Tax News and Developments North America Client Alert July 16, 2019 Treasury and IRS Release Final and Proposed Regulations on GILTI and the States Have Now Weighed In Introduction On June 14, 2019, the Treasury Department ("Treasury") and the Internal Revenue Service ("IRS") released final regulations related to "Global Intangible Low-Taxed Income" ("GILTI"), as reflected in new section 951A of the Code (the "Final Regulations"). Additionally and concurrently, Treasury and the IRS released proposed regulations to the GILTI and Subpart F regimes related to (1) domestic partnership ownership treatment and (2) "high taxed" income otherwise taxed under GILTI (the "2019 Proposed Regulations"). This Client Alert will focus on the Final Regulations and the 2019 Proposed Regulations. We will not concentrate on the temporary and proposed regulations to sections 245A and 954(c)(6), issued by Treasury and the IRS on the same day. There is a separate Client Alert on these regulations available for your review. For prior guidance related to the proposed regulations under GILTI issued in September 2018 (the "2018 Proposed Regulations"), please refer to our Client Alert from October 3, 2018. The 2018 Proposed Regulations remain important and instructive because the Final Regulations largely follow the guidance and terms of the 2018 Proposed Regulations, with considerable discussion of comments and recommendations. With some exceptions, such as the rules for consolidated groups and the allocation rules under Treas. Reg. § 1.951-1(e), the Final Regulations will apply to taxable years of foreign corporations beginning after December 31, 2017 and to taxable years of U.S. shareholders in which or with which the taxable years of such foreign corporations end. The consolidated return rules are intended to apply prospectively as of the date the regulations are published in the Federal Register. The allocation rules are intended to apply to taxable years of U.S. shareholders ending on or after October 3, 2018. Importantly, the 2019 Proposed Regulations on "high taxed" GILTI income are intended to be prospective and applicable only after final regulations are adopted. This will be disappointing for many readers who otherwise would benefit from these provisions, as shall be noted below. Treasury has suggested that it may finalize these rules retrospectively, but, until then it has finalized a more limited exception based on whether the income otherwise would be Subpart F income. Separately, but rather significantly, the states have diverged in their treatment of GILTI, and the divisions have now become clearer. Clients should pay close Baker McKenzie 2 Tax News and Developments - Client Alert July 16, 2019 attention to how GILTI is treated among the states and how they can best manage and mitigate any state tax exposure. Executive Summary The Final Regulations largely follow the 2018 Proposed Regulations, but made several changes to Subpart F income and GILTI inclusion rules, including (i) a revision to the anti-abuse rule for specified tangible property held temporarily, (ii) a revision to the pro rata share anti-abuse rule, (ii) an adjustment to the inclusion period rules, (iii) technical changes to the cumulative preferred stock rule and (iv) a rule barring reductions in both Subpart F income and GILTI tested income as a result of dividend distributions. The Final Regulations generally adopt an aggregate approach for domestic partnerships for purposes of applying section 951A, including any related provision that applies by reference, such as sections 959 (providing for "previously taxed earnings and profits"), 960 (providing for "deemed paid" foreign tax credits) and 961 (providing for basis adjustments). Importantly, the Final Regulations do not adopt the "hybrid aggregate-entity" approach from the 2018 Proposed Regulations. Similarly, the 2019 Proposed Regulations modify the Subpart F regime to generally extend the aggregate approach for controlled foreign corporation ("CFC") investments made by domestic partnerships. Treasury and the IRS finalized a "high tax" exception to GILTI, but only for CFC income otherwise subject to Subpart F and excepted under the "high tax" regime of section 954(b)(4). This limitation means that, to be eligible for the exception, the income would have to be considered foreign base company income ("FBCI") under section 954(a) or insurance income under section 953. Many taxpayers have been engaged in attempts to convert CFC income to FBCI to enjoy foreign tax credits with no haircut and timing constraints or enjoy the "high tax" exception. However, the 2019 Proposed Regulations introduced an expanded "high tax" exception to GILTI for CFC income subject to a rate of tax similar to section 954(b)(4), that is greater than 90 percent of the U.S. statutory corporate tax rate of 21 percent (or greater than 18.9 percent). The 2019 Proposed Regulations are intended to be prospective only, although Treasury has encouraged comments to the newly proposed "high tax" exception to GILTI and hinted that it would consider making the final regulations retroactive by election. It would be applied on a qualified business unit ("QBU") by QBU basis and would be elective for all commonly controlled U.S. shareholders of the CFC. While the election may be revoked, upon revocation, it generally cannot be made again for another 60 months. Deduction or Loss Attributable to Disqualified Basis Generally, Prop. Reg. § 1.951A-2(c)(5) established a rule that disallows, for purposes of calculating tested