On July 20, 2020, Treasury and the IRS issued proposed regulations (“Proposed Regulations”) under section (“Section”) 954(b)(4) of the Internal Revenue Code of 1986, as amended (“Code”) conforming the rules for electing into a high-tax exception (“HTE”) for “subpart F” income and a high-tax exclusion from global intangible low-taxed income (“GILTI”) (“GILTI HTE”). As part of the same regulations package, Treasury and the IRS issued final regulations under Sections 951A and 954 for the high-tax election to limit federal tax on GILTI subject to a high rate of foreign tax (“Final Regulations”). Under Proposed Regulations, when finalized, the high-tax election for GILTI HTE in Final Regulations would be removed and substituted with HTE rules in Proposed Regulations for both subpart F income and GILTI.
Section 951A was enacted under section 14201 of Pub. L. No. 115-97 (2017), commonly known as the Tax Cuts and Jobs Act, or “TCJA”. Section 951A generally requires inclusion in gross income of a United States shareholder of a controlled foreign corporation (“CFC”), as defined in Section 957, “tested income” of a CFC. The GILTI regime works in tandem with Section 250 and with other TCJA provisions, which were enacted to replace the extraterritorial system of taxing income of a United States citizen or resident with a territorial-like approach. Generally, tested income consists of intangible income of a CFC, less 10 percent of adjusted basis in depreciable tangible property of the CFC, the latter reduced by interest expense allocable to interest income, which is excluded from tested income.
A purpose of the GILTI regime was to ensure that a U.S. shareholder of a CFC does not avoid income tax by relocating operations to a low-tax jurisdiction. However, a foreign income tax rate may be sufficiently high so that tax liability would be greater under the new participation exemption system than under the extraterritorial framework preceding TCJA. Under Section 951A(c)(2)(A)(i)(III), foreign base company income and insurance income excluded under the high-tax exception in Section 954(b)(4) from subpart F, the Code provisions governing federal tax treatment with respect to foreign income of a CFC, is not gross income included in tested income to calculate GILTI. By definition, reflecting Congressional intent, GILTI is low-taxed income.
To ensure tax parity and avoid an incentive for taxpayers in high-tax foreign jurisdictions to convert tested income into subpart F income, Treasury regulations proposed in 2019 created a “high tax exclusion” (“HTE”) from GILTI, excluding income subject to a foreign tax rate of at least 18.9 percent. The statutory authority for the GILTI HTE remains subject to debate. In general, the regulations allow a U.S. shareholder to make a Section 954(b)(4) election to exclude high-taxed CFC income from GILTI.
Treasury and the IRS finalized the GILTI HTE regulations on July 20, 2020 (“Final Regulations”), and simultaneously, issued proposed regulations (“Proposed Regulations”), to conform the HTE with the high-tax exception. The IRS substituted calculation of income of each qualified business unit (“QBU”) under Subpart F with a new, “tested unit” method under proposed amendment to Section 954(b)(4). This article discusses the method of computing CFC tested income in Proposed Regulations and compares the tested unit basis to a QBU level determination.
Grouping Rules in Final Regulations and Proposed Regulations
The Final Regulations permit a shareholder to elect annually into the GILTI HTE. Section 954(b)(4) generally excepts certain items of foreign base company income or insurance income from U.S. tax if the taxpayer demonstrates that such income was taxed by a foreign country at an effective income tax rate exceeding 90 percent of the highest corporate income tax rate under the Code, or 18.9 percent. The effective tax rate on income excluded under the HTE contrasts with the 13.125 percent effective tax rate on GILTI after taking into account the Section 250 deduction. CFC income with an effective tax rate above 13.125 and 18.9 percent or below is included in tested income of a CFC and is not subject to a GILTI HTE.
As a result of a Section 950 deduction and available foreign tax credits, a U.S. corporate shareholder may not owe any GILTI tax on CFC income with an effective foreign tax rate of at least 13.125 percent. On the other hand, an individual U.S. shareholder, such as a partner in a domestic partnership that owns the CFC, would have to make a Section 962 election under final Treasury regulations issued in July 2020 to claim a Section 250 deduction. The Section 962 election would result in a federal corporate income tax rate, currently 21 percent, applying to a distributive share of both GILTI and any subpart F income of the shareholder partner. Individuals should consult with counsel to determine whether a Section 962 election with respect to GILTI subject to an effective foreign income tax rate below 18.9 percent would result in favorable tax treatment to the partner of other Section 951(a) inclusions.
Final Regulations require tentative gross tested income to the extent attributable to a tested unit of a CFC to be aggregated within a separate category of income for HTE purposes. This rule contrasts with the net foreign base company income determination in current Section 954 regulations. Furthermore, tentative items of tested income and foreign taxes of tested units of a CFC, including the CFC, which have substantially equal effective tax rates, are aggregated. This structure limits “blending” of different tax rates that may apply to a certain item of income in a foreign jurisdiction. The uniform taxing rule was to ensure only high-taxed income was excepted.
