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Cruel and Unusual Punishment for the GILTI: Disappearing Basis

There was an unexpected — and unpleasant — surprise in the first tranche of GILTI1 guidance, in the form of proposed regulations, that Treasury made public in October 2018. Notably, a rule contained in those proposed regulations can result in the loss of a domestic corporate shareholder’s stock basis on disposition of a controlled foreign corporation (“CFC”). This can lead to recognition of non-economic gain without any corresponding benefit.

Here is how the rule works. Assume U.S. parent owns 100 percent of CFC1 with a basis of $100 in CFC1 stock and sells all of its CFC1 stock for $110. But it turns out that in prior years $50 of tested losses2 of CFC1 were used to offset tested income of other CFCs owned by U.S. parent. Under Prop. Reg. 1.951A-6(e), U.S. parent does not realize only $10 gain on the disposition of the CFC1 stock (defined as “specified stock” in the regulations). That provision requires a reduction of the adjusted basis of the specified stock immediately before the disposition by the domestic corporation’s “net used tested loss” amount with respect to the CFC attributable to the specified stock. Where the net used tested loss is greater than the available basis, the excess is treated as gain from the sale or exchange of stock. That occurs in this example because the net used tested loss amount is defined to reflect the aggregate amount of prior tested losses of the CFC that were applied against tested income of other CFCs, reduced by the aggregate amounts of tested income of the CFC that were offset by tested losses of other CFCs. Here, U.S. parent’s stock basis in CFC1 is reduced by $50 immediately before the sale so U.S. parent has a $60 gain on the sale rather than a $10 gain. Moreover, that gain is subject to tax at the corporate tax rate of 21%.

The intent of the rule, according to the preamble, is to ensure that taxpayers benefit from tested losses applied against tested income solely through reduction of their GILTI inclusion and to prevent a double benefit from a corresponding increase in a loss or a reduction in gain with respect to the disposition of stock.

However, for most taxpayers, the loss of the stock basis is a greater detriment than the benefit received from reducing tested income with tested loss. For example, consider the case of a domestic corporate shareholder. The GILTI inclusion is accompanied by a 50 percent deduction under section 250 that reduces the maximum effective U.S. tax rate on the income to 10.5 percent. Thus, in the example above, assume that CFC1’s $50 of tested losses were applied against CFC2’s tested income of $50 to reduce U.S. parent’s GILTI inclusion by $50. GILTI arising from CFC2’s tested income generally would have been subject to an effective U.S. tax rate of no more than 10.5 percent and, accordingly, the reduction of tested income by the CFC1 tested loss provides a limited tax benefit compared to the reduction of stock basis and increase in gain taxable at a 21 percent rate. Further, for CFCs with depreciable tangible assets, some portion of the tested income would not be treated as GILTI in any event; therefore, any reduction of tested income that does not exceed the depreciable tangible income return provides no tax benefit to the U.S. shareholder. Thus, the loss of stock basis (which reduces capital gains taxed at 21 percent) is a greater loss of benefit than the benefit received from the reduction of GILTI income in just about every instance.

The example can be tweaked to illustrate how the proposed rule can be particularly harsh in its application to domestic corporations owning CFCs with high-taxed GILTI because they may have received no U.S. tax benefit from the use of the tested loss against tested income. Assume that CFC2’s tested income had been taxed in the foreign jurisdiction at a rate of 13.125% or higher. If the U.S. shareholder had not reduced CFC2’s tested income via the use of the tested loss, such additional CFC2 tested income might not have resulted in any incremental U.S. tax liability because of the availability of foreign tax credits arising from the GILTI inclusion.3 Thus, the U.S. shareholder obtained no reduction in its tax liability and no tax benefit via the reduction of CFC2’s tested income by the amount of CFC1’s tested loss. By contrast, the reduction of stock basis in CFC1 might have a real U.S. tax consequence by increasing the amount of income taxed at a 21 percent tax rate (or in other cases reducing a stock loss that could have reduced capital gains taxed at 21 percent).

If the consequences above were not bad enough, these consequences may arise even when the U.S. corporate taxpayer is not disposing of any stock because the rules can apply to the stock of a lower-tier CFC with a used tested loss that is being disposed of indirectly by an upper-tier CFC. This is the case because, to the extent that there is insufficient basis in the affected stock to cover the full basis reduction amount, the U.S. shareholder and upper-tier CFCs may recognize gain to the extent of the shortfall.

It is expected that there will be a number of public comments on the proposed regulations and it may be the case that Treasury modifies the rule prior to finalizing the regulation. For example, the American Bar Association recently submitted a comment letter recommending removal of the stock basis adjustment rule and, if it were not removed, recommending that the computation of the basis reduction be adjusted to reflect the actual tax benefit obtained by the U.S. shareholder from application of tested losses against tested income.

We may not know for some time what adjustments, if any, Treasury will make to the proposed rule upon its finalization. Accordingly, domestic corporations with CFCs should take this potential basis reduction into account in designing or revising their offshore structure and in considering the consequences of dispositions of their CFCs.

For more information, please contact Vinson & Elkins lawyers George Gerachis, Natan Leyva, Jason McIntosh, or any member of our International Tax practice.

1 “GILTI” refers to global intangible low-taxed income and the provisions addressing the treatment of such income in section 951A and section 250.

2 “Tested income” and “tested loss” are the categories of income and loss that are taken into account in computing a U.S. shareholder’s section 951A inclusion.

3 Subject to the section 904 limitation, section 960(d) would provide foreign tax credits equal to 80% of the foreign taxes imposed on the tested income, such that foreign taxes imposed at a 13.125% effective tax rate would generally offset U.S. tax imposed on GILTI at a 10.5% rate (i.e., 80% of 13.125% equals 10.5%).

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.