GILTI regime guidance answers many questions

The Treasury Department and the IRS in September issued proposed regulations¹ under the new global intangible low-taxed income (GILTI) regime. The highly anticipated regulations package also proposes amendments and additions to the Subpart F income and consolidated return regulations.

The proposed regulations:

• Describe the manner of calculating the fundamental elements underlying the GILTI inclusion (e.g., “tested income” and “qualified business asset investment” (QBAI));
• Revise the definition of “pro rata share” for purposes of inclusions of both GILTI and Subpart F income;
• Set out anti-abuse rules in respect of certain basis step-up transactions for purposes of the GILTI regime;
• Adopt a hybrid aggregate/entity approach to U.S. partnerships and their partners for purposes of the GILTI regime; and
• Generally require a consolidated group to compute its GILTI inclusion as a group rather than member by member.

This article provides background information on the GILTI regime, including the relevant statutory provisions, and a detailed discussion of the proposed regulations. It also covers notable implications of the proposed regulations.

Background

The GILTI regime was enacted as part of the law commonly known as the Tax Cuts and Jobs Act² (TCJA), which added new Secs. 250 and 951A to the Internal Revenue Code and revised Sec. 960.

Sec. 951A requires a U.S. shareholder of any controlled foreign corporation (CFC) to include the U.S. shareholder’s GILTI for each tax year — computed based on the CFC’s attributes — currently in gross income. The GILTI inclusion is similar in certain respects to an inclusion of Subpart F income under Sec. 951.

Sec. 250 generally permits a corporate U.S. shareholder a deduction equal to 50% of its GILTI inclusion (resulting in an effective U.S. federal income tax rate of 10.5%). Sec. 960 treats a corporate U.S. shareholder as paying itself a portion of the non-U.S. income taxes paid by its CFCs — and therefore allows the U.S. shareholder to take those taxes as a credit against its GILTI tax liability under Sec. 901 (subject to certain other limitations).

The proposed regulations do not address Secs. 250 and 960; forthcoming regulations will do so. The proposed regulations also do not address many of the questions left open under the statute regarding the interplay between the GILTI rules and other Code sections, although some of these questions are raised in the preamble. Treasury notes that taxpayers have raised questions on the application of the dividends-received deduction under Sec. 245A, the anti-hybrid rules of Sec. 267A, and the interest limitation in Sec. 163(j) to the calculation of tested income and tested loss. Rather than resolve these questions in the proposed regulations, Treasury has noted that these items will be addressed in future guidance.

Treasury notes in the preamble that it anticipates issuing proposed regulations assigning the Sec. 78 gross-up attributable to the foreign taxes deemed paid to the GILTI foreign tax credit basket. However, Treasury does not indicate that future guidance will address other foreign tax credit-related issues. For example, the preamble does not indicate whether the lookthrough rule in Sec. 904(d) will apply to GILTI. Neither the preamble nor the proposed regulations address whether withholding taxes on GILTI previously taxed income (PTI) distributions will be included in the GILTI basket and subject to the 20% “haircut” in Sec. 960(d). The proposed regulations and preamble are also silent on the treatment of taxes that are “properly attributable” to tested income and are paid in a year other than the year in which the tested income is included in the U.S. shareholder’s GILTI inclusion amount.

Comments submitted before issuance of the proposed regulations asked Treasury to adopt rules to allow for the carryover of a tested loss, similar to the existing rules for net operating loss carry­overs that apply for determining the taxable income of a U.S. corporation. The proposed regulations, however, do not adopt such a rule to allow for the carryover of a tested loss.

Consistent with the definition of tested income under Sec. 951A(c)(2), the proposed regulations exclude from tested income any Subpart F income of a CFC that is excluded from foreign base company income or insurance income solely by reason of the high-tax exception. Accordingly, the proposed regulations do not exclude (or permit an exclusion) from tested income any non-Subpart F income that is subject to a high amount of tax.

Sec. 951A

As described in greater detail in the next section, the proposed regulations modify some of the provisions of Sec. 951A.

Under Sec. 951A and the proposed regulations, a U.S. shareholder’s GILTI inclusion amount for a tax year equals the excess (if any) of the U.S. shareholder’s “net CFC tested income” over its “net deemed tangible income return.” Thus formulated, GILTI represents an amount deemed to be “excessive” as compared with a specified return.

A person is treated as a U.S. shareholder of a CFC only if that person owns (directly or indirectly) stock in the CFC on the last day in the tax year of the foreign corporation on which the foreign corporation is a CFC. A foreign corporation is treated as a CFC for any tax year if the foreign corporation was a CFC at any time during that tax year.

Net CFC tested income

A U.S. shareholder’s net CFC tested income for a tax year equals the excess (if any) of: (1) the U.S. shareholder’s aggregate pro rata share of the tested income of each of its CFCs for the tax year over (2) the U.S. shareholder’s aggregate pro rata share of the tested loss of each of its CFCs for the tax year.³ (For purposes of Sec. 951A, a U.S. shareholder’s pro rata share of a relevant item of a CFC is determined under Sec. 951(a)(2) in the same manner as that section applies to Subpart F income, taken into account in the tax year of the U.S. shareholder (the “U.S. shareholder inclusion year” under the proposed regulations) within or with which the tax year of the CFC (the “CFC inclusion year” under the proposed regulations) ends.)