income or loss, any deduction or loss attributable to Baker McKenzie 3 Tax News and Developments - Client Alert July 16, 2019 "disqualified basis" in depreciable or amortizable property. "Disqualified basis" is defined as the excess of a property's adjusted basis immediately after the "disqualified transfer" over the sum of the property's adjusted basis immediately before the disqualified transfer and the amount of the gain recognized by the transferor that is subject to tax as Subpart F income or effectively connected income ("ECI"). "Disqualified transfer" is a transfer of property by a transferor CFC during the transferor's disqualified period to a related person in which gain was recognized. "Disqualified period" for a transferor CFC is the period that begins on January 1, 2018 and ends on the close of the transferor CFC's last taxable year that is not a CFC inclusion year. Treasury and the IRS received numerous comments questioning their authority for issuing these rules. Generally, the commentators argued that while there is authority to issue regulations "appropriate to prevent the avoidance of the purposes of this subsection," such authority is insufficiently expansive for Treasury and the IRS to issue these rules. Relying on section 7805(a), Treasury and the IRS revised the 2018 Proposed Regulations to reflect the source of its authority, namely, to prescribe all necessary rules for enforcement of the statute. Accordingly, Treasury and the IRS determined that a deduction or loss attributable to basis created through a transfer from a CFC to a related CFC during the disqualified period should not be permitted to reduce a taxpayer's U.S. tax liability in subsequent years. Thus, the Final Regulations treat any deduction or loss attributable to disqualified basis as not properly allocable to gross tested income, Subpart F income or ECI of the CFC. This was deemed necessary to ensure transfers during a disqualified period, and that were not subject to U.S. tax, would not reduce or eliminate a taxpayer's income that would be subject to U.S. tax after the disqualified period. Importantly, the Final Regulations allocate and apportion any deduction or loss to gross income other than gross tested income, Subpart F income or ECI. By doing so and thus allocating any deduction or loss to residual CFC gross income, the Final Regulations ensure that any such item attributable to disqualified basis is not taken into account for determining the CFC's income subject to U.S. tax (gross tested income, Subpart F income or ECI). Specified Tangible Properly Held Temporarily A U.S. shareholder's GILTI inclusion amount is based on a formulaic approach under which the excess (if any) of certain income over a stipulated "normal return" is effectively treated as intangible income. The "normal return" is 10-percent on certain tangible assets, defined as "qualified business asset investment" ("QBAI"). The 2018 Proposed Regulations included an anti-abuse rule (the temporary ownership rule) intended to address taxpayers attempting to reduce their GILTI inclusion by having a CFC temporarily hold specified tangible property to artificially increase the U.S. shareholder's "normal return" on tangible assets. Treasury included a "per se" rule, which deemed property to be held temporarily and Baker McKenzie 4 Tax News and Developments - Client Alert July 16, 2019 acquired with a principal purpose of reducing a GILTI inclusion amount if the acquisition would reduce a GILTI inclusion amount of a U.S. shareholder and the CFC held the property for less than a 12-month period that includes at least the close of one quarter during its taxable year. Treasury revised the "per se" rule in the Final Regulations, converting it to a rebuttable presumption. The standard for rebuttal is if the facts and circumstances clearly establish that the subsequent transfer of the property by the CFC was not contemplated when the property was acquired and that a principal purpose of the acquisition of the property was not to increase the normal return of a U.S. shareholder. Additionally, a second rebuttable presumption applies where property is held for longer than 36 months, in which case the property is presumed not to have been acquired with a principal purpose of reducing a GILTI inclusion amount. Last, a safe harbor applies to transfers between CFCs that are owned in the same proportion by U.S. shareholders, have the same taxable years and are all tested income CFCs. Pro Rata Share Anti-Abuse Rule The proposed pro rata share anti-abuse rule allowed the IRS to ignore a transaction or arrangement that alters a U.S. shareholder's ownership in, or rights regarding, shares in a CFC if a principal purpose of the transaction or arrangement is the avoidance of Federal income tax. Practitioners raised concerns that the rule as proposed was overbroad and could theoretically apply to virtually any activity that reduces a pro rata share amount of a U.S. shareholder. Further, ignoring a transaction disposing of CFC shares could theoretically leave the disposing party, for example, liable for income inclusions indefinitely. Treasury revised the rule to clarify that it will operate only to reallocate the allocable earnings and profits as of the hypothetical distribution date, and thus ultimately the inclusion amounts, among shareholders holding shares as of that hypothetical date. A transfer of shares will not result in a reallocation to the transferor, absent additional changes to the distribution rights in respect of the stock (such as by