Editor: Annette B. Smith, CPA
Prior to the enactment of the 2017 tax reform legislation (P.L. 115-97, commonly known as the Tax Cuts and Jobs Act of 2017 (TCJA)), U.S. shareholders of a controlled foreign corporation (CFC) generally were subject to tax on foreign-derived income to the extent that the income was repatriated back to the United States through an actual or deemed dividend distribution or if the income was included in the shareholder's income under Subpart F and Sec. 951 in a manner similar to a deemed dividend distribution.
The TCJA made sweeping changes to the international tax provisions of the Internal Revenue Code to bring the United States closer to a territorial system of taxation. These changes include enactment of Sec. 951A, which created a new category of income known as global intangible low-taxed income (GILTI) and Sec. 59A, which created the base-erosion and anti-abuse tax (BEAT), a minimum tax for certain transactions deemed undertaken to erode the U.S. income tax base.
While both provisions targeted certain U.S. tax planning by multinational corporations to shift income to lower-tax jurisdictions, the actual effect also has been felt by U.S. corporations undertaking what otherwise were thought of as domestic transactions. Furthermore, the effects of both provisions on domestic transactions have been amplified by the release of proposed regulations under Secs. 951A and 59A.
This discussion focuses on the GILTI and BEAT implications for the benefit received by a U.S. corporation reporting a worthless stock deduction under Sec. 165(g) for a CFC's stock. To explore the overlap, and ultimate impact of GILTI and BEAT, this discussion considers the facts of Rev. Rul. 2003-125.
Worthless stock deduction in general
In general, under Sec. 165(a), a taxpayer can claim a deduction for any loss that is sustained during the tax year and not compensated for by insurance or otherwise. Sec. 165(b) provides that the amount of the loss is determined by reference to the property's adjusted basis as provided in Sec. 1011. The general rule in Sec. 165(a) is extended to losses resulting from a security that is a capital asset that becomes worthless during the tax year.
Specifically, under Sec. 165(g)(1), if a security that is a capital asset becomes worthless during the tax year, the resulting loss is treated as a loss from the sale or exchange of a capital asset on the last day of that tax year. The term "capital asset" is defined by exclusion in Sec. 1221(a). Stock held by a taxpayer is a capital asset unless in the hands of the taxpayer it is (1) "stock in trade"; (2) property of a kind that "would properly be included in . . . inventory . . . if on hand at the close of the taxable year"; or (3) "held . . . primarily for sale to customers in the ordinary course of [a] trade or business" (Sec. 1221(a)(1)).
However, a security (including a share of stock in a corporation) that meets the requirements of Sec. 165(g)(3) is not treated as a capital asset for purposes of applying Secs. 165(a) and (g)(1). Sec. 165(g)(3) effectively provides an exception to capital loss treatment by allowing a domestic corporation an ordinary loss deduction on the worthlessness of securities of affiliated corporations if (1) the taxpayer directly owns at least 80% of the total voting power of the stock of the corporation and 80% of the total value of the stock of the corporation, and (2) more than 90% of the aggregate of the corporation's gross receipts for all tax years is from sources other than royalties, rents, dividends, interest, annuities, and gains from sales of stocks and securities.
Rev. Rul. 2003-125
In Situation 2 of Rev. Rul. 2003-125, P, a domestic corporation and calendar-year taxpayer, owned 100% of the equity of FS, a foreign entity classified as a corporation for U.S. federal tax purposes. Since the date of its organization, FS derived all of its gross receipts from manufacturing operations. FS was indebted to P and certain trade creditors. The ruling notes that on Dec. 31, 2002, the stock of FS was not worthless for purposes of applying the rules under Sec. 165. On July 1, 2003, P made an entity classification election to change the classification of FS from a corporation to a disregarded entity for U.S. federal tax purposes. At the close of the day immediately before the effective date of the election, the fair market value (FMV) of FS's assets, including its intangible assets (such as goodwill and going-concern value), did not exceed the sum of its liabilities, making FS insolvent for U.S. federal income tax purposes.
