The Tax Cuts and Jobs Act, passed at the end of 2017, made significant changes to the structure of the Internal Revenue Code for both individual taxpayers and companies throughout the United States. Among other things the Act focused on forcing the repatriation or deemed repatriation of foreign income back to the US, so it could be taxed. To that end, the Act added section 956 and section 951A to the Internal Revenue Code. The latter section created the global intangible low-taxed income (GILTI) tax structure to reduce the incentive to us intellectual property to shift corporate profits out of the United States.
The GILTI structure under Section 951A requires US shareholders of any controlled foreign corporation (CFC) to recognize as part of gross income the shareholder’s pro rata share of GILTI. To determine the GILTI inclusion amount, a US shareholder must calculate certain items, such as net tested income, net tested loss, and the pro rata share of qualified business asset investment (QBAI). These values are aggregated for taxpayers with interest in multiple CFCs to identify a single GILTI amount.
To make sense of this new tax regime, in October of 2018 the Treasury Department and the Internal Revenue Service issued proposed regulations (REG-104390-18) describing the application of Section 951A and how shareholders of CFCs should recognize GILTI.
After reviewing written comments on the proposed regulations, the Treasury and the Service issued final regulations (TD 9866) on June 14th with a significant change to the GILTI tax structure for domestic US partnerships. Additionally, and concurrently, Treasury and the IRS released proposed regulations to the GILTI and Subpart F regime related to domestic partnership ownership treatment, and “high taxed” income exception election.
Under October’s proposed regulations the Treasury took an entity-aggregate, or “hybrid,” approach to attributing ownership of CFCs to domestic partnerships. Under the hybrid approach a partnership could be treated as a foreign entity that calculated and distributed GILTI to partners that are not US shareholders or as an aggregate for its partners if those partners are US shareholders.
Between October 2018 and June 2019 a number of concerns were raised with this hybrid approach. From a computation standpoint the hybrid approach created an overly complex framework that would require taxpayers to determine whether and to what extent they were US shareholders of CFCs and how to calculate GILTI. The Treasury, in turn, feared that this could lead to an administrative headache in assessing and collecting tax on GILTI.
In response to these concerns the final regulations adopted a pure aggregate approach. Under this framework domestic partnerships are not treated as owning the stock of CFCs. Instead, a partnership’s ownership interest in a CFC is attributed to its partners based proportionally on their interest in the domestic partnership. Because the domestic partnership no longer owns the CFC’s stock per the meaning of Section 958(a), the domestic partnership does not have a GILTI inclusion amount to distribute to its partners.
The consequences of this change are potentially significant for the partners of domestic partnerships. Under the hybrid approach if a domestic partnership owned 10% or more of a CFC, the partnership would pass GILTI through to its partners. However, under the revised aggregate approach any shareholder owning less than 10% interest in the CFC following an attribution of interest from the partnership would not be a United States shareholder under Section 951(b) and thus would not have a GILTI inclusion.
This aggregate approach should not cause the GILTI income inclusion burden to shift since those partners and shareholders who meet the 10% voting or value threshold would have had to include their distributive share of GILTI under either approach. The end beneficiaries of the aggregation approach are those shareholders with less than 10% interest in the CFC.
Another key aspect of the GILTI final regulations is the “high-tax” exception. Treasury and the IRS have rejected the many comments received to expand the scope of the GILTI high-tax exclusion, and retained the narrow exclusion as set out in the proposed regulations from October. Thus, under the final GILTI regulations, to be eligible for this exception, taxpayer’s income must fall within the Section 954(a) definition of foreign base company income (“FBCI”) or insurance income under section 953.
However, the Proposed Regulations introduced an expanded high-tax election pursuant to which taxpayers who invest in non-U.S. corporations through U.S. partnerships can exclude income in a CFC if it is subject to a tax rate greater than 90 percent of the U.S. statutory tax rate. The preamble to the GILTI proposed regulations cites to legislative history to support the decision for including such an election. One important key point is that the proposed regulations are intended to be prospective and applicable ONLY after the regulations are adopted. Thus, they are not beneficial to taxpayers at this time.