the issuance of a new class of stock). Inclusion Period Rules To determine the GILTI inclusion amount, the 2018 Proposed Regulations required a U.S. shareholder to take into account its pro rata share of the tested income earned by the CFC provided the CFC’s inclusion date was within the U.S. shareholder’s inclusion year. However, commentators suggested that these proposals could lead to a U.S. shareholder inclusion of the CFC's testing income for a U.S. shareholder inclusion year that does not include the last day of the CFC inclusion year. For example, suppose a U.S. person with a taxable year ending Baker McKenzie 5 Tax News and Developments - Client Alert July 16, 2019 December 31, 2019, sells a wholly-owned foreign corporation with a taxable year ending November 30, 2020, to a foreign person on December 1, 2019 and, as a result of the sale, the foreign corporation ceases to be a CFC. Under the 2018 Proposed Regulations, the CFC inclusion date for the foreign corporation would be December 1, 2019, whereas the CFC inclusion year of the foreign corporation would not end until November 30, 2020. Additionally, the comments to the 2018 Proposed Regulations also expressed concerns that U.S. shareholders would be unable to determine a pro rata share of any tested income of the CFC, because the CFC’s tested income could not be determined until the end of its taxable year relevant to the inclusion date, which in the example above is November 30, 2020. Further, the comments also noted that the 2018 Proposed Regulations' definition of CFC inclusion date was inconsistent with section 951A(e)(1), which provides that the pro rata share of certain amounts is taken into account in the taxable year of the U.S. shareholder in which or with which the taxable year of the CFC ends. The comments recommended that the relevant definitions be revised to accord with section 951A(e)(1). Treasury and the IRS agreed and modified the inclusion period rule accordingly. Under the Final Regulations, a U.S. shareholder will include tested income in its inclusion year up to the last day of the CFC’s inclusion year. The Final Regulations also provide that a U.S. shareholder’s pro rata share is to be determined based on section 958(a) stock, which is now consistent with sections 951A(e)(1) and 951(a)(2). Lastly, the Final Regulations changed the terminology of the rules. The term “hypothetical distribution date” in the Final Regulations has the same meaning as the term “CFC inclusion date” in the 2018 Proposed Regulations. Cumulative Preferred Stock Rule Where there are multiple classes of stock, the Final Regulations adopt the approach of allocating pro rata income shares based on the distribution rights of the respective classes. Discretionary arrangements pose particular difficulties, and additional rules were provided to account for these challenges. Classes of stock with cumulative preferred dividends are classified as discretionary arrangements unless specific tests are met. Under the test outlined in the 2018 Proposed Regulations, preferred share classes with mandatory redemption dates and payment of interest on accrued but unpaid dividends compounding annually at or above the applicable Federal rate ("AFR") under section 1274(d)(1) would avoid discretionary distribution treatment. The test in the 2018 Proposed Regulations was unclear as to the whether the AFR from the time of issuance or from the current year should be used in applying the rule. Treasury clarified that the AFR at time of issuance should apply. Similarly, any arrearage on cumulative preferred stock is determined using time value of money principles. Baker McKenzie 6 Tax News and Developments - Client Alert July 16, 2019 Barring Double Benefits Section 951(a)(2)(A) is the operative provision that determines a U.S. shareholder's pro rata share of Subpart F income and pro rata GILTI tested income. Under section 951(a)(2)(B), a U.S. shareholder's pro rata share of Subpart F income and GILTI tested income is reduced by dividends paid to any other person on the stock. Treasury was concerned that this provided an inappropriate double benefit in reducing income twice on the same dividend distributions, once as a reduction in Subpart F income and once as a reduction in GILTI tested income. The Final Regulations allocate this reduction between Subpart F income and GILTI tested income in proportion to the respective amounts of each. Accordingly, if the U.S. shareholder has $60 of Subpart F income and $40 of GILTI tested income, any dividend distributions reducing the income inclusions are allocated 60 percent to reducing Subpart F income and 40 percent to reducing GILTI tested income. Treasury remains concerned about inappropriate results on the concurrent application of section 951(a)(2)(A) and section 951(a)(2)(B), particularly where a double Subpart F and GILTI benefit might arise, and so future guidance may be forthcoming. Additionally, Treasury is still studying how to account for the application of section 951(a)(2)(B) to dividends which are effectively untaxed, such as dividends paid to foreign persons, dividends that give rise to the 245A deduction or dividends paid after a U.S. person disposes of the underlying shares. Tested Interest Expense and Tested Interest Income Generally, a U.S. shareholder's net Deemed Tangible Income Return ("DTIR") is the excess of a 10 percent return on its pro rata share of qualified business asset investment ("QBAI") of each CFC over the interest expense that reduces tested income (or increases tested loss) for