Final Regulations Applying the High-Tax Exclusion to Global Intangible Low-Taxed Income by Timothy Larson, CPA
Posted on September 17, 2020
The IRS recently issued final and proposed regulations relating to the treatment of “high-taxed” global intangible low-taxed income (GILTI), introduced in 2017 by the Tax Cuts and Jobs Act (TCJA). This latest guidance is welcome news to many U.S. investors, who may now make annual elections to exclude high-taxed GILTI from their gross income — both going forward and retroactively to 2018.
To ensure multinational businesses and their U.S. investors pay their fair share of U.S. taxes on foreign profits, the TCJA created GILTI as a new category of taxable foreign income generated by a controlled foreign corporation (CFC). The GILTI anti-deferral regime triggers U.S. tax on GILTI as it is earned rather than when it is repatriated or distributed to CFC shareholders in the United States.
U.S. shareholders with at least a 10 percent ownership interest in one or more CFCs must pay the tax on their pro rata share of the CFCs’ active income that exceeds an allowable 10 percent routine rate of return on depreciable tangible property. This includes, for example, foreign equipment and real estate.
The proposed and final regulations carve out an exception to the U.S. GILTI tax, however, for CFC income subject to a high rate of foreign tax.
While these new regulations aim to simplify the global tax landscape for U.S. persons, they contain a complex web of special rules, limitations and exclusions for which professional accountants and international tax advisors should be employed to model out and evaluate the impact of making GILTI high-tax exclusion (HTE) elections.
The GILTI Calculations
The calculation of a U.S. shareholder’s GILTI inclusion, or the aggregate amount of CFC income it must report and include as gross income on its U.S. tax returns, is performed as follows:
CFC’s net tested income – net deemed tangible income return = GILTI inclusion
The first step in determining a U.S. shareholder’s net tested is aggregating all its CFCs’ gross income, reduced by the following items:
- Effectively connected income (ECI);
- Subpart F income;
- Dividends from related parties;
- Foreign oil and gas extraction income; and
- High-tax exception income, including Subpart F income and GILTI subject to an effective foreign tax rate of 18.9 percent in 2020.
A further reduction is applied for a shareholder’s pro rata portion of the CFC’s tested loss, which is the excess of deductions over tested income.
To calculate the net deemed tangible income return, U.S. shareholders may deduct the deemed 10 percent return on their aggregate pro rata share of the CFC’s depreciable tangible property—also known as qualified business asset investments—minus certain specified interest expense.
The GILTI High-Tax Exclusion Election
The impact of the GILTI anti-deferral regime varies based on the structure of the U.S. shareholder.
For example, a U.S. C corporation is entitled to a Section 250 deduction of 50 percent of its GILTI inclusion amount as well as an indirect foreign tax credit against the U.S. tax on the GILTI inclusion equal to 80 percent of the foreign taxes paid by the CFCs that are attributable to their tested net income. This results in a 10.5 percent corporate U.S. tax on GILTI.
Prior to the final GILTI high-tax exclusion election regulations, noncorporate shareholders could level the playing field with their corporate counterparts through a Section 962 election. In doing so, individuals, partnerships, and trusts and estates could make an annual election to be treated as U.S. C corporations for purposes of the GILTI inclusions (and Subpart F income inclusions). This way, they could synthetically yield the same 10.5 percent U.S. tax on GILTI for the inclusion year.
With the recent introduction of the GILTI high-tax exclusion election, however, U.S. corporate and noncorporate shareholders can instead elect to exclude from their taxable income any CFC GILTI that is subject to an effective foreign tax rate of more than 18.9 percent, which is 90 percent of the U.S.’s highest current corporate tax rate of 21 percent. Consequently, noncorporate U.S. shareholders may no longer need to make Section 962 elections.
While the test of high-taxed income seems somewhat benign on its surface, the final regulations introduce the term “tested unit,” which U.S. shareholders must identify. That is, shareholders must identify high-taxed income items at the tested unit level, which includes the following:
- A CFC with no other tested units.
- A CFC’s interest in pass-through entities, including partnerships and disregarded entities, that may be tax residents of foreign countries or treated as corporations for the CFC’s home country foreign tax purposes.
- A CFC’s foreign branches or portions of foreign branches with activities carried out directly or indirectly by a CFC and either give rise to 1) a taxable presence in the country where the branch is located or 2) a taxable presence under the foreign tax laws of its owners. This would make it eligible for an income exclusion, exemption, or preferential tax rate for income attributable to the branch operations.
Once CFCs identify all the tested units, they must combine those that are tax residents of or located in the same foreign country, then determine items of gross income attributed to each tested unit. This determination is based on U.S. income tax principles (adjusting for any disregarded payments) and on separate books and records.
Subsequently, CFCs must allocate and apportion deductions and foreign income taxes paid or accrued to this combined tentative gross tested income to arrive at the tentative tested income items. From there, U.S. shareholders can determine the effective foreign tax rate (EFTR) of the tentative tested income. This is done by dividing the foreign income tax imposed by the amount of the tentative tested income item increased by the amount of foreign income tax. If the resulting EFTR exceeds 18.9 percent (or 90 percent of the U.S. corporate tax rate), shareholders may exclude it from tested income.
To Elect or Not to Elect
Deciding whether to make the GILTI high-tax exclusion election is not complicated by the determination of whether it is beneficial to a U.S. shareholder, but rather by the quantification of whether the CFC/tested units will qualify for the exclusion. Under the most recent IRS guidance, a GILTI high-tax exclusion election will likely be the norm, not the exception, in most situations. However, U.S. shareholders should keep in mind that the election is an all-or-nothing decision. Once an election is made, it applies to all CFCs within a CFC group.
Ultimately, the best way to determine the benefits of making the GILTI election can be found only in the details of prepared models and calculations that incorporate the complexities embedded in the final regulations.
While it appears that the final regulations can help U.S. shareholders reduce or even eliminate their GILTI tax liabilities this year and prospectively, the greater challenge for U.S. shareholders will be determining whether to make retroactive elections for 2018.
For example, a retroactive GILTI high-tax exclusion election may make sense for U.S. shareholders whose previous payments of GILTI tax (with perhaps a Section 962 election) would negate or limit the benefits of a net operating loss carryforward. Under these circumstances, U.S. shareholders should note that the deadline for making retroactive GILTI high-tax exclusion elections for the 2018 tax year is Apr. 15, 2021. Although this provides a reasonable amount of time to conduct proper analysis, practitioners should begin performing that analysis now.
Nothing comes easily in the global tax landscape. While the long-awaited release of the GILTI high-tax exclusion election final regulations confirms what many tax practitioners had expected, the path to qualifying for the election is more complicated than anticipated. In fact, it could require significant quantitative analyses for many U.S. shareholders.
About the Author: Timothy Larson, CPA, is a director of Tax Services with Berkowitz Pollack Brant CPAs and advisors, where he works with individuals, privately-owned businesses and multinational entities on a wide variety of cross-border tax issues. He can be reached at the firm’s New York office at (646) 213-7600 or via email at email@example.com.
This article will be published in a future edition of TaxStringer, an online publication of the New York State Society of CPAs (NYSSCPAs).