Moreover, in Proposed Regulations, general category items of income that would have been GILTI or subpart F income, which are attributable to a tested unit, are aggregated under the unified HTE rule. The unified rule, applied to calculate the effective tax rate, results in a taxpayer avoiding determining whether an item of income is subject to GILTI or Subpart F. However, under Proposed Regulations, passive foreign personal holding company income, a category of subpart F income, and certain income and deductions attributable to equity transactions, the timing of which may be manipulated by a taxpayer is separately grouped for purposes of the HTE.
Overview of Tested Unit Concept in Applying the HTE
Treasury and the IRS, consistently with legislative history of Section 951A, intended to apply the anti-base erosion principle to the GILTI HTE. In 2019 proposed regulations, the IRS considered determining the gross tested income on a QBU by QBU basis, a QBU being defined under Section 989(a). In the preamble to Final Regulations, the IRS rejected a CFC by CFC effective foreign tax rate computation that applies generally in computing foreign tax credits under Section 904 regulations. In addition, in Final Regulations, the IRS substituted a QBU level determination of high-taxed income with a novel approach based on “tested units”.
The tested unit approach permits some blending of income subject to different tax rates under the mandatory tested unit combination rule in Final Regulations. The rule applies generally to tested units of a CFC that are tax residents of, or located in, the same country. Generally, there are three categories of tested units in Final Regulations, as reflected in Proposed Regulations.
A tested unit may be a CFC itself, or an interest held directly or indirectly by a CFC in a pass-through entity that is a tax resident of a foreign country or regarded for income tax purposes under applicable foreign law. A tested unit also may be a branch, the activities of which are carried on, directly or indirectly, by a CFC, which gives rise to a taxable presence in the foreign country. In some cases, a branch may not be subject to income tax under the laws of the foreign country, in which it is located. In that instance, the branch still may be a tested unit. However, an exclusion, exemption, preferential tax rate or other similar relief must apply with respect to income attributable to the branch under the tax laws of the foreign country, in which the CFC or other entity carrying on the activities of the branch is a tax resident. A tested unit also may be a portion of the activities of a branch, if they are carried on indirectly through an interest in a partnership.
In addition, Proposed Regulations contain a de minimis combination rule, which applies after the tested unit combination rule. The non-elective de minimis rule combines tested units with attributed gross income of less than the lesser of one percent of the gross income of the CFC or $250,000 for a tax year, without regard to the foreign country of tax residence. The de minimis rule is subject to an anti-avoidance provision in Proposed Regulations.
The High-Tax Election Under Proposed Regulations
In Proposed Regulations, the IRS conforms the rules implementing the Subpart F HTE with the GILTI HTE by applying the tested unit effective tax rate calculation under Section 954(b)(4). The preamble to the Final Regulations states the purpose of Proposed Regulations is to eliminate the disparity between the two elections or the incentive for taxpayers to structure into the Subpart F high-tax exception. Under Proposed Regulations, the Section 954(b)(4) election must be made with respect to all of the CFCs that are members of a CFC group pursuant to the GILTI HTE consistency requirement.
In addition, a unified rule applies to cover both subpart F income and tested income under a Section 954(b)(4) election (“HTE”). Furthermore, taxpayers are afforded additional flexibility in being permitted to make the GILTI HTE election on an annual basis. United States shareholders making the election are subject to specific contemporaneous documentation requirements.
An HTE election on an amended return must be filed within six months during the 24 months following the due date of the original income tax return without extensions. The original return would have been filed within the inclusion year of the controlling domestic shareholder, with or within which the relevant CFC inclusion year ends. Generally, all U.S. shareholders of the CFC must file amended returns within the prescribed period in order to make or revoke an HTE election on an amended return, unless the original returns of the shareholders had not been filed yet for the tax year.
If a U.S. shareholder is a partnership, the HTE election may be made or revoked by filing an amended Form 1065 or an administrative adjustment request (“AAA”). In the case of an AAA, a partner that is a U.S. shareholder in the CFC and the partnership comply with the requirement if both timely comply with the AAA requirements under Section 6227. Additional Form 5471 reporting requirements apply with respect to an HTE.
Another special rule applies in determining subpart F income for purposes of the HTE which carries over to a subsequent tax year of a CFC due to the application of the earnings and profits (“E&P”) limitation under Section 952(c)(1). Generally, under Section 952(c)(2), any E&P in excess of the subpart F income of the CFC for such subsequent tax year is recharacterized as subpart F income to the extent of the carryover of subpart F income due to the limitation from a prior tax year. To determine the carryover amount, rules similar to the rules under Section 904(f)(5) apply. In the event of a Section 381(a) transaction, Proposed Regulations clarify that there is a carryover of an overall foreign loss account of the distributing or transferor corporation to the acquiring or transferee corporation as of the close of the date of the distribution or transfer.
Calculating Gross Income for HTE Under Proposed Regulations
Final Regulations currently provide rules for calculating gross income attributable to a tested unit, subject to adjustments for certain disregarded payments, for the GILTI HTE. An item of income attributable to more than one tested unit would be deemed attributable to only one tested unit, and in a tiered structure, the item would be deemed attributable to the lowest-tier tested unit. Proposed Regulations generally mirror the rules in Final Regulations for calculating gross income attributable to a tested unit and the effective foreign tax rate for the HTE for both subpart F income and GILTI.