the taxable year of the U.S. shareholder, to the extent the interest income attributable to that expense is not considered in determining the U.S. shareholder's net CFC tested income. The 2018 Proposed Regulations adopted a netting approach to determine the amount of interest expense of a U.S. shareholder, ("specified interest expense"), defining such amount as the excess of such shareholder's pro rata share of “tested interest expense” of each CFC over its pro rata share of “tested interest income” of each CFC. Notwithstanding some comments to the contrary, Treasury and the IRS viewed the netting approach as balancing administrative concerns with the need to avoid the complexity inherent in a tracing approach. Accordingly, the Final Regulations retain the netting approach, but made certain modifications. Commentators variously questioned in differing formats whether the 2018 Proposed Regulations created a new standard for definition of interest expense and interest income, which might create confusion. Recognizing some confusion Baker McKenzie 7 Tax News and Developments - Client Alert July 16, 2019 and seeking administrative simplicity, the Final Regulations adopt the definition of interest expense and interest income under section 163(j). The 2018 Proposed Regulations define “tested interest expense” as interest expense paid or accrued by a CFC that is taken into account in determining the tested income or tested loss of the CFC, reduced by the qualified interest expense of the CFC. Treasury revised the definition of "tested interest expense" in the Final Regulations to mean interest expense that is allocated and apportioned to gross tested income of a CFC reduced by qualified interest expense. The 2018 Proposed Regulations define a "qualified CFC" as an eligible controlled foreign corporation under section 954(h)(2) or a qualifying insurance company under section 953(e)(3). Further, "qualified interest income" is defined as interest income included in the gross tested income of a qualified CFC that is excluded from foreign personal holding company income ("FPHCI") under sections 954(h) or (i). "Qualified interest expense" is the portion of interest expense of a qualified CFC, determined under a two-step approach. Under the first step, a qualified CFC's interest expense is multiplied by a fraction, the numerator of which is the CFC's average basis in the assets which give rise to income excluded from FPHCI and the denominator is the CFCs average basis in all of its assets. Second, the product of the first step is reduced by the interest income of the qualified CFC that is excluded from FPHCI by reason of Section 954(c)(3) or 954(c)(6). This two-step approach effectively treats all interest expense as attributable proportionately to the qualified CFC that gives rise to income excluded from FPHCI, but then traces that interest expense to any interest income received from related CFCs. Commentators viewed the 2018 Proposed Regulations as unnecessarily complicated or argued that they understated the amount of qualified interest expense. Treasury and the IRS recognized these points, particularly as to the application of the above formula. Within the formula, Treasury and the IRS eliminated the second step for simplicity and to avoid the potential of double counting. In addition, regarding the effect of related party receivables, the Final Regulations clarified that a receivable that gives rise to income that is excludable from FPHCI by reason of Section 954(c)(3) or 954(c)(6) is not included in the numerator of the fraction. In a similar vein, the Final Regulations provide that a CFC's qualified interest expense shall be taken into account only to the extent established by the CFC. Thus, if a CFC does not establish an amount of qualified interest expense, the taxpayer can assume that none of the CFC's interest expense is qualified interest expense. Finally, a commentator observed a mismatch between the treatment of interest income of a qualifying insurance company subsidiary, which is qualified interest income of a qualified CFC, and interest expense of the holding company, which is not qualified interest expense of a qualified CFC, in calculating specified interest expense. To address this mismatch, the Final Regulations eliminated the term "qualified CFC." Accordingly, if a holding company is not engaged in an active financing or insurance business and borrows funds to fund subsidiaries that are so Baker McKenzie 8 Tax News and Developments - Client Alert July 16, 2019 engaged, the interest expense may constitute qualified interest expense and therefore be disregarded in determining specified interest expense. Section 952(c) Coordination Rule and Qualified Deficits Generally, section 952(c) provides that the amount of Subpart F income for a taxable year is subject to an earnings and profits ("E&P") limitation and recapture provisions. That is, a CFC's Subpart F income cannot exceed its E&P for that year and, to the extent Subpart F income is reduced by an E&P limitation, any excess E&P for any subsequent taxable year is recharacterized as Subpart F income. Because there is no specific rule that coordinates the Subpart F exclusion from GILTI with the qualified deficit regime of section 952(c), Prop. Reg. § 1.951A2(c)(4)(i) established a coordination rule by providing that the gross tested income and allowable deductions properly allocable thereto are determined without regard to section 952(c). Accordingly, income that would be Subpart F income, but for the application of the E&P