By definition, a CFC in a CFC inclusion year can have tested income or a tested loss, but not both. A CFC has tested income for a CFC inclusion year to the extent that: (1) the CFC’s gross income for the tax year (“gross tested income” under the proposed regulations), excluding items of gross income in certain categories (“excluded gross income”), exceeds (2) the deductions (including taxes) properly allocable (under rules similar to those of Sec. 954(b)(5)) to the gross tested income (“allowable deductions” under the proposed regulations).⁴ A CFC with tested income in a CFC inclusion year is a “tested income CFC” for that year under the proposed regulations. A CFC has a tested loss for a tax year to the extent that its allowable deductions exceed its gross tested income.⁵ A CFC with a tested loss in a CFC inclusion year is a “tested loss CFC” for that year under the proposed regulations.

The categories of excluded gross income (ignored in calculating the tested income or loss of a CFC for a CFC inclusion year) are:

• U.S.-source items of income that are effectively connected with the CFC’s conduct of a trade or business within the United States, provided that the rate of U.S. federal income tax to which the item is subject is not reduced by treaty;
• Gross income taken into account in determining the Subpart F income of the CFC;
• Gross income excluded from foreign base company income or insurance income (within the meaning of Secs. 954 and 953, respectively) under the so-called high-tax exception of Sec. 954(b)(4);
• Dividends received from related persons (within the meaning of Sec. 954(d)(3)); and
• “Foreign oil and gas extraction income” (within the meaning of Sec. 907(c)(1)).⁶

Sec. 951A also provides a coordination rule that is intended to deny a double benefit resulting from tested losses. Under that coordination rule, a tested loss CFC increases its earnings and profits (E&P) by the amount of its tested loss for purposes of applying the Subpart F current-year E&P limitation in Sec. 952(c)(1)(A) (the “tested loss add-back”).⁷ There is no indication that tested loss must offset tested income to be subject to this rule.

Net deemed tangible income return

A U.S. shareholder’s “net deemed tangible income return” for a U.S. shareholder inclusion year equals the excess of: (1) 10% of the U.S. shareholder’s aggregate pro rata share of the QBAI of each of its CFCs (for the CFC’s inclusion year ending with or within the U.S. shareholder inclusion year) over (2) the amount of interest expense of each of the U.S. shareholder’s CFCs that constitutes an allowable deduction in the U.S. shareholder inclusion year, to the extent that the interest income attributable to the expense is not taken into account in determining the U.S. shareholder’s net CFC tested income.⁸ The proposed regulations generally refer to the amount in item (2) as “specified interest expense.”

QBAI

A CFC’s QBAI for a tax year means the average of its aggregate adjusted bases (for U.S. federal income tax purposes, as measured as of the close of each quarter of the tax year) in specified tangible property used by the CFC in a trade or business and for which a deduction is allowable under Sec. 167.⁹ “Specified tangible property” generally means any tangible property used in the production of tested income.¹⁰ Tangible property used by a CFC in the production of tested income and income that is not tested income is treated as specified tangible property in the same proportion as the tested income produced with respect to the property bears to the total gross income produced with respect to the property. The adjusted basis in any property is determined by using the alternative depreciation system (ADS) under Sec. 168(g) and by allocating the depreciation deduction ratably to each day during the period in the tax year to which the depreciation relates.¹¹

If a CFC holds an interest in a partnership at the close of a CFC inclusion year, the CFC includes as part of QBAI its distributive share of the partnership’s adjusted basis in tangible property held by the partnership to the extent the property:

• Is used in a trade or business of the partnership;
• Is of a type for which a deduction is allowed under Sec. 167 (depreciation); or
• Is used in the production of tested income.¹²

A CFC’s distributive share of the adjusted basis of any property of a partnership is the CFC’s distributive share of income with respect to such property.

Sec. 951A(d)(4) directs Treasury to issue regulations or other guidance as it determines appropriate “to prevent the avoidance of the purposes of” Sec. 951A(d) (defining QBAI), including regulations or other guidance providing for the treatment of property if: (1) the property is transferred, or held, temporarily, or (2) the avoidance of the purposes of Sec. 951A(d)(4) is a factor in the transfer or holding of the property (the QBAI anti-abuse direction of Sec. 951A(d)(4)).

Treatment as Subpart F income for certain purposes

A GILTI inclusion amount will be treated in the same manner as Subpart F income for purposes of certain enumerated sections, including Secs. 959, 961, 1248(b)(1), and 1248(d)(1).¹³ For the purposes of the enumerated sections, if an amount from a CFC is taken into account in determining a U.S. shareholder’s GILTI, then the portion of the GILTI treated as being with respect to that CFC is:

• For a CFC with no tested income, zero; or
• For a tested income CFC, the portion of the GILTI bearing the same ratio to the GILTI as the U.S. shareholder’s pro rata amount of the CFC’s tested income bears to the aggregate of the shareholder’s share of the tested income of each CFC.¹⁴

Effective date for Sec. 951A

Under the TCJA, Sec. 951A is effective for tax years of foreign corporations beginning after Dec. 31, 2017, and for tax years of U.S. shareholders with or within which those tax years of the foreign corporations end.