The IRS held that at the close of the day immediately before the effective date of the entity classification election, the stock of FS was worthless under Sec. 165 because the FMV of FS's assets (including intangible assets such as goodwill and going concern value) did not exceed the amount of FS's liabilities. Therefore, P did not receive payment on its FS stock in the deemed liquidation of FS, so the liquidation of FS did not qualify as a tax-free liquidation under Sec. 332. Since the deemed liquidation was an identifiable event that fixed P's loss with respect to the FS stock, P was allowed a worthless stock loss deduction under Sec. 165(g)(3) on its U.S. federal income tax return for the tax year ending on Dec. 31, 2003. The amount of P's deduction was equal to P's basis in FS at the time of the deduction.
The IRS's holding in Rev. Rul. 2003-125 solidified the entity classification election as an effective tax planning tool for a U.S. CFC shareholder that wanted to claim a worthless stock deduction without taking on the administrative and non-U.S. tax burdens of legally liquidating the CFC.
Rev. Rul. 2003-125: GILTI as charged
The new GILTI regime significantly broadens the scope of U.S. taxation on foreign earnings by requiring a U.S. shareholder to include in gross income certain intangible income earned through a CFC. GILTI is calculated under Sec. 951A(b)(1) as the U.S. shareholder's pro rata share of "net CFC tested income" over its "net deemed tangible income return," which generally is equal to 10% of the aggregate of the U.S. shareholder's pro rata share of the qualified business asset investment over the amount of interest expense taken into account in determining the U.S. shareholder's net CFC tested income, to the extent the interest expense exceeds interest income for the year.
A significant component of the GILTI calculation is net CFC tested income, which is defined under Sec. 951A(c)(1) as the excess of the U.S. shareholder's pro rata share of each CFC's "tested income" over each CFC's "tested loss" with respect to the U.S. shareholder for the tax year of the U.S. shareholder. Sec. 951A(c)(2)(A) defines "tested income" with respect to any CFC for any tax year of the CFC as the excess of the gross income of the CFC over the deductions properly allocable to that gross income. Sec. 951A(c)(2)(B) defines a tested loss with respect to a CFC for any tax year of the CFC as the excess of the deductions utilized by the U.S. shareholder in calculating tested income of any CFC over the U.S. shareholder's pro rata share of the tested income of the CFC. The preamble to the proposed regulations under Sec. 951A states that tested income and tested loss are calculated by treating the CFC as a domestic corporation and applying the principles of gross income under Sec. 61.
In the case of a disposition of stock in a CFC by a domestic corporation, Prop. Regs. Sec. 1.951A-6(e) requires that the domestic corporation's adjusted basis in the stock of the CFC (specified stock) be reduced immediately before the disposition by the domestic corporation's net used tested loss amount with respect to the CFC (if any) attributable to the specified stock. If the reduction exceeds the adjusted tax basis in the specified stock immediately before the disposition, the excess is treated as gain from the sale or exchange of the stock in the tax year in which the disposition occurs.
For purposes of this basis adjustment rule, a disposition is defined under Prop. Regs. Sec. 1.951A-6(e)(6)(ii)(A) as any transfer of specified stock that is taxable, including a deemed sale or exchange by reason of the specified stock becoming worthless within the meaning of Sec. 165(g). The net used tested loss amount generally is any tested loss of the disposed CFC that has been used to offset tested income of any other CFC in determining the U.S. shareholder's net CFC tested income. Prop. Regs. Sec. 1.951A-6(e)(9), Example 1, highlights this rule:
Example: USP, a domestic corporation, owns 100% of the single class of stock of CFC1 and CFC2. In year 1, CFC2 has $90x of tested loss, and CFC1 has $100x of tested income. At the beginning of year 2, USP sells all of the stock of CFC2 to an unrelated buyer for cash. USP has no used tested loss amount or offset tested income amount with respect to CFC2 in years prior to year 1.
This example indicates that at the time of the disposition, USP has a net used tested loss amount of $90x with respect to CFC2 because the $90x tested loss was used to offset CFC1's tested income of $100x. Thus, immediately before the disposition of the CFC2 stock, the basis of the CFC2 stock is reduced by $90x.