limitation in section 952(c)(1)(A), is excluded from gross tested income and, further, income that gives rise to E&P that results in Subpart F income recapture is not excluded from gross tested income. In short, the coordination rule treats an item of gross income as "taken into account" in determining Subpart F income, to the extent that the item would be included in Subpart F income but for the application of Section 952(c). Prop. Reg. § 1.951A-2(c)(4)(iv)(A) illustrates this rule with the following example. In Year 1, FS, a wholly owned CFC of a U.S. shareholder has $100 of FPHCI, a $100 loss of foreign oil and gas extraction income, and no E&P. In Year 2, FS has gross income of $100 that is not excluded from gross tested income, no allowable deductions and $100 of E&P. In Year 1, FS has no Subpart F income because of the E&P limitation and no gross tested income. In Year 2, because FS's E&P is $100, which exceeds its Year 2 Subpart F income ($0), the $100 of Subpart F income of Year 1 is recaptured in Year 2 under section 952(c)(2) and FS also has $100 of gross tested income because gross tested income is determined without regard to section 952(c). Despite numerous comments to the contrary, Treasury and the IRS determined that the section 952(c) coordination rule is consistent with the relevant statutory provisions under sections 951 and 951A. Treasury and the IRS noted that the GILTI regime is based on a taxable income concept, whereas the Subpart F regime is based on a distributable dividend model focused on the existence of E&P. The Final Regulations also revised the section 952(c) coordination rule to apply to disregard the effect of a qualified deficit or chain deficit in determining gross tested income. Reductions to Stock Basis for the Use of Tested Losses Prop. Reg. § 1.951A-6(e) provided for a downward basis adjustment to the adjusted basis in stock of a tested loss CFC to the extent its tested loss offsets Baker McKenzie 9 Tax News and Developments - Client Alert July 16, 2019 tested income of another CFC. This was intended to prevent duplicative use of a loss. These adjustments generally would be made at the time of a direct or indirect disposition of the tested loss CFC stock. Numerous comments raised significant issues regarding these rules. The Final Regulations did not adopt the basis adjustment rules from the 2018 Proposed Regulations and reserved on the basis adjustment rules under Treas. Reg. § 1.951-6(c). Treasury and the IRS intend to address the basis adjustment rules and related comments in a separate project. Aggregate Approach for Partnerships Aggregate Approach for GILTI The Final Regulations generally adopt an aggregate approach to the partners of a domestic partnership for purposes of applying section 951A. Similarly, the aggregate approach to the partners of a domestic partnership was also adopted for any provision that applies by reference to section 951A, such as sections 959 (providing for previously taxed income), 960 (providing for "deemed paid" foreign tax credits) and 961 (providing for basis adjustments). The "hybrid aggregateentity" approach to domestic partnerships from the 2018 Proposed Regulations was abandoned in favor of the aggregate approach with the reasoning that the aggregate approach best reconciled the relevant statutory provisions, the underlying GILTI policies and administrative/compliance concerns raised. Under the aggregate approach, a domestic partnership, except for certain circumstances noted below, would not be treated as owning stock in a foreign corporation, and would not have GILTI income. Instead, the partners of a domestic partnership are deemed to proportionately own the stock of the foreign corporation. This is the same treatment applied to foreign partnerships under section 958(a)(2). Thus, a U.S. person that directly, indirectly and constructively owns less than 10 percent of a CFC through a domestic partnership that owns 10 percent or more of the CFC would not have a GILTI inclusion. This approach is illustrated by an example in the Final Regulations. The example generally provides if a domestic corporation (USP) and an unrelated individual (A) that is a U.S. citizen own 95 percent and 5 percent, respectively, of a domestic partnership (DP) that, in turn, owns 100 percent of a foreign corporation (FC), then DP is not treated as owning FC for purposes of section 951A. Instead, for purposes of determining a GILTI inclusion under section 951A, USP is treated as owning 95 percent and A is treated as owning 5 percent of the stock of FC. Thus, USP is a U.S. shareholder of FC, and determines its pro-rata share of any tested item of FC. However, A is not a U.S. shareholder of FC, and does not have a prorata share of any tested item of FC. Baker McKenzie 10 Tax News and Developments - Client Alert July 16, 2019 Aggregate Approach for Subpart F Similar to the approach taken in the Final Regulations, the 2019 Proposed Regulations adopt an aggregate approach to the partners of a domestic partnership for purposes of applying section 951 and any other provisions that apply by reference to section 951. Treasury and the IRS note that this aggregate approach is consistent with Congressional intent for the Subpart F and GILTI regimes to work together. Under the aggregate approach, a domestic partnership, except for certain circumstances noted below, would not be treated as owning stock in a foreign corporation, and would not have Subpart F income. Instead, the partners of a domestic partnership are deemed to proportionately