Editor: Mary Van Leuven, J.D., LL.M.
The Subpart F high-tax exception in Sec. 954(b)(4) was significantly affected by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Even though it was not directly revised, other TCJA changes affect application of the high-tax exception, as well as its function within the new international tax system. The high-tax exception is one of the few post-TCJA elements of a territorial tax system because it may provide domestic corporations with a way to avoid U.S. tax on a controlled foreign corporation's (CFC's) foreign earnings.
Following the TCJA's enactment, a U.S.-parented multinational group (U.S. group) generally can repatriate the untaxed foreign earnings of its CFCs on a tax-free basis through the 100% dividends-received deduction in newly enacted Sec. 245A. Nevertheless, as a practical matter, this shift toward a territorial tax system often is only minimally present because the majority of a CFC's distributed earnings will not be untaxed but rather will have been previously subject to U.S. tax by operation of the Subpart F rules or the newly enacted global intangible low-taxed income (GILTI) rules.
Currently, U.S. groups are allowed a deduction of up to 50% of their GILTI inclusion, which results in a reduced 10.5% U.S. effective tax rate when the full GILTI deduction is allowed. Further, U.S. groups are allowed deemed paid foreign tax credits to offset the U.S. tax imposed on GILTI inclusions. Importantly, the deemed paid foreign tax credits for GILTI inclusions must be used in the current year; unlike foreign tax credits associated with Subpart F inclusions, any excess foreign tax credits associated with GILTI inclusions cannot be carried backward or forward. As a result, U.S. groups will lose the benefit of any foreign taxes associated with GILTI inclusions that cannot be claimed in a current year. Depending in part on the U.S. group's foreign tax credit position (and subject to a number of factors beyond the scope of this discussion), the GILTI rules may not necessarily be more favorable than the Subpart F rules, even though the U.S. group is allowed a deduction for its GILTI inclusions (and not for its Subpart F inclusions).
In general, the GILTI rules impose current U.S. tax on U.S. groups based on their CFC's income that is not otherwise included in Subpart F income, subject to a few exceptions. One exception excludes from a CFC's income for GILTI purposes an amount excluded from the CFC's Subpart F income under the high-tax exception. Thus, when this exception is applied, the U.S. group would not be subject to current tax under either the Subpart F or GILTI rules, and the CFC could have untaxed earnings that may be eligible for the Sec. 245A deduction when distributed to the U.S. group. Naturally, many U.S. groups are considering the high-tax exception's impact on their structures because it is one of the few paths to territoriality following the TCJA's enactment. In light of the importance of the high-tax exception, this item provides an overview of the high-tax exception mechanics along with a discussion of how the TCJA affects its application.
The controlling U.S. shareholder of a CFC may elect to apply the high-tax exception to exclude an item of foreign base company income (foreign personal holding company income (FPHCI), foreign base company sales income, or foreign base company services income) or insurance income received by its CFC from Subpart F income when the relevant net item of income is subject to tax in a foreign country at an effective rate of greater than 90% of the maximum U.S. corporate tax rate. The mechanics are seemingly simple in concept:
- Calculate a CFC's net item of foreign base company income or insurance income;
- Determine the foreign taxes paid by the CFC on each net item of income;
- Calculate the effective tax rate on each item of income;
- Compare the effective tax rate on each item of income to 90% of the maximum U.S. corporate tax rate; and
- Timely elect to apply the high-tax exception to the relevant item of income.
Nevertheless, as discussed below, the operation of the high-tax exception can become very complex in practice — especially post-TCJA.
While the statutory language to the high-tax exception was unchanged by the TCJA, other amendments affect the determination of whether an item of income meets the high-tax exception. First, the TCJA reduced the top U.S. corporate tax rate from 35% to 21%. As a result, an item of income will meet the high-tax exception if it is subject to tax in a foreign country at a rate greater than 18.9% (rather than the 31.5% pre-TCJA rate). With the corporate tax rate in many foreign countries exceeding 18.9%, there is a greater likelihood that U.S. groups of multinational enterprises can take advantage of the high-tax exception post-TCJA because it is more likely that the effective tax rate requirement will be satisfied.
Second, and more significantly, the Sec. 902 pooling regime for foreign taxes was repealed, and Sec. 960 was amended to require a direct association of current-year foreign income taxes with particular CFC income items for purposes of determining deemed paid foreign tax credits related to Subpart F inclusions and GILTI inclusions. To understand the impact of this change, it is helpful to review the mechanics of the high-tax exception. Although the high-tax exception technically seems to apply to an "item" of income, Regs. Sec. 1.954-1(c) defines "item" by reference to various categories of income. Specifically, the regulations apply the high-tax exception based on the following categories of income divided between the Sec. 904(d) passive and general limitation categories, rather than on an item-by-item basis:
- Foreign base company sales income;
- Foreign base company services income; and
- Full inclusion foreign base company income.
