The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, created a new global minimum tax on certain foreign income of U.S. shareholders, commonly referred to as global intangible low-taxed income (GILTI). The intent of the provision is to discourage U.S. multinational corporations from shifting the income of foreign subsidiaries into jurisdictions with low tax rates, but the mechanical nature of the calculation means it can have broad and even unexpected results.
The tax is generally calculated by including in the income of a U.S. shareholder most income of a controlled foreign corporation (CFC) in excess of a "routine return" on its tangible fixed assets. The computation of the income inclusion is based on a number of "tested items" arising at the CFC level, including tested income or loss, qualified business asset investment (QBAI) (tax basis in tangible assets of the CFC), tested interest income, and tested interest expense. Many taxpayers understand less about the implications of these complex requirements than they think. This discussion focuses on the computation of tested income or loss and comments on the mechanics of the computation, clarifies common misconceptions, and uncovers snags that may catch unsuspecting practitioners who have little experience navigating the GILTI provision.
Under Sec. 951A(c)(2), the tested income or loss of a CFC is determined by starting with the gross income of a CFC and then excluding certain items. These exceptions from gross income include Subpart F income, effectively connected income, income excluded by the high-tax exception, dividends received from certain related parties, and several other items. Gross income is then reduced by subtracting deductions allocable under the rules of Sec. 954(b)(5). Expanded mechanics are provided in Prop. Regs. Sec. 1.951A-2(c)(2), which instructs that the rules of Regs. Sec. 1.952-2 are to be followed when determining income and allocable deductions for purposes of computing tested income or loss. This regulation prescribes that the gross income of a foreign corporation is to be determined by treating the foreign corporation as a domestic corporation taxable under Sec. 11 and by applying the principles of Sec. 61 and the regulations thereunder.
Guidance for the computation of taxable income is provided under Regs. Sec. 1.952-2(b), which states that it is determined by treating the foreign corporation as a domestic corporation under Sec. 11 and applying the principles of Sec. 63. The aforementioned computations of gross income and taxable income are subject to the special rules of Regs. Sec. 1.952-2(c). These special rules contain a list of subchapters of Chapter 1 of the Internal Revenue Code that should not be applied. Among those to not be applied are Subchapter F, Exempt Organizations, Subchapter L, Insurance Companies, and Subchapter N, Tax Based on Income From Sources Within or Without the United States. Regs. Sec. 1.952-2(c) also provides for the application of the principles of Regs. Sec. 1.964-1, including, but not limited to, the following items:
- The books of account to be used should be those regularly maintained by the corporation;
- The local books and records require adjustment to U.S. GAAP if the required adjustment would have a material effect;
- The tax accounting methods used should be consistent with the treatment of depreciation, inventories, and elections referred to in Regs. Secs. 1.964-1(c)(1)(ii), (iii), and (iv); and
- The net operating loss (NOL) deduction and the operations loss deduction are not permitted.
One of the most common misconceptions surrounding the computation of tested income or tested loss is that it is based on the calculation of the CFC's earnings and profits (E&P). By following the taxable income approach described above, complexities that previously arose infrequently may now do so regularly in determining a CFC's tested income or tested loss. Specifically, taxpayers were required to track the "permanent" adjustments for CFCs only when computing Subpart F income that now are required by the GILTI calculation. For example, consider the adjustment required for meals and entertainment expense. All CFCs will now be required to track these expenses for purposes of computing their tested income or loss. Additional analysis could be required for a number of other permanent adjustments, including for fines and penalties, leased luxury automobiles, and charitable contributions.
Although there are distinct differences between the computation of tested income of a CFC and its E&P, there will also be significant overlap. Adjustments such as those made for reserves and accruals will continue to be required to be tracked. Similarly, both tested income and E&P computations require depreciation expense to be determined using the alternative depreciation system (ADS) under Sec. 168(g). In the past, some taxpayers may have taken the position that the depreciation adjustment required when computing E&P was immaterial and therefore did not use ADS. This will no longer be an option, as the computation of QBAI requires the tax basis of the asset to be computed using ADS.
Another misconception is that the computation of tested income or tested loss is not required if it would not result in the payment of incremental U.S. tax. The computation of tested income or tested loss applies regardless of whether a CFC or its U.S. shareholders have historically incurred losses or if they expect no incremental U.S. tax liability as a result of the overall GILTI computation. As a result, these complex and burdensome computations may be required for taxpayers that may never pay incremental U.S. tax as a result of the provision.
Snags that may catch unsuspecting US taxpayers
A number of unfavorable results may arise as a result of the rules for computing tested income and tested loss. For example, Regs. Sec. 1.952-2 does not allow the NOL deduction under Sec. 172(a), so tested losses cannot be carried forward or backward to offset tested income. This may lead to undesirable results for taxpayers. If a foreign jurisdiction allows for the carryforward of losses, the taxpayer's local country taxable income may be significantly limited or be reduced to zero in the year when the carryforward is used. This would in turn limit foreign income tax liability, while a large balance of tested income includible to a U.S. shareholder could remain. As a result, the amount of foreign tax credit available to offset the GILTI inclusion may be limited, generating incremental income for unsuspecting U.S. taxpayers.
Other changes included in the TCJA could complicate the computation of tested income or loss. For example, consider the application of the interest expense limitation under Sec. 163(j), the anti-hybrid rules of Sec. 267A, and the interaction with the participation exemption system under Sec. 245A. Each provides its own unique challenge when applied to the context of a tested income or loss computation. These provisions were not addressed in the first batch of proposed regulations under Sec. 951A released Sept. 13, 2018. However, the IRS and Treasury did request comments.
Taxpayers and practitioners should also further consider the interaction between Regs. Secs. 1.952-2 and 1.964-1. As previously mentioned, Regs. Sec. 1.952-2(c)(2)(ii) prescribes the use of accounting principles described in Regs. Sec. 1.964-1(b) and states, "Thus, in applying accounting principles generally accepted in the United States . . . no adjustment need be made unless such adjustment will have a material effect, within the meaning of paragraph (a) of [Regs. Sec.] 1.964-1." However, Regs. Sec. 1.952-2(c)(2)(iv) does not explicitly mention "material effect" in determining tax accounting methods. It is unclear whether "thus" is meant to distinguish the application of materiality between the book and tax provisions, or if it is reinforcing an existing principle in Regs. Sec. 1.964-1 for the avoidance of doubt. Tax advisers should question whether the distinction was to account for the fact that permanent adjustments exist for tax purposes. If the intended application is for materiality to not apply to the determination of tax accounting methods, taxpayers may face an even greater burden than anticipated by many practitioners.
The computation of tested income or loss is a complex and time-consuming undertaking. U.S. shareholders of CFCs and international tax practitioners should begin planning for the increased compliance burden. They should give thought to whether the computations can be properly performed with the processes and information reporting currently in place.
Taxpayers and practitioners also should evaluate the interaction between Regs. Secs. 1.952-2 and 1.964-1. If there is no materiality threshold for determining necessary tax accounting methods, full taxable income computations could be required each year for every CFC, with no exception.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.