own the stock of the foreign corporation. Thus, a U.S. person that directly, indirectly and constructively owns less than 10 percent of a CFC through a domestic partnership that owns 10 percent or more of the CFC would not have Subpart F income. Exceptions The Final Regulations and the 2019 Proposed Regulations provide for certain exceptions to the aggregate approach for purposes of sections 951 and 951A. More specifically, a domestic partnership is treated as owning stock in a foreign corporation for the purpose of (a) determining whether a U.S. person is a U.S. shareholder, (b) determining whether a U.S. shareholder is a “controlling domestic shareholder” and (c) determining whether a foreign corporation is a CFC. These exceptions were included because Treasury and the IRS believe that a rule that applied the aggregate approach to domestic partnerships under the CFC rules in their entirety would be inconsistent with relevant statutory provisions. Finally, the aggregate approach “does not apply for any other purposes of the Code, including for purposes of [s]ection 1248.” Effective Date The Final Regulations are effective for taxable years of foreign corporations beginning after December 31, 2017. The 2019 Proposed Regulations are intended to be effective for taxable years of foreign corporations beginning on or after the date when such proposed regulations are published as final regulations in the Federal Register, and to taxable years of a U.S. person in which or with which such taxable years of foreign corporations end. However, subject to certain consistency rules, domestic partnerships that own stock in CFCs may apply the 2019 Proposed Regulations to earlier taxable years of foreign corporations that begin after December 31, 2017. Baker McKenzie 11 Tax News and Developments - Client Alert July 16, 2019 Expanded "High Tax" Exception to GILTI Treasury and the IRS responded to the concerns from taxpayers regarding the applicability of GILTI to CFC income taxed at high foreign tax rates by proposing an expanded "high tax" exception to GILTI similar in concept and scope to the "high tax" exception for Subpart F income under section 954(b)(4). Importantly, the expanded "high tax" GILTI exception is to be prospective only. Treasury and the IRS otherwise finalized rules under the GILTI regime that preserves and applies GILTI to all income of a CFC other than the exceptions to tested income enumerated under section 951A(c)(2)(A), such as the existing "high tax" exception under section 954(b)(4). In short, that means that, for now, unless CFC income is otherwise FBCI under section 954(a) or insurance income under section 953 and "high taxed" under section 954(b)(4), it will continue to be subject to GILTI and inclusion to a U.S. shareholder. Taxpayers had argued that GILTI was intended for low or zero taxed structures, not for income subject to regular tax in mainstream jurisdictions. The application of GILTI to CFC income in jurisdictions with a high foreign rate of tax, along with the 80 percent GILTI foreign tax credit ("FTC") limitation and regular section 864(e) expense allocation regime, gives rise to the result where residual U.S. tax could apply to such income on a recurring annual basis. Under prior law, taxpayers otherwise could defer U.S. taxation of that income until and when it could potentially absorb the high foreign taxes applicable to such income through the U.S. FTC regime. For example, a profitable group of operating affiliates in France, India, Japan and other countries, could be subject to GILTI at the U.S. shareholder level despite an average rate of tax well above 13.125 percent, with residual U.S. taxation in addition to high foreign taxes because of U.S. based debt and interest expense or U.S. based research and development expense. In an often-cited provision in the Conference Report (H.R. Rep. 115-466 at 627), 1 it perhaps was assumed that CFC income taxed at a foreign rate of 13.125 percent or higher would not be subject to further U.S. taxation. Under the 2019 Proposed Regulations, this would no longer be the case, subject to a U.S. shareholder election. The "high tax" GILTI exception would be broadened to include any item of income subject to an effective rate of tax greater than 90 percent of the U.S. statutory tax rate of 21 percent (or greater than 18.9 percent), even if the income is not otherwise foreign base company income or insurance income . The determination of "high taxes" would be made on a QBU by QBU basis by measuring taxes on the items of a QBU of the CFC. It would not be measured on a blended rate at the CFC level or more narrowly at each item of income. This 1 The language in the Conference Report provides as follows: "At foreign tax rates greater than or equal to 13.125 percent, there is no residual U.S. tax owed on GILTI, so that the combined foreign and U.S. tax rate on GILTI equals the foreign tax rate." H.R. Rep. No. 115-466, at 627 (2017). Baker McKenzie 12 Tax News and Developments - Client Alert July 16, 2019 could be favorable to taxpayers, since it acknowledges the complexity of how different CFCs will be taxed, while preserving the integrity of isolating business income at high rates of tax. But, it does require careful review based on a taxpayer's particular circumstances. For example, the rules generally require that taxpayers include disregarded payments in QBU income for purposes of measuring high taxes. The 2019 Proposed Regulations describe a CFC with two QBUs, one in the home office of the CFC itself and the second in