The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, signed into law on Dec. 22, 2017, was the most significant change to U.S. tax policy in 30 years. For multinationals, the changes to the international system of taxation were perhaps of most significance. The TCJA's headline achievement for multinationals was its new territorial tax system, which provides a 100% dividends-received deduction for certain qualifying dividends. While this provision represents a monumental shift in U.S. tax policy, the TCJA also contains safeguards to prevent abuse. One such safeguard is Sec. 951A, concerning global intangible low-taxed income (GILTI). Only after careful examination of GILTI can U.S. taxpayers assess whether the TCJA benefits or harms their foreign earnings.
GILTI: The basics
Sec. 951A requires a 10% U.S. shareholder of a controlled foreign corporation (CFC) to include in current income the shareholder's share of the CFC's GILTI. With the GILTI regime, Congress intended to discourage the erosion of the U.S. tax base by taxpayers' moving or keeping valuable intangible property and its related income outside the United States. The reach of GILTI, however, is not limited to earnings on intangible assets. In fact, the GILTI rules result in a U.S. tax on earnings that exceed a routine return (i.e., 10%) on foreign tangible assets. The new rules apply to all taxpayers who are U.S. shareholders in a CFC. The annual GILTI inclusion generally equals the aggregate net CFC "tested income" of the U.S. shareholder, reduced by the U.S. shareholder's net deemed tangible income return (NDTIR). Net CFC tested income generally includes a CFC's gross income, subject to certain exclusions, such as income effectively connected with a U.S. trade or business and Subpart F income, less allocable deductions. The NDTIR is a 10% return on the U.S. shareholder's pro rata share of the adjusted tax basis of tangible depreciable property of CFCs that earn tested income, reduced by allocable interest expense, to the extent that the expense reduced tested income.
Eligible C corporations that are U.S. shareholders may deduct 50% of any GILTI inclusion, reducing the effective rate on GILTI to 10.5%, before taking into account any eligible indirect foreign tax credit. For tax years after 2025, the deduction is reduced to 37.5%, resulting in an effective tax rate on GILTI of 13.125%. The GILTI deduction is subject to a limitation if the sum of GILTI and foreign-derived intangible income exceeds taxable income.
U.S. corporate shareholders may claim an indirect foreign tax credit under Sec. 960 for 80% of the foreign tax paid by the shareholders' CFCs that is allocable to GILTI income. The allocable amount of foreign taxes paid is calculated by multiplying an "inclusion percentage" by the foreign income taxes paid that are attributable to the GILTI inclusion. Available GILTI foreign tax credits have their own separate foreign tax credit "basket," which means they can be used only against GILTI and not other foreign income. Further, these foreign tax credits cannot be carried forward or back. However, because the calculation aggregates all foreign income taxes, foreign taxes paid by one CFC on GILTI may be used to offset GILTI earned by another CFC. Foreign taxes paid on income excluded from tested income, such as Subpart F income, cannot be used as a credit for taxes due on GILTI. Except as discussed below, a U.S. corporate shareholder likely has no U.S. residual tax on GILTI inclusions, provided the effective foreign rate of tax was at least 13.125%.
GILTI: A classic misdirection?
Congress passed the TCJA at a furious pace. While multinational businesses cheered the prospect of international tax reform, the impact of many provisions was not fully understood prior to enactment. The GILTI regime is no exception. GILTI has arguably made the U.S. system of taxation more worldwide than it was before Congress passed the TCJA. As a result, U.S. taxpayers must carefully structure and manage their international operations or risk being penalized.
Recently proposed foreign tax credit regulations (REG-105600-18) generally apply the existing framework of expense allocation rules under Sec. 861 and related regulations to determine taxable income in the Sec. 951A category (the GILTI basket) for foreign tax credit purposes. U.S. taxpayers may need to apportion interest, stewardship, research and experimentation, and general and administrative expenses to the GILTI basket. These allocated expenses may reduce the separate GILTI basket below the amount of the foreign base on which the CFC paid at least a 13.125% foreign effective tax rate. As a result, a U.S. shareholder may have foreign taxes deemed paid that exceed the pre-credit U.S. tax on GILTI. This foreign tax credit limitation results in "excess" foreign credits, i.e., credits that the taxpayer may not claim, to the extent they exceed the pre-credit U.S. tax on GILTI.
In some cases, the reverse will occur, and taxpayers will pay additional U.S. tax on their GILTI because the amount of foreign tax credits associated with a GILTI inclusion will not cover the full amount of U.S. tax. In this situation, the proposed regulations provide some relief by treating a portion of the taxpayer's CFC stock as an "exempt asset," which will generally have the effect of reducing expense apportionment to the GILTI basket and should increase the taxpayer's ability to claim foreign tax credits. Nonetheless, most taxpayers will likely pay some U.S. tax on their GILTI inclusions because of the rule that limits the foreign tax credit to 80% of the taxes associated with a GILTI inclusion. For taxpayers that are reinvesting foreign earnings offshore, this may represent a U.S. tax increase, compared with their pre-TCJA reporting position.
