We are nearly two months into the new tax regime, and we in the tax community are still wrapping our heads around the complex and far-reaching new provisions. The Republicans’ goal of a simplified, territorial system was clearly lost on the drafters, as we now live under an even more complicated set of rules that may be more akin to a pure worldwide tax system, largely thanks to one provision: Global Intangible Low-Taxed Income, or GILTI.
U.S. taxpayers are now subject to current tax on their share of their foreign subsidiaries’ GILTI. GILTI includes any income over and above a 10 percent return on the tax basis of tangible assets, subject to certain exceptions (earnings generating other forms of Subpart F, effectively connected income, etc.). Corporate shareholders of foreign corporations generating GILTI are generally entitled to a 50 percent1 deduction against such income, lowering the effective rate of tax from 21 percent to 10.5 percent. Further, those shareholders are able to recognize a foreign tax credit for 80 percent of local taxes paid on GILTI income (subject to the foreign tax credit limitation). Therefore, so long as the foreign structure’s average effective tax rate is 13.125 percent2 or more, the tax associated with GILTI should be fully offset by foreign tax credits. Or so that was the idea. The problem is that most companies will not be able to fully offset the tax, and many will have significant exposures, primarily due to the legacy foreign tax credit limitation rules. In this first installment in our TAW series on GILTI, we discuss how the expense allocation rules within the foreign tax credit limitations can result in GILTI exposure to many unsuspecting companies.
Revisiting the Foreign Tax Credit Limitation
In enacting GILTI, Congress carved out a new separate foreign tax credit limitation category, or Sec. 904 basket, for GILTI. Like any Sec. 904 basket, certain deductions must be allocated and apportioned against GILTI to arrive at a net foreign source income figure in the separate GILTI basket. Consider the Sec. 904 limitation calculation:
|Net Separate Category Foreign Source Income|
Worldwide Taxable Income
|x Tax on Worldwide Income|
GILTI and 861 Allocations
As mentioned above, GILTI operates such that a full foreign tax credit offset should be available to offset the tax on GILTI, so long as the foreign rate associated with such income exceeds 13.125 percent (the “low-taxed” portion of its name). Consider an example of a high-taxed foreign subsidiary of a U.S. corporation with $75 of GILTI earnings and $25 of related taxes, equating to a 25 percent foreign tax rate. This taxpayer would recognize $75 of GILTI income and $25 of Sec. 78 gross-up, then would be entitled to a 50 percent deduction, resulting in $50 of U.S. income. The tax associated with this income (at 21 percent) is $10.50. However, the taxpayer generated foreign tax credits of $25, subject to an 80 percent limitation, or $20—more than sufficient to wipe out the $10.50 US tax. In this simple example, all has operated as intended.
Suppose, however, that the taxpayer had interest expense and $10 of that expense must be allocated against GILTI basket income. The residual foreign source income in the GILTI basket would, therefore, be $40, resulting in a foreign tax credit limitation of $8.40 ($40 multiplied by 21 percent). Once again, the taxpayer has generated $20 of creditable foreign taxes but is only allowed to utilize $8.40 of those credits against the $10.50 of tax. Despite paying a higher foreign tax rate in its foreign structure than the new U.S. corporate rate, the taxpayer is subjected to GILTI tax, as each incremental dollar of expense allocation results in an additional $0.21 of tax (until the point at which the limitation becomes $0).
This may come as a shock to many companies who had reasonably assumed that GILTI was designed to apply companies with low-taxed foreign subsidiaries. You can hardly blame them for assuming high taxed income would not be subject to additional GILTI tax when the words “low-taxed” are part of the name of the income. Companies already expecting to be subject to GILTI may be similarly underestimating the exposure, as their foreign tax credit limitations will be subject to the same phenomenon. In a few words, no one (at least no one with expenses allocable to GILTI) is safe. The expense most likely to cause a problem is interest, but other types of expenses (e.g., R&E and stewardship) can also be problematic.
Alvarez & Marsal Taxand Says:
As companies continue to analyze the impact of Tax Reform on their structures, they should be alert for traps for the unwary. GILTI, often advertised as a minimum tax on foreign earnings, could cause cash tax impacts to companies regardless of their foreign tax rates, as a result of expense allocations that cost $0.21 in additional tax for every dollar of allocation.
Until the IRS issues guidance, we are modeling out the impact of expense allocation under Sections 904 and 861 to GILTI for our clients, and mining for ways to minimize the impact. In the next edition of our GILTI series, we will discuss how tax reform has changed the landscape of expense allocation at large. In the meantime, let us know what you’re seeing in your calculations!
- 37.5 percent for tax years starting after December 31, 2025.
- 16.4 percent for tax years starting after December 31, 2025.