a QBU disregarded entity ("DRE"). The income of the home office QBU is not taxed and the income of the QBU DRE is taxed at 25 percent. There is a disregarded payment from the QBU DRE to the home office QBU that is reinstated for purposes of determining tested income of the CFC. Because the "high tax" analysis is done at the QBU level, and not at a blended CFC level or through each item of income, the example concludes that the low taxed QBU is not eligible for exclusion from GILTI while the "high taxed" QBU can be eligible for an exclusion from GILTI. And, the QBU to QBU payment is reinstated to arrive at this conclusion since the payment itself geographically identifies the QBU that is entitled to the income for purposes of testing GILTI and attributing taxes under section 960. It is not clear how the new exception would be applied in the context of foreign consolidation groups or loss sharing regimes. And, because foreign base and timing differences can create substantial differences in effective tax rates when measured with US taxable income concepts, the new "high tax" exception may be harder to anticipate or apply than expected. The "high tax" exception is elective and applies to each member of a controlling domestic shareholder group. A "controlling domestic shareholder group" is defined as two or more CFCs if more than 50 percent of the stock (by voting power) of each CFC is owned (within the meaning of Section 958(a)) by the same controlling domestic shareholder (or persons related to such controlling domestic shareholder). In short, a consolidated return taxpayer cannot pick and choose which of its U.S. shareholders would make the election. Once it is made, it applies to the U.S. shareholder and its related shareholders across all of their respective "high taxed" CFCs. See Prop. Reg.§ 1.951A-2(c)(6)(v)(E). If the election is made for "high taxed" income, all of the taxes attributable to the "high taxed" income will be excluded from GILTI and the deemed paid credit under section 960. Similarly, none of the property used to generate the "high taxed" income will qualify as specified tangible property for purposes of QBAI (qualified business asset investment). Essentially, the income, taxes and investment will be excluded from any GILTI calculation and the U.S. tax base unless and until it is repatriated. This will have an important impact on the taxpayer because it effectively leaves a middle tier of income subject to ongoing treatment as GILTI (if foreign taxes are 18.9 percent or less) while removing the "high taxed" tier. Baker McKenzie 13 Tax News and Developments - Client Alert July 16, 2019 These rules generally are favorable and important to avoid residual U.S. taxation on highly taxed income or even what historically would be considered moderately taxed income. GILTI is a blunt instrument and had a perhaps unexpected and more draconian impact on higher taxed CFCs than the zero or low taxed CFC it was meant to address. Going forward, at least the average historical CFC with operations in mainstream tax jurisdictions can exclude themselves and their U.S. shareholders from GILTI and machinations to create Subpart F income and avoid GILTI and residual U.S. taxation. What happens though to U.S. taxpayers with CFCs in jurisdictions where the tax rate is higher than 10.5 percent and equal to or less than 18.9 percent, taking into account timing and base differences? This would include Ireland and other jurisdictions with favorable amortization regimes, such as Switzerland or perhaps the UK? Presumably, they are "high taxed" relative to their single digit tax rate CFC counterparts, but they are out of luck in extracting themselves from GILTI. This would leave the U.S. tax universe as one of three paradigms-- (1) zero or low taxed CFCs subject to GILTI at 10.5 percent, (2) moderately taxed CFCs subject to GILTI and possible residual U.S. tax and (3) "high taxed" CFCs subject to foreign taxation and no residual U.S. tax. Numerous comments were made to exclude all tested income taxable at a rate above 13.125 percent, the threshold rate where presumably no residual U.S. tax would apply in the hands of a U.S. taxpayer with GILTI. Treasury considered these comments, but concluded that it did not have the authority under the statute to include a "high tax" exception, except as defined in the well-trodden path of section 954(b)(4). Another central component to the new exception is the requirement that it apply to an entire controlled domestic shareholder group and not by each U.S. shareholder for each of its CFC ownership interests. The policy reason for this rule is to avoid cherry-picking pools of income and CFC that would be subject to the election, while excluding others. It's an all or nothing approach-- either you are in together or you are out entirely. What is not provided, is a timing approach that measures "high taxes" over time rather than in each CFC year. This follows the snapshot annual GILTI paradigm. For any CFC QBU that has a more volatile profile because of local losses or specific local tax benefits which would cause a reduced but temporary rate of tax at or below 18.9 percent, there is no mechanism to apply the "high tax" exception over a period of more than one accounting year. Either the income is "high taxed" and excluded by election from GILTI or it is GILTI and includible in the income of the allocable U.S. shareholder. Elections for the expanded "high tax" exception to GILTI may be made by the CFC's controlling domestic shareholders and will be binding on