Editor: Mark G. Cook, CPA, CGMA
The IRS published final regulations (T.D. 9902) on July 23, 2020, to address the application of the high-tax exclusion from global intangible low-taxed income (GILTI) under Sec. 951A(c)(2)(A)(i)(III). Sec. 951A, which contains the GILTI rules, was added to the Internal Revenue Code by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Under the high-tax exclusion, taxpayers may make an election to exclude certain highly taxed income of a controlled foreign corporation (CFC) when computing their GILTI.
The final regulations on the GILTI high-tax exclusion mostly follow the 2019 proposed regulations (REG-101828-19) but with some modifications. Some of the highlights of the final regulations include:
- The high-tax exclusion applies only if the GILTI was subject to foreign income tax at an effective rate greater than 18.9% (90% of the highest U.S. corporate tax rate, which is 21%). This threshold is unchanged from the proposed regulations.
- The effective foreign tax rate for purposes of the high-tax exclusion is calculated on a tested-unit basis. This differs from the proposed regulations, which used a qualified business unit (QBU)-by-QBU basis.
- The high-tax exclusion election can be made on an annual basis. This differs from the proposed regulations, which contained a more restrictive election rule.
The following discussion explores some of the key aspects of the final regulations on the GILTI high-tax exclusion.
For purposes of calculating the effective foreign tax rate, the final regulations replace the QBU-by-QBU approach in the 2019 proposed regulations with a more targeted approach based on "tested units" (Regs. Sec. 1.951A-2(c)(7)(ii)). The tested unit approach applies to the extent an entity, or the activities of an entity, are actually subject to tax of a foreign country as a tax resident or permanent establishment (or similar taxable presence).
The final regulations define three categories of tested units:
- A CFC;
- An interest that the CFC holds directly or indirectly in a passthrough entity that: (1) is a tax resident of a foreign country, or (2) is not subject to tax as a resident but is treated as a corporation (or as another entity that is not fiscally transparent) for purposes of the CFC's tax law;
- A branch of the CFC that either (1) gives rise to a taxable presence in the country in which the branch is located, or (2) gives rise to a taxable presence under the owner's tax law, and the owner's tax law provides an exclusion, exemption, or other similar relief (such as a preferential rate) for income attributable to the branch (Regs. Sec. 1.951A-2(c)(7)(iv)(A)).
Transparent interest is defined as an interest in a passthrough entity (or the activities of a branch) that is not a tested unit (Regs. Sec. 1.951A-2(c)(7)(ix)(C)).
In addition, the final regulations provide that tested units of a CFC (including the CFC), other than certain nontaxed branches, are regarded as a single tested unit if the tested units are tax residents of, or located in, the same foreign country (Regs. Sec. 1.951A-2(c)(7)(iv)(C)(1)).
Effective foreign tax rate
Consistent with the 2019 proposed regulations, the final regulations apply the GILTI high-tax exclusion by comparing the effective foreign tax rate with 90% of the rate that would apply if the income were subject to the maximum U.S. corporate tax rate — or in other words 18.9%, based on the maximum rate of 21%.
The effective foreign tax rate that is compared to 18.9% takes several steps to determine. It is calculated by dividing the U.S. dollar amount of foreign income taxes paid or accrued (with respect to each respective tentative tested income item) by the U.S. dollar amount of the tentative tested income item increased by the U.S. dollar amount of the relevant foreign income taxes (Regs. Sec. 1.951A-2(c)(7)(vi)).
Tentative gross tested income: To calculate the tentative tested income item, the tentative gross tested income of each tested unit must first be determined. The final regulations retain the general approach set forth under the 2019 proposed regulations that items of gross income of a CFC are attributable to a tested unit of the CFC to the extent they are properly reflected on the separate set of books and records of the tested unit (Regs. Sec. 1.951A-2(c)(7)(ii)(B)). However, if a separate set of books and records is not prepared, items required to apply the GILTI high-tax exclusion that otherwise would be reflected on the book set must be determined (Regs. Sec. 1.951A-2(c)(7)(v)(B)). In addition, tentative gross tested income of a tested unit is adjusted by disregarded payments made between tested units of the CFC under the principles of Regs. Sec. 1.904-4(f)(2)(vi). Also, if gross income is attributable to more than one tested unit, the item is considered attributable only to the lowest-tier tested unit (Regs. Sec. 1.951A-2(c)(7)(iv)(B)).
