IRS Finalizes GILTI-High Tax Exclusion
By Timothy Evans, Juan Fernandez and Ivins, Phillips & Barker, Chtd.
August 28, 2020
On July 20, the Internal Revenue Service (“IRS”) published final global intangible low-taxed income (“GILTI”) high-tax exception regulations (T.D. 9902) under sections 951A and 954 and proposed regulations conforming the subpart F high-tax election to the new GILTI rule. Historically, the high-tax exception in section 954(b)(4) has allowed taxpayers to elect to exclude, from Subpart F, income that is subject to foreign tax at an effective rate that is at least 90% of the US corporate tax rate. In a somewhat controversial move, Treasury proposed to broadly expand the exception to GILTI last July. The final regulations mostly adopt the proposed regulations in a manner that, while ostensibly expanding the high-tax election as applied to GILTI, nonetheless limits its applicability in a number of ways. Because of these restrictions, modeling out the benefits and potential downsides of making the election is essential.
If the proposed subpart F high-tax regulations are finalized in their current form, taxpayers would be required to make a single unified election for all of their controlled foreign corporations that are members of the same CFC group (a defined term in the regulations) for both GILTI and subpart F. As a result, making the high-tax election would reduce planning opportunities for foreign tax credits associated with subpart F income as well as GILTI. The rules make the high-tax election especially problematic where taxpayers have CFCs with losses and foreign taxes paid.
The final regulations provide a more favorable tax treatment than the proposed regulations in that they modify the QBU-by-QBU standard to a slightly more relaxed “tested unit” standard, and also remove the requirement that the high-tax election is binding for five years. However, they failed to modify the rules in response to other taxpayer requests, such as that the rules apply on a CFC-by-CFC basis, and also make the election less favorable by proposing for it to be applied on a unified basis with the subpart F high-tax election.
A New, Tested Unit Standard
The final regulations apply the high-tax calculation for each separate “tested unit” of a CFC (this is different from the test of the proposed regulations that would have applied a QBU approach). A tested unit may be a CFC, but can also include a CFC’s direct or indirect interest in a pass-through entity if the pass-through is resident in another jurisdiction than the CFC, and meets one of two requirements: (i) it is a resident of a foreign country; or (ii) it is not subject to tax as a resident of a foreign country, but is treated as a corporation (or otherwise not fiscally transparent) for purposes of the CFC’s local tax law.
The third category of tested unit is a branch, which is considered a tested unit if: (i) the branch itself gives rise to a local taxable presence in the country where the branch is located, or (ii) it gives rise to a taxable presence under the owner’s tax law, and the owner’s tax law provides an exclusion, exemption, or other similar relief.
The preamble to the final regulations explains that applying the high-tax exception on a tested unit basis is intended to limit taxpayers’ ability to blend high-tax and low-tax income. This is achieved by ensuring that entities subject to different tax regimes will be treated as separate units. The regulations also achieve this result by having the starting point for the calculation of the gross income of each tested unit be the books and records (modified in the proposed regulations to look to applicable financial statements instead). This is intended to ensure that the high-tax calculation will be more closely matched to the effective rate under foreign law.
The final regulations provide additional rules to complement the application of the tested unit standard, establishing a mandatory same-country combination under which different tested units of a CFC (including the CFC tested unit) are treated as a single tested unit if the tested units are treated as tax residents of, or located in, the same country
The change from a QBU-by-QBU standard to the tested unit is somewhat favorable to taxpayers, but not as favorable as the CFC-by-CFC standard many comments had requested. The administrative burden associated with following the tested unit standard will be considerable, and in some cases the cost of calculating and reviewing applicability of the exclusion may outweigh the benefits afforded by it.
The Consistency Requirement
Consistent with the 2019 proposed regulations, the final regulations retain the consistency requirement that taxpayers make the election for all the CFCs that are part of a CFC group, without the opportunity to choose on a CFC-by-CFC basis. The consistency requirement ensures that a taxpayer that seeks to cross-credit the foreign tax imposed on high-taxed tentative tested income of one or more CFCs or tested units against low-taxed tested income of other CFCs or tested units must exclude all of its high-taxed tested income, thereby losing the ability to credit any foreign taxes associated with high-taxed income along with potential adverse consequences for purposes of the section 904 foreign tax credit expense allocation calculation.
For purposes of the consistency requirement, the final regulations narrow the definition of CFC group and instead adopt the definition of an affiliated group under 1504(a), modified to apply without regard to section 1504(b)(1) through (6) and by substituting “a more than 50%” threshold instead of “at least 80%” threshold. Constructive ownership rules in section 318(a) also apply with certain modifications. A CFC can only be part of one CFC group.
Making the Election
The final regulations permit taxpayers to elect the high-tax exclusion on an annual basis, repealing the 60-month election restriction provided by the 2019 proposed regulations.
Additionally, if a high-tax election is made by a CFC group, all CFCs that are part of the group are included in that election. The election is made by the controlling U.S. shareholder (generally, U.S. shareholders who, in the aggregate, own more than 50% of the total combined voting power), but is binding on all non-controlling U.S. shareholders. Controlling shareholders are required to provide notice of elections or revocation of elections to non-controlling shareholders in accordance with the regulations.
There are special rules for how the election is made in cases where the controlling U.S. shareholder is a partnership. In general, the high-tax election can be made (or revoked) on an amended return, but in such cases, all U.S. shareholders of the CFC must file amended federal income tax returns generally within 24 months of the due date of the original return of the controlling U.S. shareholder.
Special rules are provided in cases where CFCs have different year ends and for situations where a CFC enters or leaves a group during the year.
Because the final regulations are effective on September 21, 2020, and permit taxpayers to elect this exclusion to taxable years of foreign corporations that begin after December 31, 2017, this retroactive application of the new rules, along with the exceptional allowance of net operating loss carrybacks established by the CARES Act, may benefit taxpayers who are in a loss position by increasing their net operating loss from prior years.
Together with the final regulations, the IRS issued proposed regulations under section 954(b)(4) conforming the interaction of the Subpart F high-tax exception to the GILTI high-tax exclusion. The proposed regulations are effective when final.
The proposed regulations provide for a single election under section 954(b)(4) for purposes of both the Subpart F high-tax exception and the GILTI high-tax exclusion that must meet the consistency requirement. In addition to not being able to elect the application of only one exception, a taxpayer looking to make the high-tax exclusion election must also make the election with respect to all of the controlled foreign corporations that are members of the same CFC group.
The application of the single election to Subpart F and conforming rules are developed in depth in the proposed regulations.
Even though the proposed regulation determines gross income attributable to a specific tested unit based on items properly reflected on the separate sets of books and records, it replaces the reference to books and records with a method based on the applicable financial statement of the tested unit. The proposed regulations also provide a set of anti-abuse and de minimis rules. The anti-abuse rules address transactions designed to manipulate the high-tax exception including disregarded payments, or inclusions/exclusions of items on applicable financial statements. The de minimis rule combines different tested units that belong to the same CFC when they are allocated gross income less than the lesser of 1% of the total amount of gross income of the CFC, or $250,000.
While the new rules applied to the uniform election may ultimately increase the level of complexity, the fact that the changes to the Subpart F high-tax exclusion are currently in proposed form means that a taxpayer may still benefit from electing to apply only one regime, when a uniform election results in tax planning disadvantages.
This new method of election may further complicate the analysis of whether to opt for exclusion and increase the compliance burden.
This alert was produced in conjunction with Ivins, Phillips & Barker, Chtd.