However, Proposed Regulations introduce new nomenclature with respect to gross income or net income items of a tested unit for calculating the effective foreign tax rate in determining applicability of the HTE. Also, Proposed Regulations provide that tentative gross income of a tested unit is determined based on items of gross income attributable to an applicable financial statement of the tested unit, replacing a “books and records” rule in Final Regulations. Treasury and the IRS, as stated in the preamble to Final Regulations, generally expect a tested unit to maintain a set of separate books and records. However, an entity, including a disregarded entity, a branch or a portion of the activities of a branch may qualify as a tested unit even if it does not maintain separate books and records.
In particular, an applicable financial statement of a portion of the activities of a branch that is a tested unit would be the applicable financial statement of the branch. Under the “booking rule” in Proposed Regulations, deductions, other than deductions for current year taxes, are attributable to a tested unit to the extent they are properly reflected on the applicable financial statement of the tested unit. Such deductions are allocated and apportioned on the basis of the income and activities to which the expense relates, provided that they reduce certain items of gross income attributable to the same tested unit.
Certain items of gross income may not be booked separately with respect to a portion of the activities of a CFC branch. Such activities may give rise to high-taxed income compared with other items of income of the same branch. Moreover, the branch may be subject to cost sharing arrangements or other circumstances, which may result in proper allocation and apportionment of expenses to a tested unit other than the portion of the activities of the branch which gave rise to high-taxed income. In this manner, applying the definition of an applicable financial statement may result in a high-taxed income qualifying for the HTE due to failure to book items separately. Domestic shareholders should obtain counsel to avoid adverse tax consequences in such circumstances.
In addition, subpart F coordination rules apply to ensure appropriate qualification for the HTE. These rules include determining subpart F income subject to the HTE without applying the earnings and profits limitation under Section 952(c)(1), determining foreign base company income for the HTE before applying the full inclusion rule and conforming amendments to Section 951A regulations.
Allocation and Apportionment of Deductions Under Proposed Regulations
The effective foreign tax rate is calculated first by taking into account gross tested income attributable to a tested unit, and then determining tentative net items of tested income by allocating and apportioning deductions to the extent they are properly reflected on an applicable financial statement of the tested unit. By contrast, allocation and apportionment rules under Section 861 would have applied for purposes of the HTE under Final Regulations. Those latter rules still apply for purposes of calculating foreign tax credits under Section 960, GILTI and Subpart F income. However, the IRS requested comments on conforming the two separate calculations for administrability and to avoid “double counting” of deductions for HTE, and GILTI or Subpart F.
Therefore, the taxpayer must allocate and apportion deductions to tentative gross tested income items to determine the amount subject to an effective foreign tax rate for GILTI HTE. Items of income of a tested unit approximate foreign taxable income. In contrast, timing and other tax accounting principles under the Code apply to tested income, gain, deduction and loss items for purposes of the HTE. The effective foreign tax rate, at which taxes are imposed on a tentative net item is the U.S. dollar amount of foreign taxes paid or accrued with respect to the tentative net item, divided by the U.S. dollar amount of the tentative net item, adding in the above foreign tax.
In addition, a taxpayer allocates and apportions the deductions to tentative gross tested income items for the CFC inclusion year, as if each tentative gross tested income item was in a separate tested income group. The current treatment is described in Treas. Reg. section 1.951A-2(c)(7)(iii). Likewise, the scope of a separate tested income group is defined in Treas. Reg. section 1.960-1(d)(2)(ii)(C). The superimposition of these rules may result in part or all of certain deductions on the books and records of a tested unit, which are generally taken into account for foreign tax purposes in computing foreign taxable income, not being taken into account for purposes of the GILTI HTE.
In some instances, the allocable and apportioned deductions, including a deduction for foreign taxes paid on the income, may exceed the amount of gross income. Therefore, booking the tentative net income item may result in an undefined or negative effective foreign tax rate. In that case, the tentative net item of tested income is treated as high-taxed under Proposed Regulations. Therefore, the items of gross income and deductions allocated and apportioned to such gross income under Section 861 regulations are assigned to a residual grouping and credit is not allowed for the foreign taxes allocated and apportioned to such gross income.
Applicability of Proposed Regulations and Final Regulations
Proposed Regulations generally would apply to tax years of CFCs beginning after the date of publication of final regulations and to tax years of U.S. shareholders in which or with which such CFC tax years end. However, the subpart F income recapture provision under Prop. Treas. Reg. section 1.954-1(f)(4) would apply to tax years of a foreign corporation ending on or after July 20, 2020 and would affect recapture accounts of an acquiring corporation for such tax year, even if the distribution or transfer subject to Section 381(a) occurred in a tax year ending before July 20, 2020.
The Final Regulations are effective on September 21, 2020. Consistent with the applicability date in proposed Section 951A and Section 954 GILTI HTE regulations, the Final Regulations provide that the GILTI HTE applies to tax years of CFCs beginning on or after July 23, 2020 and to tax years of U.S. shareholders in which or with which such CFC tax years end.