Furthermore, FPHCI is subdivided into the following categories: (1) dividends, interest, rents, royalties, and annuities; (2) gain from certain property transactions; (3) gain from commodities transactions; (4) foreign currency gain; and (5) income equivalent to interest. FPHCI in the passive category may be further subdivided, for example, when the item of income is earned through a foreign qualified business unit (as defined in Sec. 989(a)) or based on the nature and rate of tax (or lack of tax) imposed on the item.
Both before and after the TCJA, the foreign effective tax rate for the high-tax exception is determined separately for each category (as described above) of income. For this purpose, the amount of foreign taxes paid with respect to each category is based on the Sec. 960 rules, which cross-referenced the pooling rules in Sec. 902 prior to the TCJA. The allocation of a CFC's items of income among the various categories of income often had less relevance pre-TCJA because of the pooling approach for associating foreign taxes with a CFC's income. Under the pooling approach, each item of foreign base company income in the general category or passive category would have had the same effective tax rate as the Sec. 902 foreign tax pool of the CFC for each category, as illustrated in the example below.
Example: USP owns a Dutch CFC (DutchCo) that operates through a Japanese company (JapanCo) and an Irish company (IrishCo), each of which is disregarded as an entity separate from DutchCo for U.S. tax purposes. JapanCo earns $1,250 of foreign base company services income and pays $500 of Japanese taxes on the income. IrishCo earns $250 of foreign base company sales income and pays $31.25 of Irish taxes on the income. Assume that DutchCo, JapanCo, and IrishCo incur no other expenses.
Pre-TCJA, the foreign income taxes would have been pooled within the general category at DutchCo, resulting in an effective tax rate of approximately 35.4% ($531.25 of foreign income taxes ÷ $1,500 of current-year earnings) for each of the foreign base company services income and the foreign base company sales income (that is, for each separate item of foreign base company income within the general category). As a result of this pooling approach for foreign income taxes, the Japanese and Irish taxes would be blended, and both items of income would satisfy the high-tax exception (provided USP made a valid election to apply the high-tax exception). This example illustrates the potential blending of foreign taxes that could cause an item of foreign base company income that was otherwise subject to a low foreign tax rate to satisfy the high-tax exception.
As mentioned above, the TCJA amended the Sec. 960 deemed paid foreign tax credit rules to require that current-year foreign income taxes of a CFC be associated with a particular item of income earned by the CFC — a clear departure from the prior Sec. 902 pooling regime illustrated in the example. While currently there are no final regulations under Sec. 960, the foreign tax credit proposed regulations included proposed guidance on the application of this provision (with proposed retroactive applicability). Specifically, Prop. Regs. Sec. 1.960-1 provides detailed rules for associating foreign income taxes with a CFC's income.
The rules in Prop. Regs. Sec. 1.960-1 would affect the high-tax exception in two specific ways. First, the proposed regulation requires the CFC to divide income in the general category and the passive category among a Subpart F income group (to associate foreign taxes with a U.S. shareholder's Subpart F inclusions), a tested income group (to associate foreign taxes with a U.S. shareholder's GILTI inclusions), and a residual income group (to associate foreign taxes with income earned by the CFC that is subject to neither the Subpart F nor the GILTI rules). The Subpart F income group is further divided into the separate items of income that are required to be tested for purposes of the high-tax exception. Second, while the income allocated among the income subgroups is based on U.S. tax principles, the foreign taxes are allocated among the items within each particular grouping under foreign tax principles. The result of these changes is that, among other things, foreign taxes within the general category or passive category can no longer be blended to satisfy the high-tax exception.
Revisiting the example above and applying the rules in Prop. Regs. Sec. 1.960-1, the $1,250 of income earned by JapanCo and the $250 of income earned by IrishCo each would be allocated to the Subpart F income group within the general category. Next, the $1,250 and $250 would be further divided and treated as an item of income within the foreign base company services income group and the foreign base company sales income group, respectively.
In contrast to the pre-TCJA methodology, the foreign taxes would not be pooled within the general category but rather would be allocated among the foreign base company income groups — in this case, $500 to the foreign base company services income group and $31.25 to the foreign base company sales income group. As a result, DutchCo's Subpart F income related to JapanCo's operations would continue to qualify for the high-tax exception, as the effective tax rate paid in Japan would be 40% ($500 ÷ $1,250) (provided USP makes a valid election to apply the high-tax exception). However, DutchCo's Subpart F income related to IrishCo's operations would not qualify for the high-tax exception because the effective tax rate paid in Ireland would be only 12.5% ($31.25 ÷ $250).
As the examples above illustrate, the TCJA substantially modified the determination of whether a CFC's items of income satisfy the high-tax exception. With the increased importance of the high-tax exception, it is critical for U.S. groups to understand the mechanics of the effective tax rate calculation to determine whether the exception is available.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com..
Contributors are members of or associated with KPMG LLP. These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.