Conference Report disregard rule

In connection with the enactment of the TCJA, the House of Representatives passed a bill, and the Senate passed an amended version.¹⁵ A Committee of Conference convened to resolve the differences between the two bills. In so doing, the committee released a “Joint Explanatory Statement” that was incorporated into the Conference Report.¹⁶ In the statement, in describing the intended operation of Sec. 951A and under the subheading of “Regulatory authority to address abuse,” the committee stated:

The conferees intend that non-economic transactions intended to affect tax attributes of CFCs and their U.S. shareholders (including amounts of tested income and tested loss, tested foreign income taxes, net deemed tangible income return, and QBAI) to minimize tax under [Sec. 951A] be disregarded. For example, the conferees expect the [Treasury Department] to prescribe regulations to address transactions that occur after the measurement date of post-1986 earnings and profits under amended [Sec.] 965, but before the first [tax] year for which new [Sec.] 951A applies, if such transactions are undertaken to increase a CFC’s QBAI.¹⁷

Hereinafter, this is referred to as the “Conference Report disregard rule.” Other than the QBAI anti-abuse direction of Sec. 951A(d)(4) — which appears limited to QBAI — Sec. 951A itself contains no provision authorizing or directing Treasury to effect the Conference Report disregard rule.

Details of the proposed regulations

The following discussion describes the proposed regulations, with a particular focus on the provisions that deviate from the statute.

Prop. Regs. Sec. 1.951A-1: General provisions

Prop. Regs. Sec. 1.951A-1 provides general rules regarding a U.S. shareholder’s GILTI inclusion amount; ensuing sections include specific rules as to the calculation of tested income, tested loss, QBAI, tested interest expense, and tested interest income (each a CFC tested item). This section describes three important rules in Prop. Regs. Sec. 1.951A-1: (1) the relevant date for pro rata share determination; (2) the calculation of a U.S. shareholder’s pro rata share of CFC tested items; and (3) the definition of specified interest expense.

Relevant date for pro rata share determination: Prop. Regs. Sec. 1.951A-1 also introduces and defines other terms, including:

• “CFC inclusion date,” meaning the last day of a CFC inclusion year on which a foreign corporation is a CFC;¹⁸ and
• “Sec. 958(a) stock,” meaning stock of a CFC directly or indirectly owned by a U.S. shareholder within the meaning of Sec. 958(a).¹⁹

Unlike the statute, which calculates tested income and tested loss based on the tax year of the CFC that ends with or within the U.S. shareholder’s year, the proposed regulations require inclusion based on the CFC inclusion date, irrespective of the CFC’s year end.

Pro rata share rules: Consistent with the statute, the proposed regulations provide rules to determine a U.S. shareholder’s pro rata share of each CFC tested item, based on the pro rata share rules of Sec. 951(a) and the regulations thereunder (including amendments under new Prop. Regs. Sec. 1.951-1; the “Sec. 951(a)(2) rules”). Prop. Regs. Sec. 1.951A-1, however, modifies the application of the Sec. 951(a)(2) rules to CFC tested items in certain important respects. In general, a U.S. shareholder’s pro rata share of each CFC tested item is generally independent of its pro rata share of any other CFC tested item. The amount of a U.S. shareholder’s pro rata share of any CFC tested item is translated into U.S. dollars using the average exchange rate for the CFC inclusion year.²⁰

Prop. Regs. Sec. 1.951–1(e): Current Regs. Sec. 1.951-1(e) specifies that a U.S. shareholder’s pro rata share of Subpart F income of a CFC for a particular CFC tax year is determined consistently with a hypothetical distribution of the CFC’s E&P in that year (current-year E&P) in which all shares of stock of the CFC participate. For a CFC with multiple classes of stock (including preferred stock), special rules — largely mechanical — apply to calculate the extent to which each class participates. Prop. Regs. Sec. 1.951-1(e) retains the hypothetical-distribution rule. It replaces the special mechanical rules, however, with a facts-and-circumstances test and a “principal purpose” anti-abuse rule.

Further, Prop. Regs. Sec. 1.951-1(e) changes the total amount deemed distributed in the hypothetical distribution. Prop. Regs. Sec. 1.951-1(e) determines not only a U.S. shareholder’s pro rata share of a CFC’s Subpart F income but also its pro rata share of the CFC’s tested income and loss. Tested income and loss are taxable income concepts that, unlike Subpart F income, are not limited by current-year E&P. In view of this fact, to permit the hypothetical-distribution rule to operate simultaneously and consistently with respect to Subpart F income (on the one hand) and tested income and loss (on the other), Prop. Regs. Sec. 1.951-1(e) specifies that the amount of the hypothetical distribution is the greater of: (1) the CFC’s current-year E&P (determined under Sec. 964) and (2) the sum of the Subpart F income (increased by reason of any tested loss add-back) and the CFC’s tested income for the year.²¹

Tested income: Generally, a U.S. shareholder’s pro rata share of tested income from a tested income CFC is determined in the same manner as its pro rata share of Subpart F income under the Sec. 951(a)(2) rules. However, tested loss that has been allocated to any class of stock in a prior CFC inclusion year generally is first allocated to each such class to the extent of the prior tested loss allocations.

