In the first edition of our ongoing series on tax reform’s most memorable acronym, GILTI, we discussed how expense allocation under IRC Sec. 861 could leave many unsuspecting taxpayers exposed to incremental tax on their foreign earnings. Despite paying a high effective rate of tax overseas that would seemingly offer a full foreign tax credit offset against US tax on GILTI, every dollar of expense allocation may cause an incremental $0.21 of tax, an issue similarly identified in a letter sent by the US Chamber of Commerce to the Treasury Department last week. Whether this is an intentional part of the new law, or simply a side effect of the quick process of drafting and passing the law, many tax professionals are now scrambling to revisit their GILTI estimates and evaluate their potential exposure. Critically, this exercise involves examining how expenses, particularly interest, are meant to be allocated against GILTI for foreign tax credit purposes.
Allocating Interest to Statutory Groupings of Income
The “low-taxed” portion of the GILTI name comes from the presumption that any U.S.-based multinational paying an aggregate effective rate of tax on their foreign earnings of at least 13.125 percent through 2025, and 16.4 percent thereafter, should be able to claim a foreign tax credit to fully offset the resultant U.S. tax. However, as we’ve seen often with the new reform bill, these provisions were designed within the framework of existing law, and are subject to a long-standing body of related rules. For example, the GILTI foreign tax credit mechanism was established via a new income basket under the existing Sec. 904 foreign tax credit limitation rules. Meaning, GILTI is subject to a largely unchanged body of law, including expense allocation rules for Sec. 904 purposes.
Sec. 861, which was largely left alone during the reform process, provides substantial guidance on how a variety of expenses, including interest, should be allocated and apportioned against Sec. 904 income baskets, including GILTI. Domestic corporations are required to use the asset method for allocating interest expense. Under the asset method, the taxpayer allocates interest to the various statutory groupings based on the average total value of assets assigned to each grouping. Assets fall into statutory groupings based on the source(s) and type(s) of income they generate, have generated, or may reasonably be expected to generate. Accordingly, the first step is to identify each of the taxpayer’s assets that generate income and to value such assets. In that regard, assets that produce no directly identifiable income yield or that contribute equally to the generation of all income are not considered. For tax years beginning before January 1, 2018, taxpayers had flexibility in their valuation methodology, generally using either tax basis or fair market value. For subsequent tax years (i.e. for years to which the GILTI provisions apply), the allocation must be determined using tax basis.
Having valued each asset that generates income, taxpayers must then characterize those assets according to the source(s) and type(s) of income they generate. In the case of assets generating foreign source income, this means further “basketing” the assets to one or more of the various Sec. 904 baskets. Taxpayers are then left with various statutory groupings of assets that give rise to the relevant categories of income, and a value prescribed to each grouping based on the value of the assets within each grouping.
Assigning an asset to one or more statutory groupings is not always clear-cut, especially when it comes to stock of a foreign subsidiary. Treasury regulations provide a look-through approach to characterizing stock of a controlled foreign corporation (CFC). Taxpayers look to the underlying assets held by the CFC to determine the character of income they generate. The assets are divided between income characters according to their respective tax basis or according to the gross income they produce, although in many cases, the tax basis approach may be required. Following these rules back up the ownership chain, a U.S. taxpayer’s outside basis in a CFC is therefore characterized according to the income generated by the CFC’s underlying assets, and the taxpayer’s interest expense is allocated to a particular Sec. 904 basket according to that characterization.
Interest Allocation to the GILTI Basket
Nearly every U.S. corporate taxpayer with profitable foreign subsidiaries will be required to do a GILTI calculation annually, demanding a foreign tax credit limitation calculation and interest expense allocation. This begs the question of how the current body of regulations will apply to the Sec. 904 GILTI basket.
As discussed above, outside basis in the stock of a CFC must be assigned to one or more Sec. 904 baskets to determine how much interest is attracted to that basket. This characterization depends on the CFC’s underlying assets. Under the tax basis approach, the taxpayer would identify assets in its CFC that give rise to GILTI.
