a GILTI perspective.
The proposed regulations also attempt to simplify things for QBAI held through a partnership. The QBAI computations occur generally at the partnership level by allocating property to income at the partnership level, and similarly the quarterly tests are done at the partnership level. Prop. Reg. section 1.951A-3(g). The quarterly test rules are more detailed than in the section 956 quarterly test regime.
The treatment of domestic partnerships is one of the most interesting wrinkles in the proposed regulations. The proposed GILTI regulations take a hybrid aggregate/entity approach to domestic partnerships that are U.S. shareholders of a CFC. A partnership that is a U.S. shareholder of a CFC will do its own GILTI computations as a U.S. shareholder. U.S. partnerships are required to furnish information to partners for GILTI inclusion or, as relevant, pro rata share of CFC-tested items.
It remains to be seen whether the proposed regulations’ hybrid view of partnerships is a foreshadowing of what Treasury and the IRS might do in the section 163(j) context. It seems clear that the application of section 163(j) to a partnership produces drastically different results when the partners are corporations versus when partners are individuals.
Other provisions in the proposed regulations are hard to understand, hard to apply, and potentially present traps.
The proposed regulations contain three separate anti-abuse rules.
As noted above, a transition period anti-abuse rule applies to transfers of assets that create amortizable or depreciable basis during the “donut” period—the period between January 1, 2018, when section 245A first springs into being as a way to get foreign earnings home tax-free, and the end of the transferor CFC’s first tax year ending in 2018, when GILTI first applies to the CFC.
Under this rule, if an asset already held by a CFC is transferred to another CFC in a manner that increases its basis, then the incremental basis may be ignored for GILTI purposes. Unlike the other anti-abuse rules provided by the proposed regulations, it is a per se rule and not a principal purpose test. As a result, taxpayers will need to carefully review their CFC-to-CFC transactions. The deduction or loss attributable to a stepped-up basis is disqualified for purposes of determining tested income/loss, to the extent gain creating stepped-up basis is not subject to U.S. tax.
Notably, the rule is only a GILTI rule. If a CFC is buying property and getting a stepped-up basis for subpart F purposes—the asset is used to produce subpart F income and depreciation is allocable against subpart F income—this rule does not apply.
Another anti-abuse rule involves “temporarily held” QBAI under Prop. Reg. section 1.951A-3(h)(1).
Under this provision, ownership of property will be disregarded for QBAI computation purposes when a CFC holds property temporarily, but for over at least one quarter end. As generally stated, this rule requires a “bad purpose”—that is, that the property be acquired with a principal purpose of reducing the GILTI inclusion. However, the rule applies on a per se basis if property is held for less than 12 months and over at least one quarter end, regardless of principal purpose.
Again, this will require taxpayers to carefully review transactions to determine if there are ordinary course transactions that might inadvertently be caught by this “anti-abuse” provision. In addition, it is important to note that the “temporarily held” rule applies on CFC-by-CFC basis—it doesn’t look to the U.S. shareholders even though QBAI itself is ultimately a U.S. shareholder level computation. Given the complications and unclear policy underpinnings, one can only hope that this rule will be revisited when the proposed regulations are taken final.
The broadest and potentially most significant of the anti-abuse rules is contained in Prop. Reg. section 1.951-1(e)(6). Although contained within the subsection of the proposed regulation that addresses a U.S. shareholder’s pro rata share of subpart F income or GILTI, the condition that triggers this rule is any transaction or arrangement that is part of a plan with a principal purpose to avoid federal income taxation. Thus, it seems that the rule can be invoked even if the potential avoidance is not directly tied to subpart F income or GILTI.
The consequence of falling within the rule is that any transactions or arrangements made pursuant to the plan are disregarded for purposes of determining the pro rata share of subpart F income or GILTI items. The formulation of the rule leads to remarkable ambiguity and confusion.
There are no examples in the proposed regulations, and the preamble doesn’t discuss or provide any context for the rule.
Another unique and complex rule (although not in this case styled as an anti-abuse rule) contained the proposed regulations is Prop. Reg. section 1.951A-6(e)’s tested loss basis reduction that prevents double use of deductions. Under this rule, a suspense account is created with respect to stock of a CFC the tested loss of which offsets tested income of another CFC. Special rules allow for recapture of the suspense account when the same CFC’s tested income is offset by tested loss of another CFC and for the tiering (but non-duplication) of the suspense account.
Interestingly, there is neither direct statutory authority for this rule nor even hints of it in the legislative history—in contrast to the legislative history’s explicit discussion of similar considerations for the sharing of deficits under section 965(b). Against this backdrop, it seems particularly odd that the GILTI basis reduction is mandatory and operates on a deferred basis whereas the corresponding rule in Prop. Reg. section 1.965(2)(f) is elective but operates immediately.
It is also noteworthy that the basis reduction rules operate any time that tested losses offset tested income, even if there is no net tax benefit to the U.S. shareholder (because, for example, the tested income was subject to a sufficient rate of foreign tax to be fully sheltered under section 960).
Tested losses generally are allocated only to common stock, but they will be allocated to preferred stock in two situations:
The rules would not seem to affect situations in which all the common and preferred stock is underneath one U.S. shareholder or one consolidated group. But to the extent there is externally held common or preferred stock within a group, it could create a major complication.
Under Prop. Reg. section 1.951A-3(f), QBAI is reduced when a CFC has a short tax year, generally to reflect the portion of the tax year during which the CFC held the property. This rule’s mechanical application is likely to create more GILTI considerations in M&A transactions.
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