The U.S. Treasury Department (“Treasury”) has released final regulations and proposed regulations (T.D. 9882) (the “Guidance”) providing rules related to the determination of the foreign tax credits (“FTC”) under the new international tax regime as amended by the Tax Cuts and Jobs Act of 2017 (“TCJA”). Among other things, the Guidance provides relief to companies with global intangible low-taxed income (“GILTI”) by excluding research and development expenses from the calculation of FTC limitations.
Under the regular anti-deferral regimes prior to the TCJA, U.S. shareholders (whether corporations or individuals) that owned 10% or more of the voting stock in a foreign corporation classified as a CFC generally were taxed on the CFC's earnings only upon receipt of a dividend. The primary exception to this rule was passive income or related party income that comprised the complex reporting rules known as the Subpart F regime that required the inclusion of certain types of income earned by a CFC on a current basis, regardless of whether a distribution is received. A U.S. shareholder could, with proper structuring, plan around this regime and achieve tax deferral on income earned from a CFC.
However, under the TCJA, a new anti-deferral tax was implemented, the GILTI tax regime. Similar to the taxation of Subpart F income, a 10% U.S. shareholder of one or more CFCs will be required to include its GILTI currently as taxable income (in addition to any Subpart F income), regardless of whether any amount is distributed to the U.S. shareholder. The GILTI tax causes a U.S. shareholder to be taxed on its current allocable share of CFC income to the extent such earnings exceed a 10% return on the shareholder's allocable share of tangible assets held by CFCs. Notably, the GILTI tax applies equally to U.S. shareholders that are corporations or to flow through taxpayers. Once the amount of GILTI has been determined, a U.S. corporate taxpayer may claim a deduction, subject to certain limitations, equivalent to 50% of its GILTI (reduced to 37.5% for tax years starting after 2025). Prior to the consideration of U.S. foreign tax credits, this results in a 10.5% minimum tax on a corporate U.S. shareholder's GILTI.
Corporate shareholders can claim a foreign tax credit for 80% of the foreign taxes associated with GILTI. Therefore, after applying the foreign tax credit, if the tested income is subject to an effective foreign income tax rate above 13.125%, for tax years before 2026, and 16.406% thereafter, the corporate shareholder would have no GILTI tax (10.5%/80%=13.125%). Flow through taxpayers, by contrast, do not benefit from foreign tax credits on GILTI thereby increasing the impact of the new GILTI regime on flow through taxpayers.
Proposed FTC regulations (the “Proposed Regulations”) were published in December of 2018 and included guidance addressing, among other things, how foreign taxes are to be allocated among categories of income, including Subpart F and GILTI, and how expenses are to be allocated among FTC limitation baskets. While the Proposed Regulations did clarify how FTC’s can be claimed against GILTI tax liability, they did not provide for any exemption from the allocation of expenses to GILTI. Without such an exemption, the allocation of expenses to GILTI may result in an increase of FTC limitations thereby increasing the overall tax burden of U.S. companies who were hoping to rely on high foreign tax rates to alleviate the effect of the GILTI tax.
The Guidance confirms that no general exemption from allocation of expenses to GILTI will be provided. The preamble to the Guidance notes that the TCJA did not provide for any changes to the rules setting forth how expenses are to be allocated to categories of foreign income and therefore there is no evident Congressional intent to prohibit expense allocation to GILTI. However, the Guidance did include proposed rules providing that research and development expenses do not have to be allocated against foreign income (including dividends, Subpart F income or GILTI). Consequently, U.S. companies with significant research and development expenses would not have their FTCs reduced because of such expenses. Note that the Guidance is chiefly concerned with allocation of income and ordering of credits due to the importance of income categorization in calculating a U.S. taxpayer’s foreign tax credits.
In addition to confirming the required allocation of non-research and development expenses to foreign income, the Guidance largely adopts the positions set forth in the Proposed Regulations. However, a few notable changes were included:
- The final regulations included in the Guidance disallow credits for the applicable percentage of foreign income taxes deemed paid under Section 960(b) with respect to distributions to the domestic corporation of Section 965(a) and 965(b) previously taxed earnings and profits. The regulations also provide a coordination rule with proposed regulation Section 1.960-3, which provides rules for Section 960(b). In essence, these ordering rules address claiming a foreign tax credit where the income was previously taxed under the GILTI or Subpart F regime.
- The requirement that, for purposes of the new basket for business profits of a U.S. person attributable to a foreign branch, a U.S. person determines branch income on an aggregate basis and not branch-by-branch. The final regulations included in the Guidance generally retain the Proposed Regulations rules governing foreign branches and determinations of income in the foreign branch category, including the limitation that such rules apply only for purposes of determining the category of income and not the source or character of such income.
- Disregarded payments other than interest are generally taken into account for foreign branch category income.
- Section 367(d) applies to impute payments for certain disregarded transfers of intangible property.
- Gain from the sale of an interest in a foreign branch is not attributable to that branch.
- The Look-Through Rule does not produce GILTI income. Under the final regulations included in the Guidance, GILTI income only includes amounts includible in gross income under Section 951A and therefore look-through cannot give rise to Section 951A category income.
- An election to re-allocate a portion of general FTC carryforwards to the foreign branch basket equal to the amount of FTCs that would have been allocated to the foreign branch basket if it had existed prior to 2018.
- Clarity on the foreign tax redetermination rules, which now require all foreign tax redeterminations to be taken into account in the year to which the redetermination relates. Under these rules, a foreign tax redetermination includes certain situations covered by Section 905(c) that do not involve a change in the foreign tax liability, such as the failure to pay accrued taxes within two years and the subsequent payment of any such accrued but unpaid taxes. A foreign tax redetermination also includes adjustments to tax method, refund on previously paid taxes, and taxes accrued for greater than a 24-month period.
- Clarity regarding expense allocations among assets that give rise to foreign derived intangible income (“FDII”) (a new category of income introduced under the TCJA). The final regulations included in the Guidance retain the Proposed Regulations rule that the portion of the Section 250 deduction attributable to FDII is allocated to the specific class of gross income included in its foreign-derived deduction-eligible income (“FDDEI”) and the deduction is apportioned between the statutory and residual groupings based on the FDDEI in each grouping. The result is that because FDDEI can consist of both U.S. source and foreign source income, the Section 250 deduction for FDII may reduce a taxpayer’s ability to claim foreign tax credits on its total income.
- A reduction in the number of categories of previously taxed earnings and profit from 16 to 10.
Practical Tax Effect
The practical tax effect of these changes is that U.S. corporate taxpayers have greater confidence in their ability to claim foreign tax credits for their GILTI income while understanding any FDII income will result in a deduction at the corporate level but not a foreign tax credit. Therefore, U.S. corporate taxpayers should weigh the benefits of both the GILTI and FDII regime and plan accordingly to maximize the benefits of both regimes. For example, a U.S. corporate parent may license its intellectual property or provide technical services from its U.S. intellectual property subsidiary in order to maximize the benefit of its FDII deduction while at the same time having actual foreign operations through an offshore company and use the FTC regime under GILTI to defer U.S. tax on its offshore company income. The Guidance allows taxpayers and practitioners to clearly understand the nuances of the new international tax regime with greater clarity for proper tax and deferral planning.