Introduction: From a Global to a Hybrid Territorial Tax System
The Tax Cuts and Jobs Act of 2017 (TCJA) moved the United States from a global to a hybrid territorial tax system. In doing so, the TCJA eliminated the taxation of repatriated dividends but simultaneously increased the scope of taxation on income earned by controlled foreign corporations. As a result, U.S. residents are required to report income earned by controlled foreign corporations, subject to various exclusions.
The newly enacted Section 951A of the Internal Revenue Code created the global intangible low-taxed income (GILTI) inclusion. Broadly speaking, the inclusion imposes a tax on any returns in excess of 10% of a foreign resident’s tangible assets, in order to mitigate some of the base erosion incentives introduced by the new system that allowed U.S. companies to shift profits to foreign subsidiaries in low-tax jurisdictions.
The GILTI regime requires taxpayers to report income earned by intangible assets that are, as a result of their highly mobile nature, ideal vehicles through which corporations can artificially shift the situs of their income to foreign jurisdictions. Determining the applicability and amount of GILTI attributable to a taxpayer operates entirely independently of the presence and value of intangible assets in foreign jurisdictions.
The GILTI regime functions by deeming any income earned in excess of 10% of a foreign subsidiary's tangible asset base as attributable to intangible assets and therefore, taxable domestically. Fortunately, where the TCJA takes with one hand, it gives with the other through accompanying credits and deductions that can drastically reduce or eliminate the tax liability that results from a GILTI inclusion.
GILTI in Focus: Recent and Potential Future Developments
On June 14, 2019, the U.S. Treasury Department and the IRS issued final regulations and a new round of proposed regulations under Section 951A and related provisions of the Code. The regulations resulted in a number of changes that impact the applicability of the regime and recharacterization of constituent elements required for the calculation of GILTI.
GILTI through Partnerships or S corporations: Final Regulations
After some debate, the 2019 Final Regulations opted to treat controlled domestic partnerships as an aggregate of its partners in the same manner as foreign partnerships prior to the final regulations to determine stock ownership for purposes of sections 951 to 964.
Prior to the changes, domestic partnerships were treated as entities for the purposes of qualifying as a U.S. Shareholder of a foreign corporation notwithstanding the fact that it is a pass-through entity. The partnership would include the foreign corporation’s Subpart F income and the partners would be required to include their share of the partnership’s Subpart F income in their income, even if a partner has less than a 10% interest in the partnership.
Following the changes, a partner in a domestic partnership would have an inclusion percentage proportional to its interest in the partnership for the purposes of qualifying as a U.S. Shareholder. Since an entity is only considered a U.S. Shareholder if it owns 10% or more of a controlled foreign corporation, a minority partner that has less than a 10% interest in the partnership would no longer have any Subpart F or GILTI inclusion by virtue of its minority partnership interest. The same rules apply for S corporations, which also behave as flow-through entities. The aggregate approach is subject to a few exceptions and does not apply for any other purposes of the Internal Revenue Code.
High-Tax Exception: Final Regulations and New Proposed Regulations
Currently, the Final Regulations only include a “high-tax” exception for CFC income that would otherwise be foreign base company income or foreign insurance income under the Subpart F rules. Any high-taxed income that would not otherwise be Subpart F income cannot be excluded from tested income under the high-tax exclusion in the current state of the Regulations.
However, the new set of Proposed Regulations provide for an election that would exclude gross income subject to foreign income tax at an effective rate that is greater than 90% of the maximum U.S. corporate tax rate (which currently sits at 21%). If the election is revoked, then a U.S. shareholder cannot make the election again for 60 months and cannot subsequently revoke the election for another 60 months. The expansion of the High-Tax exception is expected to have wide-ranging implications
A U.S. Shareholder’s interest expense and interest income is important for the purposes of calculating its Net Deemed Tangible Income Return, which is the excess of 10% of its Qualified Business Asset Investment over the interest expense. A taxpayer’s GILTI is calculated by taking the excess of its Net Deemed Tangible Income Return over its Aggregate Tested Income.
The Final Regulations adopted the netting approach suggested in the 2018 Proposed Regulations to determine the amount of interest expense through the incorporation of a new term – specified interest expense, which is defined as the excess of tested interest expense of each CFC over its tested interest income in accordance with the definitions of interest expense and income under section 163(j). The approach applies to each CFC regardless of whether the CFC sustained a tested loss. This is expected to simplify the determination of these amounts by eliminating the complexity associated with a tracing approach.
Technology and Tools to Track Updates
If you’re interested in learning more about recent and potential future developments in GILTI and how Tax Foresight's GILTI Navigator can help with quickly estimating your or your client's GILTI tax liability, register for Blue J Legal’s upcoming webinar on September 26, 2019 at 10:00 AM EDT, hosted by Abdi Aidid, Blue J Legal’s Director of Legal Research and University of Toronto Faculty of Law Adjunct Professor.