QBAI: The cliff effect
A U.S. shareholder's NDTIR for a tax year is 10% of its aggregate pro rata share of the qualified business asset investment (QBAI) of each of its CFCs, reduced by interest expense that was taken into account in reducing net CFC tested income, to the extent the corresponding interest income was not taken into account in increasing net CFC tested income. To the extent a U.S. shareholder's pro rata share of CFC net tested income exceeds NDTIR, there will be a GILTI inclusion. In essence, the U.S. shareholder is allowed a 10% rate of return on assets as exempt income before being subject to GILTI.
A 10%-rate-of-return concept is simple on the surface, but important nuances exist. For example, Sec. 951A(d)(2)(A) defines "specified tangible property" used to calculate QBAI as tangible property used in the production of tested income. However, CFCs with a tested loss are deemed to have zero QBAI. Consider a CFC with $10 million of QBAI and $1 of tested income. The U.S. shareholder would have $1 million of NDTIR exempt from GILTI. Alternatively, if the same CFC had $1 of tested loss, the U.S. shareholder would have $0 of NDTIR. Taxpayers should monitor the all-or-nothing QBAI "cliff" effect closely. In addition, taxpayers should be diligent about intercompany transfer pricing among their CFCs, as well as consider "check-the-box" planning on lower-tier CFCs to aggregate QBAI for U.S. tax purposes into one or more upper-tier CFCs.
Calling all intangibles
By their nature, intangibles are difficult to value, so Congress opted for a formulaic approach in drafting the GILTI rules, and perhaps big tech and pharma were top of mind. However, the wide net cast by GILTI affects every U.S. multinational, regardless of whether it has any intangibles abroad. U.S. companies with foreign subsidiaries performing basic functions — whether sales and marketing or acting as a low-risk distributor — generally earn a routine rate of return with proper transfer pricing. Subjecting this routine rate of return to GILTI arguably defeats the purpose of a territorial system.
The proposed GILTI regulations (REG-104390-18) confirmed that a CFC must compute its tested income or tested loss as if it were a domestic corporation. However, it is not clear whether, or how, a tested loss carryover can be used for GILTI purposes. Domestic corporations may generally carry over an NOL to subsequent years. Extending this treatment to CFCs and their U.S. shareholders is fair and equitable. Absent such treatment, if a U.S. shareholder of a CFC has a tested loss of $100 in year 1 and tested income of $100 in year 2, the U.S. shareholder receives no benefit from the year 1 loss. While the U.S. shareholder has not recognized a cumulative economic benefit, the shareholder may still have a GILTI inclusion and pay U.S. tax on the inclusion. Given the potential for lost tested losses, taxpayers should assess their transfer pricing and accounting methods for federal income tax purposes.
Coordinated global tax planning
Historically, U.S. multinationals' planning has focused on deferral, tax-efficient repatriation, and local country tax planning. GILTI places a greater emphasis on coordination of local country tax planning with U.S. tax planning. As previously noted, foreign tax credits in the GILTI basket cannot be carried forward or back. For example, consider CFC1, which engages in a tax planning strategy to accelerate certain deductions to year 1. This tax planning strategy results in a one-year temporary difference from a local country perspective that will be brought back into CFC1's taxable income in year 2. From a worldwide perspective, the following could occur:
- CFC1's temporary difference is not recognized for U.S. income tax purposes;
- CFC1 has lower taxable income in year 1 and pays less foreign tax;
- CFC1 has higher tested income and GILTI for U.S. income tax purposes than local country taxable income;
- The U.S. shareholder pays residual U.S. tax in year 1, as available foreign taxes (reduced because of the local country temporary difference) are not sufficient to offset U.S. tax;
- In year 2, CFC1's temporary difference reverses, resulting in more local country taxable income and foreign tax; and
- The U.S. shareholder in year 2 is in an excess foreign tax credit position.
Due to this timing difference and the inability to carry forward or carry back foreign tax credits, a higher cumulative U.S. tax may result than would be the case if CFC taxable income for U.S. and foreign purposes were more similar.
A time for reexamination
The GILTI rules present a significant change in the law that will require companies, tax directors, and advisers to reexamine their historic planning, global structures, and transfer pricing. Although the book on GILTI has not been fully written, the tax regime is unlikely to vanish anytime soon, and, therefore, taxpayers will need to adapt to this new age of global taxation.
Mo Bell-Jacobs, J.D., is a manager, Washington National Tax for RSM US LLP.
Contributors are members of or associated with RSM US LLP.