Tentative tested income: The final regulations provide that a tentative tested income item is determined by allocating and apportioning current-year deductions for the CFC (including current-year taxes) to the tentative gross tested income item under the principles of Regs. Sec. 1.960-1(d)(3). As defined in Regs. Sec. 1.960-1(b)(4), current-year tax is a foreign income tax paid or accrued by a CFC in a current tax year; therefore, the U.S. dollar amount of the CFC's current-year taxes can be allocated and apportioned to the tentative tested income.
High-tax exclusion election
The GILTI high-tax exclusion election can be made on an annual basis. Although the 2019 proposed regulations contained a more restrictive rule, the IRS decided in the final regulations to allow an annual election, in response to comments that some taxpayers have significant fluctuations in foreign income and that the determination of whether the election is beneficial will vary from year to year.
The final regulations retain the rule in the 2019 proposed regulations that the election, if made or revoked, applies to each member of the controlling domestic shareholder group (CFC group). And the final regulations revise the definition of a CFC group to be an affiliated group defined in Sec. 1504(a) without the exclusion of foreign corporations and with an inclusion of a more-than-50% threshold (rather than 80%) of the total voting power or value of the CFC in Sec. 1504(a) to determine whether a CFC is a member of a CFC group (Regs. Sec. 1.951A-2(c)(7)(viii)(E)(2)(i)).
The election is made by the controlling domestic shareholders of a CFC by filing a statement with a tax return. The controlling domestic shareholders of a CFC generally are the U.S. shareholders who, in the aggregate, directly or indirectly (but not constructively) own more than 50% of the total combined voting power of the CFC. Also, the final regulations clarify that the controlling domestic shareholders must provide notice of elections (or revocations), as required by Regs. Sec. 1.964-1(c)(3)(iii), to each U.S. shareholder that is not a controlling domestic shareholder.
The final regulations continue to allow the election to be made on an amended return, but with additional requirements that:
- All U.S. shareholders of the CFC must file amended federal income tax returns (unless an original return has not yet been filed, in which case the original federal income tax return may be filed consistently with the election, (or revocation)) for the tax year; and:
- For any other tax year in which their U.S. tax liabilities would be increased by reason of that election (or revocation); or
- In the case of a partnership, if any item reported by the partnership or any partnership-related item would change as a result of the election (or revocation); within 24 months of the unextended due date of the original federal income tax return of the controlling domestic shareholder's inclusion year with or within which the CFC inclusion year, for which the election is made (or revoked), ends;
- All U.S. shareholders of the CFC for the CFC inclusion years must file amended federal income tax returns (or timely original federal income tax returns) reflecting the effect of such election, or revocation, within a single six-month period during the 24-month period; and
- Special rules apply if the U.S. shareholder is a partnership or a partner in a partnership (Regs. Sec. 1.951A-2(c)(7)(viii)(A)).
Consistent with the applicability date in the 2019 proposed regulations, the final regulations provide that the GILTI high-tax exclusion applies to tax years of foreign corporations beginning on or after July 23, 2020, and to tax years of U.S. shareholders in which or with which those tax years of foreign corporations end. In addition, taxpayers may elect to apply the GILTI high-tax exclusion retroactively to tax years of foreign corporations beginning after Dec. 31, 2017, and before July 23, 2020, and to tax years of U.S. shareholders in which or with which those tax years of the foreign corporations end.
Revisit election annually
Taxpayers must closely evaluate whether the GILTI high-tax exclusion election is helpful year by year. The GILTI high-tax exclusion may cause difficulty for some taxpayers because a separate set of books and records (or the related-items determination) of each tested unit is needed to calculate the foreign tax rate. However, the election may benefit certain taxpayers that have deductions under the U.S. rules only or income based on foreign principles only, because the taxpayers' effective foreign tax rate will be higher as the tentative tested income is decreased by the U.S. deduction and the foreign income taxes paid are increased by the foreign income.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
All contributors are members of SingerLewak LLP.