QBAI: A U.S. shareholder’s pro rata share of QBAI of a tested income CFC for a CFC inclusion year generally bears the same ratio to the CFC’s total QBAI for that year as the U.S. shareholder’s pro rata share of tested income of the CFC bears to the total tested income of the CFC for that year. However, a special rule applies in case of “excess QBAI,” namely, the amount by which a CFC’s QBAI in a particular CFC inclusion year exceeds 10 times the amount of the CFC’s tested income in that year. Excess QBAI is allocated pursuant to a special rule solely to the CFC’s common stock.²²

Tested loss: A U.S. shareholder’s pro rata share of tested loss of a tested loss CFC is generally determined by treating the amount of the tested loss as the current-year E&P of the CFC under the Sec. 951(a)(2) rules and applying the hypothetical-distribution rule such that only the common stock of the CFC participates. Preferred stock can be allocated a portion of a tested loss, however, to the extent (in general) that the tested loss has reduced the CFC’s E&P below the amount necessary to satisfy any accrued but unpaid dividends with respect to the preferred stock.

In addition, common stock with a liquidation value (determined as of the beginning of the CFC inclusion year) of zero does not participate in the hypothetical distribution if there is at least one other class of equity with a liquidation preference relative to the common stock. In such instances the next most junior class of stock participates to the extent of its (positive) liquidation value, then the next most junior class, and so on.²³

Tested interest expense and tested interest income: A U.S. shareholder’s pro rata share of a CFC’s tested interest expense is the amount by which the tested interest expense reduces (as an allowable deduction) the U.S. shareholder’s pro rata share of tested income (or increases the U.S. shareholder’s pro rata share of tested loss, or both). A U.S. shareholder’s pro rata share of tested interest income is the amount by which the CFC’s tested interest income increases (as an item included in gross tested income) the U.S. shareholder’s pro rata share of tested income (or reduces the U.S. shareholder’s pro rata share of tested loss, or both).²⁴

Specified interest expense: The proposed regulations adopt a netting approach for purposes of determining the net deemed tangible income return. Specifically, under this approach, the net deemed tangible return is the U.S. shareholder’s deemed tangible return (10% of QBAI) less specified interest expense. “Specified interest expense” means the excess (if any) of the aggregate of the U.S. shareholder’s pro rata share of tested interest expense of each CFC over the aggregate of the U.S. shareholder’s pro rata share of the tested interest income of each CFC. Prop. Regs. Sec. 1.951A-4 defines a CFC’s tested interest expense and tested interest income (each discussed below) for purposes of determining a U.S. shareholder’s specified interest expense.²⁵

Prop. Regs. Sec. 1.951A-2: Tested income and tested loss

For purposes of computing tested income and tested loss, gross income and allowable deductions of a CFC are determined under the rules of Regs. Sec. 1.952-2. The proposed regulations provide that allowable deductions are allocated and apportioned to gross tested income under the same Sec. 954(b)(5) principles that apply in allocating and apportioning deductions for purposes of Subpart F. The proposed regulations further provide that gross tested income is treated as a single separate category and a single item of gross income.²⁶

Exclusions from gross tested income under the high–tax exception: Consistent with the statute, the proposed regulations provide that gross tested income does not include items of CFC gross income excluded from foreign base company income and insurance income by reason of electing the high-tax exception of Sec. 954(b)(4). The proposed regulations, along with the associated preamble, clarify that such exclusion from gross tested income applies only to income that is excluded from Subpart F solely by reason of an election to exclude the income under the high-tax exception. Accordingly, the exclusion from gross tested income would not apply to any income that would not otherwise be Subpart F income or is excluded from Subpart F income due to exceptions other than the high-tax exception (e.g., Sec. 954(c)(6) lookthrough).²⁷

Nonapplication of the Sec. 952(c) E&P limitation in computing tested income and tested loss: Consistent with the statute, the proposed regulations provide that gross tested income excludes gross income taken into account in determining a CFC’s Subpart F income. In determining the amount of gross income taken into account in determining Subpart F income, the proposed regulations disregard Sec. 952(c), which limits Subpart F income to a CFC’s current E&P. As a result, Subpart F income is not limited to current E&P for purposes of determining the Subpart F gross income excluded from gross tested income. This also means that tested gross income can give rise to both Subpart F income and gross tested income in the year the Subpart F income reduction is recaptured under Sec. 952(c)(2).

