Since the enactment of the law known as the Tax Cuts and Jobs Act (TCJA) at the end of 2017,1 the TCJA's tax reform provisions have been subject to significant regulatory development, IRS interpretation, and further attempts at explication by the tax professional community.
One of the foremost areas of change under the tax reform was the introduction of the global intangible low-taxed income (GILTI) regime, containing a new set of anti-deferral rules that apply to controlled foreign corporations (CFCs).
Due to the recent implementation of the GILTI regime, analysis of its provisions has until now focused mainly on practical implementation, particularly within the context of real-life application. As new questions begin to arise regarding the application of the GILTI rules to more varied circumstances, it has become increasingly important to step back and contemplate the fundamental underpinnings of the regime. A useful exercise in gaining a better understanding of how the GILTI regime works is to compare it with its much older conceptual sibling, the Subpart F regime, in a specific situation.
Subpart F and GILTI: A brief comparative history
The Internal Revenue Code's campaign against overseas tax deferral dates to the 1960s with the enactment of the Revenue Act of 1962,2 which refined the definition of a CFC3 and added Subpart F4 to the Code. Prior to this, non-U.S.-source income generated by a CFC was not taxable to controlling U.S. shareholders until it was repatriated via a distribution, creating a golden tax-deferral opportunity, particularly when profits could accumulate in foreign corporations organized in low-tax or zero-tax jurisdictions.
To prevent this offshore abuse, the Code required, and to this day still requires, Subpart F income (made up of mainly "passive" income) to be included in the current-year taxable income of a CFC's "United States shareholder,"5 whether or not such income is distributed in the current year.
Exceptions to Subpart F inclusion generally reflect situations in which tax deferral or avoidance is likely not the main goal or outcome of the foreign company's existence. For instance, under the high-tax exception, income of a CFC that is subject to tax in its local jurisdiction at a rate that is at least 90% of the U.S. corporate tax rate is not subject to Subpart F inclusion.6
Jumping forward five-and-a-half decades, the TCJA provided a new wrinkle to the treatment of certain CFC income in the form of the GILTI anti-deferral regime. Like Subpart F, the GILTI rules were designed to prevent tax-deferral opportunities, but this time as a result of another of the TCJA's tax reforms — namely, the establishment of a "participation exemption" under which certain earnings of a foreign corporation can be repatriated to a corporate U.S. shareholder without U.S. tax.
In the preamble to the Oct. 10, 2018, proposed regulations implementing the GILTI regime, the IRS stated, "Congress recognized that, without any base protection measures, the participation exemption system could incentivize taxpayers to allocate income — in particular, mobile income from intangible property — that would otherwise be subject to the full U.S. corporate tax rate to CFCs operating in low- or zero-tax jurisdictions."7 Therefore, Congress enacted the GILTI provisions in order to subject a CFC's "active" income from intangibles to U.S. tax on a current basis, similar to the treatment of a CFC's Subpart F income.
Further following in the footsteps of the Subpart F regime, the GILTI regime has incorporated the high-tax exception into its final regulations.8
Defining Subpart F and GILTI: A distinction with a difference
While it is important to recognize GILTI and Subpart F's commonalities, the exercise of distinguishing them sheds profound light on how each regime operates at its definitional core.
The most fundamental distinction between the definitions of Subpart F income and GILTI is this — Subpart F income is defined initially by what it includes, while GILTI is defined initially by what it excludes.
Sec. 952 of the Code defines Subpart F income to include the following items: insurance income, foreign base company income (FBCI), international boycott factor income, illegal bribes and kickbacks, and income derived from certain designated terrorism-sponsoring countries. Other sections of the Code then further categorize these items as well as provide exceptions to such categories and subcategories. One of the more familiar subcategories of FBCI, for instance, is foreign personal holding company income (FPHCI), defined in Sec. 954 and the regulations thereunder to generally include passive-type income, such as dividends, interest, and rents, as well as sales of property that give rise to such passive-type income (e.g., stock, debt instruments, and real estate property).
