Three Taxpayer-Friendly Developments in the New GILTI Regulations
V&E Tax Update, August 29, 2019
On June 14, 2019, Treasury released final and proposed regulations implementing the Global Intangible Low Tax Income (GILTI) regime. These follow the Treasury’s initial stab at GILTI regulatory guidance published on October 10, 2018.
Here are three taxpayer-favorable takeaways from the new regulations:1
- Partners of a domestic partnership that owns 10% or more of the stock in a controlled foreign corporation (CFC), but who themselves own less than a 10% indirect interest in the CFC, will no longer be subject to GILTI tax as a consequence of holding their interest in the CFC through a U.S. partnership;
- A new “high-tax” exception to GILTI tax eliminates an incentive for U.S. shareholders of CFCs to restructure active foreign income as passive “subpart F” income to benefit from the high-tax exception in the subpart F regime; and
- Treasury put the brakes on a provision that would have reduced a U.S. shareholder’s basis on disposition of CFC stock by the amount of certain previously recognized losses, even if there were no corresponding economic benefit to the shareholder.
As part of the Tax Cuts and Jobs Act, Congress developed the Global Intangible Low Tax Income (GILTI) regime in an effort to disincentivize U.S. taxpayers from migrating intangible property, and the income it produces, to low-tax foreign jurisdictions. GILTI is a new category of foreign-derived income that generally taxes at the U.S. shareholder level earnings in excess of a 10% annual return on certain invested foreign assets. Rather than calculating the income derived from the intangible assets of a CFC,2 the GILTI regime takes into account income in excess of a 10% rate of return on a CFC’s tax basis in depreciable tangible property and imposes a tax on that excess. Accordingly, the GILTI tax can reach income from high-return activities, whether attributable to intangible assets or not. Generally, corporate U.S. shareholders receive a 50% deduction on their GILTI income (reducing their effective tax rate on GILTI to 10.5% from 21%)3 and credits for foreign tax imposed on GILTI. Individuals, however, are taxed at the full individual rate on their GILTI.
While the GILTI tax was enacted with the understandable goal of keeping IP assets in the United States, layering the new tax on top of an already complicated international taxation regime has proven tricky. Fortunately, Treasury has listened to taxpayer concerns on some of these issues. Three provisions in particular in the newly promulgated regulations are favorable to taxpayers.
1. Fewer U.S. Shareholders Subject to GILTI Under New Look-Through Rule
The GILTI tax applies to a CFC’s “U.S. shareholders,” defined as a “U.S. person” that owns at least 10% (directly or indirectly) of the vote or value of the CFC. The definition of U.S. person includes U.S. citizens, residents, partnerships, and corporations, and certain estates and trusts.
Under the prior proposed regulations, the IRS swept into the GILTI regime partners who themselves indirectly own less than 10% of the CFC’s equity, but whose domestic partnerships hold 10% or more, by computing the GILTI inclusion at the partnership level and then allocating such income to the U.S. partner. These partners would have been subject to GILTI tax to the extent of their economic interest in the CFC, notwithstanding that if they held their interest in the CFC directly, they would not have been subject to GILTI.
Under the new finalized regulations, the IRS will “look-through” the domestic partnership to the individual partner and determine whether such partner is subject to GILTI based on his or her indirect interest in the CFC. This is a taxpayer-favorable development for multinational private equity funds and joint ventures operating through domestic partnerships. The previous proposed regulations sent taxpayers scrambling to figure out how to restructure as foreign partnerships (to which a look-through approach applies under existing law) so that their partners who own less than 10% of a CFC would not be subject to GILTI. The final regulations generally make such restructuring unnecessary.
2. New High-Tax Exception for GILTI
The GILTI regulations provide a new “high-tax” exception, eliminating an incentive for U.S. shareholders of CFCs to restructure their foreign activities to take advantage of the existing high-tax exception under the subpart F regime.4
When enacted as part of the Tax Cuts and Jobs Act, the GILTI regime provided an exception for income that qualifies as high-tax income under subpart F. Subpart F is an anti-deferral regime that requires U.S. shareholders of CFCs to include in their gross income their pro rata share of certain types of a CFC’s passive and related party income. Existing law provides an exception to the subpart F inclusion for income subject to a high rate of foreign tax (90% of the highest U.S. corporate tax rate).
Prior to the release of the proposed regulations, it appeared that, while the GILTI regime excluded income that met the subpart F high-tax exception, it did not exclude high-taxed income that would not have otherwise been subpart F income. This led to the odd result that, for example, high-taxed passive CFC income, such as interest or other investment income, received more favorable treatment than high-taxed active income from active offshore business activities of a CFC. The absence of a GILTI high-tax income exception created a perverse incentive for taxpayers to restructure operations and transactions to convert non-subpart F income to subpart F income, so as to qualify for the existing high-tax exception under subpart F and avoid both subpart F and GILTI treatment of such income.
The proposed regulations, however, provide a separate high-tax exception for GILTI. The GILTI high-tax exception generally applies to foreign earnings that are taxed at an effective rate equal to at least 90% of the then-current U.S. corporate tax rate (currently, this equates to a foreign tax rate of 18.9%). Under the proposed regulations, the determination of whether income meets the high-tax exception is made by breaking out the income into certain specified categories within each “qualified business unit” of the CFC. A CFC may have more than one qualified business unit if it has operations in multiple countries.
The GILTI high-tax exception is a favorable development for taxpayers, and will frequently eliminate the need for complex tax planning to benefit from the subpart F high-tax exception. However, it applies only to tax years beginning after the proposed regulations are finalized, which means that in 2019, calendar-year taxpayers will not be able to claim it unless there is a change to the effective date rule in the final regulations.
3. Stock Basis Reduction Rule Reconsidered
In a previous article, we pointed out that the proposed regulations released in October 2018 required a tax basis reduction on the disposition of an interest in a CFC by a U.S. shareholder, which could lead to the recognition of taxable gain without any corresponding economic benefit. In short, the proposed regulations required a basis reduction for certain losses used by U.S. shareholders to reduce their GILTI inclusions. However, in certain situations the amount of the basis reduction and resulting increase in taxable gain could outweigh the economic benefit of the GILTI reduction.
A number of comment letters, including one submitted by the American Bar Association’s Section of Taxation (of which V&E’s Natan Leyva participated in the drafting), pointed out this issue and recommended removal or amendment of the stock basis adjustment rule to limit basis adjustments so as not to exceed the actual tax benefits obtained by U.S. shareholders from the use of losses to reduce GILTI. In the final regulations just promulgated, Treasury reserved on this rule, indicating that it would be addressed in a future regulatory project and any future rule would apply prospectively. We see this as a taxpayer-favorable development, as it indicates that Treasury took criticism of the rule seriously and is taking further time to consider modifications of the proposed rule.
For more information, please contact Vinson & Elkins lawyers Natan Leyva, Curt Wimberly, or any member of our International Tax practice.
1 There are many complexities and nuances presented in the new final and proposed regulations that are beyond the scope of this high-level summary. It is important that all U.S. shareholders of foreign corporations consult with their tax advisors on the potential impact of the new GILTI inclusion rules.
2 A foreign corporation is a CFC when 10 percent U.S. shareholders own more than 50 percent of the corporation’s stock by vote or value.
3 That deduction decreases to 37.5% in 2026 (increasing the effective tax rate to 13.125%).
4 Most of the key provisions of the subpart F regime are contained in sections 951 to 964 of the Internal Revenue Code of 1986, as amended.