Anti–abuse rule: The proposed regulations include an anti-abuse rule that disregards certain deductions or losses for purposes of determining tested income and tested loss of a CFC. In general, a deduction or loss is disallowed to the extent that it is attributable to basis in specified property resulting from certain transfers from Jan. 1, 2018, through the close of the transferor CFC’s last tax year that is not a CFC inclusion year (the “gap period,” which exists only as to a transferor CFC with a fiscal tax year). Specified property is a type of property for which a deduction is allowable under Sec. 167 (i.e., depreciation) or Sec. 197 (i.e., amortization). That is, the anti-abuse rule is not limited to property eligible to constitute QBAI. An exception applies to basis resulting from an otherwise covered transfer, to the extent (in general) that the transfer results in gain that is subject to U.S. federal income taxation.²⁸

Prop. Regs. Sec. 1.951A-3: QBAI

Prop. Regs. Sec. 1.951A-3 restates the codified definition of QBAI as the average of a tested income CFC’s aggregate adjusted bases in specified tangible property that is used in the CFC’s trade or business and is a type for which a deduction is allowed under Sec. 167. “Specified tangible property” generally means tangible property used in the production of gross tested income. The proposed regulations explicitly provide that a tested loss CFC has no QBAI and that none of the tangible property of a tested loss CFC is specified tangible property for purposes of Sec. 951A.²⁹

Specified tangible property of a tested income CFC includes the adjusted basis of dual-use property, based on the same proportion that the gross tested income bears to the total gross income produced (the dual-use ratio). “Dual-use property” is property that produces gross tested income and gross income that is not gross tested income — for example, Subpart F income. When an item of specified tangible property produces directly identifiable income (e.g., a machine packaging a specific product), the dual-use ratio is calculated using that specified tangible property’s gross tested income and total gross income. When the specified tangible property does not produce directly identifiable income (e.g., an office building), the dual-use ratio is the CFC’s total gross tested income compared with its total gross income.

Sec. 951A(d)(3) provides that the adjusted basis in any property, for purposes of Sec. 951A, should be determined using the ADS under Sec. 168(g) and by allocating the depreciation deduction ratably to each day during the period in the tax year to which the depreciation relates. The proposed regulations clarify that ADS should be applied to all property for purposes of Sec. 951A, even if that property was placed into service before Dec. 22, 2017. The rule applies as if ADS had been used from the date the property was placed in service.³⁰

The proposed regulations provide special rules for short tax years. When a tested income CFC has a CFC inclusion year of less than 12 months, the CFC’s QBAI is the sum of the aggregate adjusted bases in its specified tangible property at the close of each full quarter divided by four (quarters in a year), plus the aggregate adjusted bases in the specified tangible property at the close of each short quarter multiplied by the sum of the number of days in each short quarter divided by 365 (days in a year).

A tested income CFC that holds a partnership interest at the end of the CFC’s inclusion year should increase its QBAI by its share of the partnership’s adjusted basis in the partnership specified tangible property (partnership QBAI). The CFC’s share is calculated using the partnership QBAI ratio, which, like the dual-use ratio described earlier, varies based on whether the partnership specified tangible property produces directly identifiable gross income or gross income is not directly identifiable. The proposed regulations define “partnership specified tangible property” consistent with the definition in Sec. 951A(d)(3). The partnership QBAI is determined using the average of the partnership’s adjusted basis as of the close of each quarter. The partnership’s adjusted basis in specified tangible property and the portion taken into account in determining a tested income CFC’s partnership QBAI is determined by applying the principles applicable to tested income CFCs described previously.³¹

Anti–abuse rules: Consistent with the QBAI anti-abuse direction of Sec. 951A(d)(4), Prop. Regs. Sec. 1.951A-3 includes two distinct anti-abuse rules. Each rule disregards certain basis amounts in specified tangible property for purposes of computing a tested income CFC’s QBAI. First, under Prop. Regs. Sec. 1.951A-3(h)(1), the disregarded basis amount is the entire basis in specified tangible property of a tested income CFC if the tested income CFC acquires the property with a principal purpose of reducing a U.S. shareholder’s GILTI inclusion and the property is held temporarily (but over at least the close of one quarter). For this purpose, specified tangible property held for less than 12 months generally is treated as temporarily held and acquired with the relevant principal purpose.

Second, under Prop. Regs. Sec. 1.951A-3(h)(2), the disregarded basis amount is generally basis resulting from “gap period” transfers. This second rule is very similar to the anti-abuse rule in Prop. Regs. Sec. 1.951A-2(c)(5) (discussed previously), although Prop. Regs. Sec. 1.951A-3(h)(2) applies only to property eligible to constitute QBAI. A similar exception applies to basis attributable to gain that is subject to U.S. federal income taxation.

Prop. Regs. Sec. 1.951A-4: Tested interest expense and tested interest income

Prop. Regs. Sec. 1.951A-4 defines a CFC’s tested interest expense and tested interest income for purposes of determining a U.S. shareholder’s specified interest expense. Tested interest expense means interest expense paid or accrued by a CFC that is taken into account to determine the tested income or tested loss of that CFC, reduced by the CFC’s qualified interest expense. Tested interest income means interest income included in the CFC’s gross tested income, reduced by the CFC’s qualified interest income.

The proposed regulations broadly define interest expense and interest income. Interest expense means any expense or loss treated as interest expense under the Code or its regulations, and any other expense or loss incurred to secure the use of funds when the time value of money is the predominant consideration. Interest income means any income or gain treated as interest income under the Code or its regulations, and any other income or gain recognized to secure the forbearance of funds when the time value of money is the predominant consideration.

