On 20th July 2020, The U.S Treasury Department and the Internal Revenue Service (“IRS”) released finalized regulations for the global intangible low-taxed income (GILTI) high-tax exception. The regulations allow certain U.S shareholders of a controlled foreign corporation (“CFC”) an exception from tax on GILTI for operations outside of the U.S taxed at high or moderate rates. GILTI was brought in under the Tax Cuts and Jobs Act of 2017 (“TCJA”), and generally refers to a portion of a CFC’s earnings exceeding a specified return on foreign assets.
The 2020 Final Regulations are based on 2019 proposals from the IRS. Additionally, the IRS has issued a proposal to modify the high-tax exception for the income of a foreign corporation (e.g., “subpart F income”) rules to conform to the finalized GILTI exception of the 2020 Final Regulations.
This article will cover the proposed regulations, and the issued regulations, from three key releases:
- the 2019 Proposed Regulations; many parts of which have been applied in the following;
- the 2020 Finalized Regulations and;
- the 2020 Proposed Regulations, which makes new suggestions going forward
GILTI
TCJA retains subpart F, under which taxpayers that hold more than 10% of vote or value as shareholders in a CFC are subject to taxation on their share of the CFC’s GILTI. Subpart F taxes passive earnings of CFCs, whereas GILTI taxes CFC earnings not subject to subpart F at a minimum rate.
High-tax exemptions under subpart F may be available for certain items, in which case the U.S shareholder can elect to exclude that item from their gross income. The exception applies to items that are taxed in a foreign country at more than 90% of the maximum U.S. corporate income tax rates, currently equal to 18.9%. The minimum threshold for the high-tax exception is calculated from the actual effective foreign tax rate imposed on the item, rather than the tax rate of the foreign jurisdiction.
Under the TCJA, a new tax was brought in for shareholder’s share of the CFC’s GILTI. GILTI is aimed at low-taxed income — such as that available under subpart F — however, this was not considered under the original rules as there was no exception for high-taxed income. Instead, U.S. shareholder corporations can have deductions equaling 50% of GILTI, and credit on foreign tax for 80% of taxes paid with respect to GILTI. This means that the U.S shareholder doesn’t pay in excess of a foreign tax rate of 13.125%. The CFC earnings are treated as subpart F income, and any income excluded in subpart F are also excluded from GILTI.
The 2019 Proposed Regulations
The proposals made in the 2019 Proposed Regulations were to offer high-tax exceptions for GILTI, like those within subpart F. These exceptions would allow controlling domestic shareholders of a CFC to exclude GILTI from their gross income, as long as it was subject to the highest rates of U.S. corporate income tax (90%). The same exception would need to be made for all CFCs under the control of the domestic shareholder.
Interestingly, the regulations also proposed that foreign tax rates would be calculated separately for each qualified business unit. This would prevent blending of high-taxed income and low-taxed income, which, if determined on an aggregate basis would allow for broadly applied high-tax exemptions. The proposed regulations also required the following:
- High-tax exceptions to be elected by a CFC’s controlling domestic shareholders
- All U.S shareholders of the CFC to be bound to this high-tax exception
- Invocations or revocations of the high-tax exception to remain in place for 60 months after actioning.
The 2019 Proposed Regulations were generally sympathetic to tax-payers, however, the provisions would only be made applicable to the taxable period of CFC beginning on or after the regulations were finalized. Therefore, before the 2020 Final Regulations were in place, taxpayers could not take advantage of GILTI high-tax exemptions except in specific circumstances where the income was excluded from subpart F.
The 2020 Final Regulations
For the most part, the 2020 Final Regulations have enacted the provisions set out in the 2019 Proposed Regulations. The rules to opt-out of the GILTI regime for income subject to foreign income tax in excess of 90% of the U.S corporate income tax rate remain the same. Feedback from taxpayers was taken into account, and some suggestions were included in the 2020 Final Regulations. Many, however, were deemed too complicated to effectively incorporate.
The main specifications of the 2020 Final Regulations include:
- Tested Unit Determination
Calculations of foreign tax do not apply QBU-by-QBU or CFC-by-CFC. The GILTI effective rate is instead calculated by a tested unit-by- tested unit approach. A tested unit may include CFCs, an interest in a pass-through entity held by a CFC, and certain branches of a CFC. Tested units of CFC must be treated as a single tested unit if they are within the same country.
- Disregarded Payments
To disregard payments made between tested units for U.S tax purposes, gross income is reallocated between the tested units. The reallocation ensures that the income is properly associated with the unit that is subject to the income tax.
- Annual Election
Invocations or revocation of high-tax exceptions will no longer be imposed for 60-months. The election can instead be made each year.
- Consistency Requirement
The regulations still require that election or revocation of high-tax exceptions must be applied to all related CFCs, despite some commentators requesting that the high-tax exception election be made available on a CFC-by-CFC basis.
The 2020 Proposed Regulations
Many taxpayers have gladly accepted regulations allowing a high-tax exception for GILTI, however, it was suggested that the 2019 Proposed Regulations modify the exception to conform to the subpart F income. Although the IRS and Treasury were in agreement with conforming to subpart F income, it was ultimately determined that the high-tax exception of the 2020 Final Regulations would be a more appropriate reflection of policies underlying the exception that the current subpart F.
The 2020 Proposed Regulations, therefore, put forward the following modifications:
- To amend the subpart F income high-tax exception to conform to the GILTI high-tax exception of the 2020 Final Regulations
- To provide for a single high-tax exception to be applied for the purposes of GILTI and subpart F
These modifications promote appropriate tax planning and simplify across the different high-tax exemptions.
Effective Date
From the 23rd July 2020, the 2020 Final Regulations will become effective for beginning tax years of foreign corporations, and ending tax years of U.S shareholders. One silver lining is that taxpayers can elect to apply the 2020 Final Regulations for tax years beginning after 31st December 2017 and before 23rd July 2020, provided consistency requirements are met. Generally, the 2020 Proposed Regulations are effective for tax years beginning on or after the finalization date of the 2020 Final Regulations.
Conclusion
The new regulations are, on the whole, sympathetic to tax-payers, expanding the high-tax exception from subpart F to the GILTI regime. This reduces the payable tax for taxpayers with foreign corporation interests. Although this provides relief to multinational corporations, there will also be complications owing to the proposal to conform subpart F income to GILTI.
For some taxpayers, there is a possibility to receive backdated relief for the GILTI high-tax exception by electing for tax years beginning after 31st December 2017. Taxpayers and their advisors should consider the benefits of applying the new 2020 Final Regulations to previous tax years.