Final regulations clarify potential benefits of the GILTI high-tax exclusion
The IRS has released final regulations regarding the election to exclude certain income subject to a high rate of tax from the global intangible low-taxed income (GILTI) calculation. Among other changes, the new guidance creates additional flexibility by allowing the election to be made on an annual basis rather than the previously proposed 60-month restriction period. Also, the final regulations permit taxpayers to choose to apply the GILTI high-tax exclusion to taxable years of foreign corporations that begin after Dec. 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
What is GILTI?
The Tax Cuts and Jobs Act of 2017 (TCJA) created a regime that allowed certain earnings of controlled foreign corporations (CFC) to be repatriated to U.S. corporate shareholders without being subject to U.S. income taxes. Income eligible for this regime is limited to earnings not subjected to current U.S. taxation under Subpart F or GILTI. The GILTI regime is intended to discourage corporations from shifting intangible property (IP) to CFCs operating in low-tax countries where the income they generate could then be repatriated to the U.S. tax-free. In short, the GILTI provisions impose a current U.S. income tax on the net income of a CFC that exceeds 10% of the net tax value of its depreciable assets.
Non-U.S. income qualifies for the GILTI high-tax exclusion if the effective foreign tax rate is greater than 90% of the maximum U.S. corporate tax rate.
Although the intent of Congress’ enactment of Section 951A was to discourage the offshore holding of IP, many taxpayers who held ownership interests in CFCs became liable for the new GILTI tax regardless of any IP holdings due to the arbitrary 10% of assets threshold.
GILTI high-tax exclusion election
Congress intended GILTI to discourage corporations from allocating IP to low-tax jurisdictions as a tax minimization strategy, not to penalize all corporations that generate income overseas regardless of the reason. If the CFC is earning income in a foreign jurisdiction with a high-tax rate, the rules are willing to consider that any IP allocated to that country is there for a purpose other than tax avoidance. These final regulations govern the election that U.S. shareholders of CFCs will use to exclude global income earned in high-tax jurisdictions from the GILTI calculation.
- What constitutes a high-tax rate? Non-U.S. income qualifies for the GILTI high-tax exclusion if the effective foreign tax rate is greater than 90% of the maximum U.S. corporate tax rate (currently 18.9%, based on the U.S. corporate tax rate of 21%). However, the calculation is significantly more complicated than just looking at a country’s corporate tax rate table to see if the rate is higher or lower than 18.9%
The effective foreign tax rate is calculated by taking the foreign income taxes paid or accrued for the “tested unit” (see below) for the CFC’s tax year and comparing them to the tested income of the tested unit as calculated under U.S. tax principles. Whether the exclusion applies will need to be analyzed for each tested unit, and should not be assumed to apply based on the statutory foreign tax rate, as differences may exist between the calculation of tested income for GILTI and the taxable income taken into account in the foreign jurisdiction.
- Tested-unit approach: The final regulations provide for a targeted approach to calculating the effective foreign tax rate paid by individual “tested units.” Any of the following entities, interests, or activities could meet the definition of a tested unit:
- A CFC.
- An interest in a pass-through entity held, directly or indirectly, by a CFC. For this purpose, a pass-through entity is defined to include a partnership or a disregarded entity.
- A branch, or a portion of a branch, the activities of which are carried on directly or indirectly by a CFC outside of the CFC’s country of incorporation.
The rules clarify that tested units are determined independently of one another. For instance, even though a CFC is itself a tested unit, the CFC may have other separate tested units. The final regulations provide for a combination rule under which tested units of a CFC (including the CFC tested unit), are generally treated as a single-tested unit if the tested units are tax residents of, or located in, the same foreign country. The combination is mandatory rather than elective and applies without regard to whether the tested units are subject to the same foreign tax rate.
The final regulations provide for a targeted approach to calculating the effective foreign tax rate paid by individual “tested units.”
- Procedure for making the election: The controlling domestic shareholder of a CFC or CFC group may claim the high-tax exclusion on an annual basis by filing an election statement and, if needed, providing notice to all other persons known by the controlling shareholder to be domestic shareholders. Since a partnership (or S corporation) is only treated as owning the stock of a CFC for purposes of determining whether any partner or shareholder of the pass-through entity is a U.S. shareholder of the CFC, there is confusion as to whether a pass-through entity should be treated as a controlling domestic shareholder for purposes of making the election. The Treasury Department and the IRS have stated an intention to address comments regarding this. Under currently applicable regulations, a domestic partnership may be a controlling domestic shareholder for purposes of determining which party elects the GILTI high-tax exclusion.
- Election applies to all members of a CFC group: The guidance provides that if a CFC is a member of a CFC group, the high-tax exclusion election (or revocation) must be made for all members of the CFC group or not made at all. For this purpose, the final regulations provide that a CFC group is an affiliated group, as defined in Section 1504(a), with certain modifications that broaden the definition. The final regulations also clarify that if a CFC isn’t a member of a CFC group, a high-tax election is made (or revoked) only with respect to the CFC.
- Amending previously filed returns: The final regulations generally provide that the election may be made (or revoked) on an amended federal income tax return only if all U.S. shareholders of the CFC file amended federal income tax returns for the taxable year (unless an original return has not yet been filed, in which case the original federal income tax return may be filed consistently with the election (or revocation)). Amended returns would also be needed for any other taxable year in which their U.S. tax liabilities would be increased by reason of that election (or revocation). In the case of a partnership, an amended return would be needed if any item reported by the partnership or any partnership-related item would change as a result of the election (or revocation).
The amended returns need to be filed within 24 months of the unextended due date of the original federal income tax return of the controlling domestic shareholder’s inclusion year with or within which the CFC inclusion year, for which the election is made (or revoked), ends. The final regulations also provide that amended federal income tax returns for all U.S. shareholders of the CFC for the CFC inclusion year must be filed within a single six-month period (within the 24-month period).
The controlling domestic shareholder of a CFC or CFC group may claim the high-tax exclusion on an annual basis by filing an election statement.
- Conformity to subpart F high-tax exception: A separate set of proposed regulations attempts to conform the rules implementing the subpart F high-tax exception to the rules implementing the GILTI high-tax exclusion, and provides of a single election for purposes of both subpart F income and tested income. The IRS will consider comments on the new proposals and intends to eventually finalize a process that works for both the exception and the exclusion at some point in the future.
The new guidance includes some favorable modifications that give taxpayers more flexibility to elect the exclusion. The rules give taxpayers the opportunity to analyze whether the election should be made on an annual basis. While the election may appear favorable initially, further analysis may reveal that certain “side effects” of the election such as BEAT, FDII, or foreign tax credit limitations make the election less attractive. Therefore, careful modeling of the election should be undertaken, accounting for all of a relevant taxpayer’s attributes.
If you have any questions about how the GILTI high-tax exclusion election could affect your GILTI calculation or would like to discuss the final regulations, please contact Plante Moran.