The proposed regulations also provide special rules (qualified interest expense and qualified interest income) for U.S. shareholders that own one or more CFCs engaged in the active conduct of a financing or insurance business. Under the special rules, certain interest expense and certain interest income related to a CFC’s active financing or insurance business is excluded from that CFC’s tested interest expense and tested interest income, respectively.

Example 1: USS, a domestic corporation, wholly owns CFC1, CFC2, and CFC3. USS, CFC1, CFC2, and CFC3 all use the calendar year as their tax year. CFC1, CFC2, and CFC3 have CFC tested items for their respective 2018 CFC inclusion years as shown in the table “CFC Tested Items From Example 1” below. USS’s net CFC tested income is $250x ($100x + $200x – $50x). USS’s deemed tangible income return is $15x (10% of QBAI from tested income CFCs, or 10% of $150x). USS’s specified interest expense is ($5x) (tested interest expense of $20x less tested interest income of $15x). USS’s net deemed tangible return is $10x ($15x deemed tangible return less $5x specified interest expense). Therefore, USS’s GILTI inclusion amount is $240x ($250x net tested income less $10x net deemed tangible return).

Prop. Regs. Sec. 1.951A-5: Domestic partnerships and their partners

A domestic partnership is a U.S. person under Sec. 7701(a)(4) and is therefore a U.S. shareholder under the statute. However, the statute does not provide rules for the treatment of domestic partnerships that are U.S. shareholders of CFCs.

Prop. Regs. Sec. 1.951A-5 adopts a hybrid approach (i.e., neither a pure entity approach nor a pure aggregate approach) for a domestic partnership that is a U.S. shareholder of one or more CFCs (a “U.S. shareholder partnership”). Specifically, the regulations provide different rules for partners of the U.S. shareholder partnership that are also U.S. shareholders (as defined in Sec. 951(b)) of a CFC owned by the partnership and partners that are not U.S. shareholders with respect to the CFC.

Under the hybrid approach, a U.S. shareholder partnership determines its GILTI inclusion amount under the general rules but, generally, only for purposes of determining the distributive share of that amount of a partner who is not a U.S. shareholder partner. When the partner is a U.S. shareholder partner with respect to a CFC, the partner takes into account its pro rata share of the CFC tested items. The partner’s pro rata share is determined based on its Sec. 958(a) indirect ownership of the CFC, treating the domestic partnership as a foreign partnership. The same rules apply to tiered domestic partnerships.

A partner may be a U.S. shareholder partner with respect to one partnership CFC of a U.S. shareholder partner but not others. When this is the case, the U.S. shareholder partner’s distributive share of the GILTI inclusion amount is determined without regard to tested items of partnerships with respect to which the partner is a U.S. shareholder partner.

The following example and analysis, based on Prop. Regs. Sec. 1.951A-5(g), Example (3), illustrates the application of Prop. Regs. Sec. 1.951A-5 to a U.S. shareholder partnership with one U.S. shareholder partner and one non-U.S. shareholder partner.

Example 2: X Corp and Y Corp are domestic corporations that own 40% and 60%, respectively, of PRS, a domestic partnership. PRS owns 20% of the single class of stock of FC1 and 10% of the single class of stock of FC2. In addition, Y Corp owns 100% of the single class of stock of FC3. FC1, FC2, and FC3 are CFCs. X Corp, Y Corp, PRS, FC1, FC2, and FC3 all use the calendar year as their tax year. In year 1, FC1 has $100x of tested income, FC2 has $80x of tested income, and FC3 has $10x of tested loss.

Partnership–level calculation: PRS is a U.S. shareholder partnership with respect to each of FC1 and FC2. As a result, PRS determines its GILTI inclusion amount for year 1. PRS’s pro rata share of FC1′s tested income is $20x ($100x × 0.20) and of FC2′s tested income is $8x ($80x × 0.10). PRS’s net CFC tested income is $28x ($20x + $8x). PRS has no net deemed tangible income return. PRS’s GILTI inclusion amount for 2018 is $28x.

Partner–level calculation:

1. X Corp is not a U.S. shareholder partner with respect to either FC1 or FC2 because X Corp owns (directly or indirectly) less than 10% of each of FC1 (40% × 20% = 8%) and FC2 (40% × 10% = 4%). Accordingly, X Corp includes in income its distributive share, or $11.20x ($28x × 0.40), of PRS’s GILTI inclusion amount in year 1.
2. Y Corp is a U.S. shareholder of FC3. Y Corp is also a U.S. shareholder partner with respect to FC1 because it indirectly owns at least 10% (60% × 20% = 12%) of the stock of FC1 but not with respect to FC2, because Y Corp indirectly owns less than 10% of the stock of FC2 (60% × 10% = 6%). Accordingly, Y Corp is treated as owning the stock of FC1 proportionally as if PRS were a foreign partnership. Thus, Y Corp’s pro rata share of FC1′s tested income is $12x ($20x × 0.60). Y Corp’s pro rata share of FC3′s tested loss is $10x ($10x × 1). Accordingly, Y Corp’s net CFC tested income is $2x ($12x – $10x), and Y Corp has no net deemed tangible income return. Y Corp’s GILTI inclusion amount for year 1 is $2x. In addition, Y Corp’s distributive share of PRS’s GILTI inclusion amount is determined without regard to PRS’s pro rata share of any item of FC1. PRS’s GILTI inclusion amount computed solely with respect to FC2 is $8x ($80x × 0.10). Y Corp’s distributive share of PRS’s GILTI inclusion amount is $4.80x ($8x × 0.60) in year 1.

