On June 14, 2019, the U.S. Department of the Treasury and the IRS released final global intangible low-taxed income (GILTI) regulations under Internal Revenue Code Section 951A and related foreign tax credit regulations. Treasury and the IRS also released a new set of proposed GILTI and Subpart F regulations and temporary regulations under the new §245A participation exemption.
Newly issued proposed regulations include a new GILTI high-tax exception election that would apply to any high-taxed controlled foreign corporation (CFC) income that would otherwise be tested income. This new exclusion is broader than the current high-tax exclusion, which only applies to CFC income that would otherwise be Subpart F income.
- The new GILTI high-tax exception is not available until the newly issued proposed regulations are finalized and effective. As currently drafted, the exception would not be effective retroactive to 2018 tax years that begin before the regulations are finalized.
Final regulations apply GILTI to partnerships, S corporations and their partners or shareholders under an aggregate approach where GILTI is computed at the partner or shareholder level and not the entity level.
- The aggregate approach is effective retroactive to CFC tax years beginning in 2018.
- Partnerships and S corps that have already filed their 2018 Form 1065 or 1120-S under the former proposed regulation hybrid method may need to file amended returns.
GILTI High-Tax Exception Election
Enacted in the Tax Cuts and Jobs Act (TCJA), §951A excludes certain types of gross income from the tested income of a CFC that a U.S. shareholder uses to compute GILTI income. Such exclusions include—but are not limited to—income the U.S. shareholder already recognizes as Subpart F income and gross income excluded from Subpart F due to the high-tax exception election of §954(b)(4). The prior GILTI proposed regulations released in October 2018 provide that the §951A exclusion of high-tax exception election income only applies to income that would otherwise be foreign base company income or foreign insurance income under the Subpart F rules. Therefore, any high-taxed income that would not otherwise be Subpart F income if not for the high-tax exception election cannot be excluded from CFC tested income under the §951A high-tax exclusion.
The final regulations issued on June 14, 2019, adopt the October 2018 proposed regulation high-tax exclusion rules without modification. However, Treasury and the IRS issued a new set of proposed GILTI regulations that day that would provide for a broader high-tax exclusion. Below is a synopsis of the new proposed GILTI high-tax exclusion:
- The proposed regulations provide that an election may be made for a CFC to exclude under §954(b)(4)—and thus exclude from gross CFC tested income—gross income subject to foreign income tax at an effective rate that is greater than 90 percent of the maximum U.S. corporate tax rate (18.9 percent based on the current rate of 21 percent).
- The election can be made or revoked at any time by the CFC’s controlling domestic shareholders for any CFC inclusion year. However, if a U.S. shareholder revokes an election for a CFC, the U.S. shareholder cannot make the election again within five years after the revocation, and then if an election is subsequently made, it cannot be revoked again within five years of the subsequent election.
- A GILTI high-tax exception election applies to each item of income for each CFC in a group of commonly controlled CFCs that meets the effective rate test.
- The effective rate test is applied separately to each qualified business unit of a CFC.
- The preamble to the final GILTI regulations clarifies that until the proposed regulations containing the new GILTI high-tax exception are finalized and effective, taxpayers may not exclude any item of income from CFC tested income under a high-tax exception election unless the income would otherwise be foreign base company income or foreign insurance income under the Subpart F rules.
- The proposed GILTI regulations provide that the new GILTI high-tax exception will be effective for taxable years beginning on or after the date that final regulations are published.
While the proposed GILTI high-tax exclusion is welcome news, deciding whether to make the election—once it is available—may not be simple. Numerous factors would need to be considered on a case-by-case basis to determine whether the GILTI high-tax exception election would be beneficial, such as:
- Whether the GILTI high-tax exception election would adversely affect the U.S. shareholder’s foreign tax credit position, especially if the U.S. shareholder also has low-taxed GILTI income for which the election would not be effective
- Whether the U.S. shareholder could otherwise benefit from a CFC grouping election under the interest deduction limitations of §163(j) that allows for a roll-up of a portion of CFC excess taxable income in the U.S. shareholder adjusted taxable income to the extent it has a GILTI inclusion
- Whether a noncorporate U.S. shareholder could potentially benefit from §951A previously taxed earnings and profits (PTEP) to reduce or eliminate a potential future §956 inclusion
Partnerships & S Corps
The October 2018 proposed regulations provide for a hybrid approach to domestic partnerships and S corps where an entity approach would apply at the domestic partnership and S corp level, but an aggregate approach would apply to certain partners and shareholders. GILTI income would be calculated at the domestic partnership and S corp level based on all CFCs held by the domestic partnership and S corp, and the distributive share of GILTI income would pass out to the partners and shareholders. However, partners and shareholders who meet a 10 percent voting or value threshold of the underlying CFC(s) would essentially ignore their distributive share of Schedule K-1 GILTI income and instead compute GILTI income at the partner or shareholder level based on all CFCs the partner or shareholder directly and indirectly holds.
The final regulations reject the hybrid approach and instead adopt a pure aggregate approach where domestic partnerships and S corps do not compute GILTI income at the entity level. Rather, they pass out CFC tested items to their partners and shareholders who—if they meet a 10 percent voting or value threshold of the underlying CFC(s)—compute GILTI income at the partner or shareholder level based on all CFCs the partner or shareholder directly and indirectly holds.
The entity approach still applies in determining whether a foreign corporation is a CFC, whether a U.S. person meets the definition of a “U.S. shareholder” and whether a U.S. shareholder is a controlling domestic shareholder that can make certain elections.