In contrast, Sec. 951A defines GILTI firstly as all of the gross income of a CFC (less allocable deductions) and only then excludes the following items: Subpart F income (even if excluded by reason of the high-tax exception), income effectively connected with a U.S. trade or business, certain dividends received from a related person, and certain foreign oil and gas income. GILTI is further reduced by subtracting a 10% return on certain qualified tangible assets.
Why the difference in definitional approach between Subpart F income and GILTI? Perhaps the TCJA legislators tapped into valuable insights gained from decades of experience with Subpart F to craft a modernized tax regime that offers less room for ambiguity, uncertainty, and the potential for onerous litigation.9
In the preamble to the Oct. 10, 2018, proposed regulations implementing the GILTI regime, the IRS stated in this regard: "[D]ue to the administrative difficulty in identifying income attributable to intangible assets . . . [GILTI] is determined for purposes of section 951A based on a formulaic approach, under which a 10-percent return is attributed to certain tangible assets . . . and then each dollar of certain income above such 'normal return' is effectively treated as intangible income."10
Defining GILTI more broadly, i.e., by exclusion rather than inclusion, ultimately hands the IRS sharper definitional tools to impose GILTI taxation on new and varied offshore transactions as they arise moving forward.
Applying Subpart F and GILTI: The case of distributions of appreciated property
Given GILTI's relative newness, it is perhaps not yet entirely obvious how the regime's shift in definitional approach will have practical implications.
Anecdotally speaking, the authors found themselves at the crossroad between the Subpart F and GILTI regimes recently when analyzing a client transaction involving a nonliquidating distribution of certain appreciated property by a wholly owned CFC to its sole U.S. owner.
The distribution transaction was particularly interesting because of the tax fiction that informs its consequences. Under Sec. 311(b), if a corporation distributes appreciated property to a shareholder, then "gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value." The "as if" connotes a quasi-transactional classification, one of sale-like treatment.
In this context, the difference in definitional approach between the Subpart F and GILTI regimes can have important implications. On its face, a strict reading of Sec. 954 and the regulations thereunder shows no specific definitional category of Subpart F income that includes a deemed sale by virtue of a distribution of appreciated property. It is therefore at least arguably unclear whether a distribution that triggers gain recognition — "as if" a sale has occurred — is subject to Subpart F taxation.
The IRS has given its opinion on the matter in two private letter rulings,11 stating that Sec. 311(b) gain of a CFC should be treated as FPHCI subject to Subpart F taxation. Notably, the rulings do not back up this conclusion with a technical discussion.12 Given the limited authoritative weight of private letter rulings, the issue is at least not clear from doubt.13
Turning to the GILTI regime, if the appreciated property were, for instance, trade or business property, the CFC's distribution of such property would presumably fall outside the definition of FPHCI and would therefore not be subject to Subpart F taxation (even if conceding that Subpart F is at least at play under these circumstances).14 Taking Subpart F out of the picture provokes the question as to whether gain from the distribution (treated as a deemed sale) should then be subject to the GILTI regime.
It is at this juncture where the broader definitional depth of GILTI gives a much clearer answer. Since GILTI firstly includes all gross income, then the gain (even if triggered by a deemed sale) should initially fall within the definition of GILTI. Assuming no exception applies, the gain should then ultimately be subject to GILTI taxation. While Subpart F income's definition by inclusion leads to certain ambiguities, GILTI's definition by exclusion gives a more definitive result.
As the GILTI regime comes into fuller form and further integrates with other areas of the Code, theoretical explorations into the regime's substantive nature can help tax practitioners more confidently apply both the GILTI and Subpart F rules to transactions with subtler and less obvious outcomes.
2Revenue Act of 1962, P.L. 87-834. Two years previously, in 1960, Congress enacted P.L. 86-780, which added Sec. 6038 to the Code, requiring the reporting of certain overseas activities of U.S.-owned foreign corporations, but it did not yet impose a substantive regime requiring a current shareholder inclusion.