The proposed regulations require a U.S. shareholder partnership to provide each partner its distributive share of the partnership’s GILTI inclusion amount (if any) and, with respect to a U.S. shareholder partner, the partner’s proportional share of each of the CFC tested items of each CFC owned by the partnership. The information is required to be provided on or with the partner’s Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., for each U.S. shareholder inclusion year of the partnership.

Prop. Regs. Sec. 1.951A-6: Treatment of GILTI inclusion amount and adjustments to E&P and basis related to tested loss CFCs

Prop. Regs. Sec. 1.951A-6 restates the statutory provision that GILTI is treated as Subpart F income for certain specified Code provisions such as Secs. 959 and 961. Additionally, the proposed regulations provide that a GILTI inclusion amount is treated in the same manner as an amount included under Sec. 951(a)(1)(A) for purposes of applying Sec. 1411 (tax on net investment income).³² For purposes of these rules, the proposed regulations use the statutory formula to allocate the GILTI inclusion amount back to individual CFCs, with tested income taken into account in determining a U.S. shareholder’s GILTI inclusion amount. The portion of the GILTI inclusion amount allocated to a tested income CFC is translated into the functional currency of the tested income CFC using the average exchange rate for the CFC inclusion year of the tested income CFC.³³

Sec. 267(a)(3)(B) generally puts a CFC on the cash method of accounting for purposes of accruing a deduction with respect to an item payable to a related CFC. Deductions are generally allowed before actual payment to the extent that the payment is includible in a U.S. shareholder’s gross income. Sec. 163(e)(3)(B)(i) provides a similar rule for original issue discount on a debt instrument held by a related CFC. The proposed regulations allow a deduction under Secs. 163(e)(3)(B)(i) and 267(a)(3)(B) for an item taken into account in determining the net CFC tested income of a U.S. shareholder. Thus, to the extent that the payment is taken into account as tested income of the recipient CFC, the deduction can generally be accrued before actual payment. There is a special rule for a U.S. shareholder that is a domestic partnership.³⁴

Consistent with the statute, the proposed regulations provide for an increase of the E&P of a tested loss CFC equal to the amount of that CFC’s tested loss when computing the Subpart F Sec. 952(c)(1)(A) E&P limitation amount of the tested loss CFC.³⁵ Importantly, no exception limits the tested loss CFC’s E&P increase to when the tested loss is “used” to offset tested income of a related CFC.

Basis adjustments for the use of tested losses

The proposed regulations provide a complex set of rules intended to prevent corporate U.S. shareholders from receiving a double benefit for a single tested loss that would result if a domestic corporation benefiting from the tested losses of a tested loss CFC could also benefit from those losses upon a direct or indirect taxable disposition of the tested loss CFC. The rules apply to a domestic corporation (other than a regulated investment company or a real estate investment trust) that is a U.S. shareholder of a CFC that has a “net used tested loss amount.” Specifically, a U.S. shareholder must reduce the adjusted basis of the stock immediately before the disposition by the amount of the domestic corporation’s net used tested loss amount with respect to the CFC that is attributable to such stock. Notably, if the basis reduction exceeds the adjusted basis in the stock immediately before the disposition, the excess amount is treated as gain from the sale of the stock and recognized in the year of the disposition.³⁶

The term “net used tested loss amount” means, with respect to a domestic corporation and a CFC, the excess (if any) of: (1) the aggregate of the domestic corporation’s “used tested loss amount” with respect to the CFC for each U.S. shareholder inclusion year, over (2) the aggregate of the domestic corporation’s “offset tested income amount” with respect to the CFC for each U.S. shareholder inclusion year.³⁷ The amount of the used tested loss amount and the offset tested income amount vary depending on whether the domestic corporation has net CFC tested income for the U.S. shareholder inclusion year.

Example 3: CFC1 has a $100 tested loss in one year that offsets $100 of tested income from CFC2 for purposes of determining a U.S. shareholder’s net CFC tested income for that year. In the next year, CFC1 has $20 of tested income that is offset by a $20 tested loss from CFC2. In that case, the $100 used tested loss attributable to the CFC1 stock from the first year is reduced by the $20 of CFC1′s tested income from the second year that was offset by the tested loss of CFC2, resulting in a net used tested loss amount of $80.

The proposed regulations provide guidance for tracking and calculating the net used tested loss amount of separate CFCs when those CFCs are held through a chain of CFCs. In certain cases, a disposition of an upper-tier CFC may require downward basis adjustments with respect to multiple CFCs that are held directly or indirectly by the upper-tier CFC. Further, the proposed regulations provide guidance with respect to tracking and calculating the net used tested loss amount with respect to a U.S. shareholder attributable to stock of a CFC when the CFC’s stock is transferred in a nonrecognition transaction or when the relevant CFC is a party to a Sec. 381 transaction.