There is no guidance yet on how to determine whether an asset generates GILTI. But based on the statutory GILTI formula, it appears that any asset, whether tangible or intangible, can give rise to GILTI and/or to income that is not GILTI. In that regard, it appears that tangible assets can give rise to GILTI if they generate a return greater than 10 percent of their tax basis, which may be rare. In contrast, it appears that intangible assets may be deemed to generate income that is not GILTI, to the extent that they generate a return which, together with the return on tangible assets, does not exceed 10 percent of the tax basis of tangible assets.
In many cases, taxpayers and their foreign subsidiaries may have very little basis, if any, in their intangible assets. Regardless of whether their intangibles have any tax basis, taxpayers must consider whether the tangible assets in their CFCs generate a return greater than 10 percent, a high bar in many industries. If this hurdle is not cleared, and if the CFC has no tax basis in its intangibles, the CFC would presumably (pending any guidance to the contrary) be treated as having no tax basis in any assets that generate GILTI, forcing the U.S. shareholder to characterize the stock in the CFC as an asset giving rise to income other than GILTI. In this case, little to no interest expense may wind up being allocated to such income.
For taxpayers that do have tax basis in intangible assets, it appears that those assets may not be automatically assigned to the GILTI basket. For example, let’s say a CFC has tangible assets with a tax basis of $2,000 and intangible assets with a tax basis of $100, and the CFC generated net income during the tax year of $250. Under these facts, the taxpayer’s tangible assets are deemed to generate a $200 return (i.e. 10 percent of the CFC’s qualified business asset investment). The excess $50 of income may be considered derived from intangibles. In the absence of any guidance to the contrary, and assuming the tangible assets do not generate a return greater than 10 percent, it appears that only a small portion of the CFC’s assets give rise to GILTI, ultimately attracting only a modest interest allocation.
Of course, such a taxpayer-friendly result depends on the taxpayer having sufficiently high tax basis in tangible assets and little-to-no tax basis in intangibles held at the CFC level. While this may be a common result for mature businesses, any recent M&A activity resulting in stepped-up asset basis could mean high-basis intangibles. Purchase price allocations on future foreign acquisitions should carefully consider the prospective GILTI implications when assigning value between tangible and intangible assets. It will also be important to be alert for any guidance requiring allocations to be made differently than described above.
Assuming forthcoming guidance does not change these conclusions, taxpayers will need to consider how stock in a CFC will be characterized, if not as an asset giving rise to GILTI. To the extent that the stock is characterized as an asset that generates GILTI and/or Subpart F income, it may attract interest expense allocations that could adversely impact the foreign tax credit limitations in those separate limitation categories. Resultant losses in those other categories, or “separate limitation losses” may trigger adverse foreign tax credit results for taxpayers claiming credits against income in a separate category. Therefore, where interest is allocated if not to GILTI basket income is especially important. Congress’s revisions to Sec. 904 add an interesting wrinkle to the rules for allocating interest expense (and in that regard, how the tax basis of stock in a specified 10 percent-owned foreign corporation should be characterized for that purpose). To the extent that the stock is characterized as an asset that generates dividends for which a 100 percent participation exemption deduction is allowed, that asset may not attract an allocation of interest expense that could adversely impact the foreign tax credit limitation(s). Therefore, to the extent a CFC does not give rise to income in a separate limitation category other than GILTI (i.e., from traditional Subpart F), interest may not be allocated to the stock of a CFC other than to the extent discussed above.
Alvarez & Marsal Taxand Says
Many companies will be required to first report the tax effect of GILTI on their first quarter financials in a few short weeks. For those expecting a full foreign tax credit offset against the U.S. tax on GILTI, the expense allocation rules could prove to be an unwelcome surprise. Therefore, taxpayers should be revisiting their expense allocation procedures and identifying whether their CFCs have tax basis in any assets that give rise to GILTI. In the absence of clear guidance from either the Treasury Department or IRS, Sec. 861 expense allocations must be modeled out by every taxpayer subject to the new GILTI rules.