3The definition of a CFC was further refined by the TCJA. Currently, a CFC is defined as any foreign (i.e., non-U.S.) corporation, if more than 50% of (1) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the shares in such corporation, is owned in the aggregate, or is considered as owned by applying certain attribution rules, by United States shareholders on any day during the tax year of such foreign corporation (Sec. 957).
4"Subpart F" (Secs. 951-965) refers to Subpart F (Controlled Foreign Corporations) of Part III (Income From Sources Without the United States) of Subchapter N (Tax Based on Income From Sources Within and Without the United States) of Chapter 1 (Normal Taxes and Surtaxes) of Subtitle A (Income Taxes) of Title 26 (Internal Revenue Code) of the U.S. Code.
5A "United States shareholder" is any U.S. person who owns, or is considered as owning, by applying certain attribution rules, 10% or more of the total voting power or the total value of stock in the foreign corporation (Sec. 951(b)).
7REG-104390-18, 83 Fed. Reg. 51072 (Oct. 10, 2018) (referring to the Senate Committee on the Budget, Reconciliation Recommendations Pursuant to H. Con. Res. 71, 115th Cong., 1st Sess., at 365 (December 2017)).
8Regs. Sec. 1.951A-2(c)(7). The GILTI rules also include a similar mechanism that eliminates residual GILTI taxation in the case of CFCs operating in jurisdictions imposing a corporate income tax at a rate of at least 13.125% (so-called non-low-tax jurisdictions). Taking into account the 80% foreign tax credit available to domestic corporate shareholders (and individual U.S. shareholders making a "962(b) election"), U.S. shareholders of CFCs in non-low-tax jurisdictions may suffer no residual U.S. tax, given that GILTI is subject to U.S. tax at the rate of 10.5% (or 80% of 13.125%). Under new Sec. 250, the U.S. corporate tax rate of 21% is reduced to 10.5% by virtue of a 50% deduction afforded to GILTI inclusions in the hands of U.S. corporate shareholders (and individual U.S. shareholders making a "962(b) election").
9While the focus here is on definitional differences, the GILTI regime has a number of other features that distinguish it functionally from the Subpart F regime. For instance, the amount of a shareholder's Subpart F inclusion with respect to one CFC is not taken into account in determining the shareholder's inclusion with respect to another CFC, while in contrast a U.S. shareholder computes a single GILTI inclusion amount by reference to all its CFCs.
10REG-104390-18, 83 Fed. Reg. 51072 (Oct. 10, 2018).
11IRS Letter Ruling 9724027 and IRS Letter Ruling 9137047.
12The IRS could argue by analogy to Sec. 964(e)(3), which states that a deemed sale is to be treated as an actual sale for the purpose of implementing the rule that gain from the sale by a CFC of another CFC is to be included in gross income as a dividend. A counterargument could then be made that Sec. 964(e) states explicitly that the deemed sale rule applies solely "for purposes of this subsection," meaning only in the context of a sale by a CFC of another CFC.
13In a more authoritative setting, a district court did in fact analyze a case where a CFC made a nonliquidating distribution of appreciated property (shares in a company) to its U.S. parent. See Pittway Corp., 887 F. Supp. 164 (N.D. Ill. 1995), aff'd, 88 F.3d 501 (7th Cir. 1996). A discussion of the CFC and Subpart F rules is noticeably absent from the court's analysis.
14Note that unlike the statutory provisions of the Code, the Sec. 954 regulations, which were promulgated three decades later (T.D. 8618, 60 Fed. Reg. 46500 (Sept. 7, 1995)), do in fact take a GILTI-like definitional approach, but only specifically in the context of sales of property by a CFC. Under Regs. Sec. 1.954-2(e)(3), sales of all types of property are initially included within the FPHCI category of sales of "property that does not give rise to any income" before various exceptions are provided.
|Joshua Ashman, CPA, is a partner, and Nathan Mintz, Esq., is tax counsel, both at Expat Tax Professionals LLC in Hackensack, N.J. For more information about this article, contact firstname.lastname@example.org.