If the facts of Rev. Rul. 2003-125 were similar to the example above and USP owned 100% of the stock of two CFCs, FS1 and FS2, USP would be required under Prop. Regs. Sec. 1.951A-6(e) to reduce its basis in FS1 by $90, the amount of the used tested loss that offset tested income of FS2. If USP's tax basis in the stock of FS1 was equal to $100, USP's worthless stock deduction prior to the enactment of Sec. 951A would be equal to $100, creating a tax benefit of $21 (assuming a consistent 21% federal tax rate). However, under Sec. 951A and Prop. Regs. Sec. 1.951A-6(e), the benefit decreases to $2.10 as a result of the reduction in basis in the shares of FS1. In light of the significant difference in results between the two scenarios, practitioners need to be mindful of these basis adjustments when seeking to obtain the benefit of a worthless stock loss for a client.
Worthless stock deductions: Are they BEAT?
Sec. 59A imposes on each applicable taxpayer a tax equal to the base-erosion minimum tax amount for the tax year when certain deductions and similar tax benefits are attributable to base-erosion payments made to certain foreign related parties (defined in Sec. 59A(g) to include any foreign 25% owner of the taxpayer and any foreign person related to the taxpayer within the meaning of Sec. 267(b), 482, or 707(b)(1)). In general, Sec. 59A(d) and Prop. Regs. Sec. 1.59A-3(b)(1) indicate that a base-erosion payment can include (1) any amount paid or accrued by the taxpayer to a foreign related party of the taxpayer for which a deduction is allowable; and (2) any amount paid or accrued by the taxpayer to a foreign related party in connection with the acquisition of depreciable or amortizable property by the taxpayer from that foreign related party. Prop. Regs. Sec. 1.59A-3(b)(2) further provides that an amount paid or accrued for this purpose can be in any form of consideration, including cash, property, stock, or the assumption of a liability.
The preamble to the proposed regulations also indicates that there may be other situations in which transactions with a foreign related party fit the definition of a base-erosion payment, including nonrecognition transactions described in Sec. 332, 351, or 368 and certain loss recognition transactions in which property is transferred at a loss to a foreign related party. One type of transaction that seems to have been excluded from the definition of a base-erosion payment is a Sec. 301 distribution, as the preamble notes that such distributions are one-sided transactions that do not involve a payment by a U.S. taxpayer to a foreign related party.
The IRS's analysis and holding in Rev. Rul. 2003-125 indicate that neither Sec. 331 nor Sec. 332 applies to an insolvent liquidation because P did not receive payment with respect to its stock in FS in the liquidation. With this ruling in mind, and applying the same rationale used by the IRS and Treasury in excluding Sec. 301 distributions from the definition of a base-erosion payment, it seems, arguably, that a Sec. 165(g) loss is a one-sided transaction, since the shareholder does not receive payment with respect to its stock in the liquidating distribution.
Compare this to a Sec. 331 liquidation in which the shareholder transfers its stock in the liquidation corporation to the corporation in exchange for the assets distributed in the liquidation. In this situation, it seems likely that the IRS could classify the surrender of stock as a base-erosion payment if the shareholder receives depreciable or amortizable assets in the distribution. Such a view appears consistent with the language in the preamble that indicates that stock transferred in a Sec. 332 liquidation could be classified as a base-erosion payment if the shareholder receives depreciable or amortizable property in the liquidating distribution.
Under the analysis suggested above, a Sec. 165(g) loss, by itself, might not be classified as a base-erosion payment. However, similar to the fact pattern in Rev. Rul. 2003-125, if the shareholder receives depreciable and amortizable assets of the liquidating CFC in satisfaction of intercompany indebtedness owed by the CFC, a base-erosion payment may be deemed to occur, as the satisfaction of indebtedness by a shareholder possibly could be viewed as an exchange of property by the shareholder for depreciable or amortizable assets.
Minding the GILTI and BEAT effects
As indicated above, both GILTI and BEAT can operate to reduce significantly the tax benefit received by a U.S. shareholder reporting a worthless stock deduction with respect to the stock of a CFC. Therefore, taxpayers engaging in worthless stock loss planning with respect to CFC shares need to be mindful of GILTI and BEAT when assessing the benefit resulting from a deduction under Sec. 165(g).
EditorNotes
Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.
For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.
Contributors are members of or associated with PricewaterhouseCoopers LLP.