Applicability date for regulations

Generally, the proposed regulations, when finalized as final regulations, will apply to tax years of foreign corporations beginning after Dec. 31, 2017, and to tax years of U.S. shareholders in which or with which such tax years of the foreign corporations end.

Implications

Many of the rules provided by the proposed regulations merely implement the statute or clarify ambiguities and are thus neither surprising nor unanticipated. For example, the calculation of the GILTI inclusion amount in the proposed regulations is consistent with the statute, other than the clarification that members of a consolidated group calculate the GILTI inclusion amount on a consolidated basis. The proposed regulations require additional calculations to arrive at the consolidated GILTI inclusion. Nevertheless, some groups may welcome the changes to the consolidated return regulations, which will prevent “stranded” tested losses and QBAI. The new rules for U.S. shareholder partnerships and their partners also provide needed clarification.

The proposed regulations require, for purposes of calculating a CFC’s tested income, a U.S. shareholder to compute the CFC’s taxable income as if it were a domestic corporation. While not unexpected, this represents a significant change for many U.S. shareholders, which have focused solely on their CFCs’ E&P for purposes of calculating the Subpart F income.

The proposed regulations include a number of important anti-abuse provisions. In particular, the proposed regulations implement the QBAI anti-abuse direction of Sec. 951A(d)(4) with two new anti-abuse provisions. Beyond that direction, but consistent with the Conference Report disregard rule, the proposed regulations also include a broader anti-abuse rule to deny certain deductions (e.g., amortization) for purposes of calculating tested income and tested loss. Companies with fiscal-year CFCs that have implemented, or are considering implementing, restructuring transactions should carefully consider how the anti-abuse rules apply to those transactions.

Many of the provisions in the proposed regulations add substantially to the compliance obligations of U.S. shareholders of CFCs. For example, complying with the basis adjustment rules for a disposition of a CFC with historic used tested losses will create significant new complexities for U.S. shareholders in tracking attributes across their ownership period.

In some respects, the proposed regulations are notable for what they do not address (e.g., deemed paid taxes in connection with the GILTI inclusion amount). Accordingly, the consequences of many of the provisions in the proposed regulations cannot yet be fully appreciated.  

Footnotes

¹REG-104390-18; see also IRS News Release IR-2018-186.

²P.L. 115-97.

³Sec. 951A(c)(1).

⁴Sec. 951A(c)(2)(A).

⁵Sec. 951A(c)(2)(B)(i).

⁶Sec. 951A(c)(2)(A)(i).

⁷Sec. 951A(c)(2)(B)(ii).

⁸Sec. 951A(b)(2).

⁹Sec. 951A(d)(1).

¹⁰Sec. 951A(d)(2)(A).

¹¹Sec. 951A(d)(3) (the first of two different, identically numbered paragraphs).

¹²Sec. 951A(d)(3) (the second of two different, identically numbered paragraphs).

¹³Sec. 951A(f)(1)(A). The Treasury Department is directed to provide rules treating a GILTI inclusion amount as Subpart F income for other provisions of the Internal Revenue Code in which the determination of Subpart F income must be made at the CFC level.

¹⁴Sec. 951A(f)(2).

¹⁵H.R. 1 first passed the House on Nov. 16, 2017, and the Senate on Dec. 2, 2017.

¹⁶H.R. Conf. Rep’t 115-466, Conference Report to Accompany H.R. 1, 115th Cong., 1st Sess. (Dec. 15, 2017).

¹⁷Id. at 645.

¹⁸Prop. Regs. Sec. 1.951A-1(e)(1).

¹⁹Prop. Regs. Sec. 1.951A-1(e)(3).

²⁰Prop. Regs. Sec. 1.951A-1(d)(1).

²¹Prop. Regs. Sec. 1.951-1(e)(1).

²²Prop. Regs. Sec. 1.951A-1(d)(3).

²³Prop. Regs. Sec. 1.951A-1(d)(4).

²⁴Prop. Regs. Secs. 1.951A-1(d)(5) and (6).

²⁵Prop. Regs. Sec. 1.951A-1(c)(3)(iii).

²⁶Prop. Regs. Sec. 1.951A-2(c)(3).

²⁷Prop. Regs. Sec. 1.951A-2(c)(1).

²⁸Prop. Regs. Sec. 1.951A-2(c)(5).

²⁹Prop. Regs. Sec. 1.951A-3(b).

³⁰Prop. Regs. Sec. 1.951A-3(e)(3).

³¹Prop. Regs. Sec. 1.951A-3(g)(2).

³²Prop. Regs. Sec. 1.951A-6(b)(1).

³³Prop. Regs. Sec. 1.951A-6(b)(2).

³⁴Prop. Regs. Sec. 1.951A-6(c).

³⁵Prop. Regs. Sec. 1.951A-6(d).

³⁶Prop. Regs. Sec. 1.951A-6(e)(1).

³⁷Prop. Regs. Sec. 1.951A-6(e)(2).