all of the US shareholders of the CFC for the year of the election and all subsequent CFC inclusion years unless revoked by the controlling US shareholders. Once an election is revoked, a new election will not be available for any CFC inclusion year Baker McKenzie 14 Tax News and Developments - Client Alert July 16, 2019 until 60 months following the close of the CFC inclusion year of revocation. And, once a new election is made, it will be binding and irrevocable generally for another 60 months after the close of the CFC inclusion year for which the subsequent election was made. The proposed and expanded "high tax" exception to GILTI is generally a welcome development. Treasury has informally suggested that it may consider finalizing the regulations with the new exception and allowing taxpayers to apply it retroactively to the date of enactment of tax reform rather than prospectively. It is looking for comments and input from taxpayers. That would be an equally welcome development and both practical and responsive to those taxpayers subject to GILTI in higher tax environments. To have different GILTI rules before and after the exception is finalized would be inconsistent with the framework of the exception itself, which intends to apply consistency and symmetry across U.S. shareholders for a "high tax" CFC. State Tax Treatment of GILTI State conformity to the Code is a fundamental consideration when it comes to analyzing the state tax implications of the TCJA. A threshold question arises in the state tax context whether GILTI can be included in the state tax base in the first instance under fundamental U.S. Constitutional principles. Assuming that GILTI can be taxed by states, taxpayers must consider not only whether a state decouples from or conforms to the federal GILTI regime (i.e., whether the state excludes GILTI from the measure of the tax base entirely, or includes all or a portion of GILTI in the state tax base), but also how these states conform to GILTI. Thus far, conformity to the GILTI regime at the state and local level has been far from consistent, and states conforming to GILTI are doing so in different ways. For example, states conforming to section 951A may or may not also conform to the corresponding 50 percent deduction set forth in section 250. In addition, certain states may also provide a dividends-received or other deduction for all or a portion of the section 951A inclusion, whereas others may not. Taxpayers should also be careful in states that decouple from the federal Subpart F regime. Subpart F income is excluded from the state income tax base in many states; however, although Subpart F income and GILTI share many of the same characteristics, taxpayers should not assume that GILTI will be treated similarly. If a state excludes Subpart F income from the base, taxpayers should pay particular attention to the definition of excludable Subpart F income in that state to determine whether GILTI is excluded. Finally, with the release of the Final Regulations, an additional question exists as to whether these regulations will apply at the state and local level since some states do not follow the federal Treasury regulations, even if they otherwise conform to the provisions of the Code underlying such regulations. Beyond these threshold conformity issues, taxpayers in GILTI-conforming states are having to confront several additional issues that are unique to state and local Baker McKenzie 15 Tax News and Developments - Client Alert July 16, 2019 taxation. For example, one glaring concern related to the inclusion of GILTI in the state tax base is the lack of a foreign tax credit at the state and local level. Unlike the federal provisions, which provide a foreign tax credit for 80 percent of taxes paid to foreign jurisdictions on GILTI, there is no state and local tax analogue to the federal credit. Thus, in some situations, the tax cost of GILTI at the state level may far exceed that at the federal level. An additional issue, and one that many states have been grappling with as of late, relates to "factor representation," i.e., how GILTI should be reflected in the state apportionment factor. Under the U.S. Constitution, states must fairly apportion the income of a multistate taxpayer. Some states (for example, New Jersey) appear to be ignoring this constitutional mandate and have crafted some constitutionally suspect apportionment rules with regard to GILTI. With the release of the Final Regulations, now is a good time for taxpayers to revisit their state tax filing positions with these issues in mind and develop a multistate approach to GILTI. Baker McKenzie 16 Tax News and Developments - Client Alert July 16, 2019 www.bakermckenzie.com For additional information please contact the authors of this Client Alert or any member of Baker McKenzie’s North America Tax Practice Group. James Gifford +41 44 384 14 38 james.gifford@ bakermckenzie.com Michael Keskonis +1 214 978 3019 michael.keskonis@ bakermckenzie.com Marc Levey +1 212 891 3944 marc.levey@ bakermckenzie.com Blake Martin +1 214 978 3043 blake.martin@ bakermckenzie.com Michelle Ng +1 650 251 5907 michelle.ng@ bakermckenzie.com Michael Tedesco +1 212 626 4284 michael.tedesco@ bakermckenzie.com Lawrence Zlatkin +1 212 626 4390 lawrence.zlatkin@ bakermckenzie.com ©2019 Baker & McKenzie. All rights reserved. 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Treasury and IRS Release Final and Proposed Regulations on GILTI and the States Have Now Weighed In
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