Because the final regulations will be published by June 22, 2019, 18 months after the TCJA’s enactment, the IRS has exercised its authority to make the final GILTI regulations—including the domestic partnership and S corp aggregate provisions—effective retroactive to taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
Treasury and the IRS recognize the pure aggregate approach to GILTI is contrary to the treatment of Subpart F, which has historically been determined and reported under an entity approach. To avoid inconsistencies, Treasury and the IRS issued proposed regulations on June 14, 2019, that would apply the same aggregate approach to the Subpart F rules. A domestic partnership or S corp may rely on the proposed regulations with respect to taxable years beginning after December 31, 2017, and before the proposed regulations are finalized provided that the aggregate treatment of Subpart F is consistently applied by the partnership or S corp and all partners or shareholders meeting the 10 percent voting or value threshold with respect to all foreign corporations.
Effect of the Change in Treatment of Partnerships & S Corps
The pure aggregate approach of the final regulations generally should not result in disparate tax consequences of partners and shareholders who meet the 10 percent voting or value threshold of the underlying CFC(s) as compared with the proposed regulations’ hybrid approach. However, the aggregate approach can have a significant effect on partners and shareholders who do not meet the 10 percent voting or value threshold. Under the proposed regulations’ hybrid method, less-than-10-percent noncorporate owners would be required to include their distributive share of Schedule K-1 GILTI income in their taxable income without the benefit of a §962 election that would otherwise permit the 50 percent GILTI deduction of §250 and the 80 percent deemed paid foreign tax credit of §960(d). However, under the final regulations’ pure aggregate approach, any partner or shareholder who directly, indirectly and/or constructively owns less than 10 percent of the voting and value of a CFC held by a domestic partnership or S corp is not considered a “U.S. shareholder” of the CFC and consequently does not have a GILTI inclusion with respect to a less-than-10-percent CFC.
The tax return compliance effect of the final regulations change in approach also is significant. Many partnerships and S corps have already filed their 2018 Forms 1065 and 1120-S using the proposed regulation hybrid approach. These partnerships and S corps may need to file amended returns to reflect the final GILTI regulations’ aggregate approach.
The 2018 version of Form 5471 introduces a new Schedule P designed for U.S. shareholders to track their share of PTEP. It appears that domestic partnerships and S corps should not include any §951A PTEP on Form 5471 Schedule P filed at the Form 1065 or 1120-S level, while partners and shareholders meeting the 10 percent voting or value threshold with respect to CFCs held by the partnership or S corp should file Form 5471 with their tax returns to report their partner or shareholder level §951A PTEP on Schedule P. If the domestic partnership or S corp files Form 5471 on behalf of its partners or shareholders under the multiple filer exception, a separate Form 5471 Schedule P for each partner or shareholder meeting the 10 percent threshold must be filed either with the domestic partnership or S corp’s Form 1065 or 1120-S—assuming the domestic partnership or S corp has sufficient information to complete Schedule P on behalf of such partners or shareholders—or separately with the partners’ or shareholders’ tax returns in accordance with the Form 5471 instructions.
Other Highlights of the Final GILTI Regulations & Temporary §245A Regulations
- A CFC that is not required to use the alternative depreciation system (ADS) to compute earnings and profits—for example, because the differences between ADS and a book depreciation method or a U.S. generally accepted accounting principles depreciation method are immaterial—may elect, for purposes of calculating qualified business asset investment (QBAI), to use its non-ADS depreciation method to determine the adjusted basis of specified tangible property placed in service before the first taxable year beginning after December 22, 2017, subject to a special rule related to salvage value.
- The final GILTI regulations adopt a depreciation allowance method rather than using the prior proposed gross income method to determine the amount of dual-use tangible depreciable property, i.e., tangible property that produces both CFC tested income and excluded income, that is included in a CFC’s QBAI. In other words, a CFC’s dual-use tangible depreciable property is included in QBAI based on the percentage of depreciation allowable in the calculation of CFC net tested income over the CFC’s total tangible property depreciation allowances for the year.
- The final GILTI regulations generally retain the netting approach of specified interest expense calculated as the excess of the U.S. shareholder’s pro rata share of CFC tested interest expense over pro rata share of CFC tested interest income. To mitigate the effect of a tested loss CFC having no QBAI, the final regulations allow a tested loss CFC to reduce its CFC tested interest expense—solely for purposes of computing specified interest expense at the U.S. shareholder level—by the 10 percent amount of QBAI that the tested loss CFC would have if it were a tested income CFC.
- The final GILTI regulations and temporary §245A regulations contain a number of anti-abuse rules targeting related-party transactions of fiscal year CFCs during the period of time between January 1, 2018, and the end of a CFC’s last taxable year beginning before January 1, 2018, during which neither §965 nor the §951A GILTI rules apply. The anti-abuse rules restrict the ability to use related-party transactions during this “black hole” or “donut” period of a fiscal year CFC to increase QBAI, decrease CFC tested income or increase tested loss through depreciation, amortization or other write-offs of stepped-up basis, increase income eligible for the §245A participation exemption and increase dividend income eligible for the §954(c)(6) related-party CFC look-through exception to Subpart F.
- The temporary §245A regulations limit the applicability of the participation exemption where a CFC dividend to a former U.S. shareholder can be used to reduce an acquiring U.S. shareholder’s Subpart F or CFC tested income under §951(a)(2)(B).
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