Article featured on Thomson Reuters' Taxnet Pro, July 2020.

Yesterday, the Treasury and the IRS released final high-tax exception GILTI regulations and proposed high-tax exception Subpart F income regulations. While the regulations are favorable in that they allow taxpayers to apply the high-tax GILTI regulations retroactively to taxable years of foreign corporations beginning after December 31, 2017, and are a little more favorable than the proposed high-tax exception GILTI regulations (the 2019 proposed regulations), the regulations will change the tax community’s view of the high-tax exception.

For purposes of computing a controlled foreign corporation’s (CFC’s) foreign base company income and insurance income (components of Subpart F income), a U.S. shareholder can currently elect to exclude any item of income that was subject to an effective rate of foreign tax equal to at least 90 percent of the U.S. corporate tax rate. With the reduction of the corporate tax rate as part of TCJA, the potential for income to be eligible for the high-tax exception dramatically increased.

The 2019 proposed regulations proposed to allow a similar election to exclude certain income items from the calculation of GILTI. However, the proposed methodology for GILTI purposes varied from the well-established methodology that applied to the Subpart F income high-tax exception. Yesterday’s release attempts to harmonize the operation of the two exceptions, largely by proposing amendments to the Subpart F regulations to adopt the concepts of the GILTI regulations. However, it is important to note that the proposed Subpart F regulations are not effective yet, and yesterday’s guidance does not permit taxpayers to rely upon them. Therefore, taxpayers will continue to apply two different rules at least until the Subpart F rules are finalized.

The following is a high-level summary of the notable changes to the high-tax exception rules.

Determination of High-Tax Income

The biggest change to the regulations is the determination of the basic unit to which the high-tax test applies. The 2019 proposed regulations would have required the GILTI high-tax test to be applied separately to each qualified business unit (QBU) of a CFC. Commentators had asked that this QBU-by-QBU approach be replaced with a CFC-by-CFC approach, under which a single effective tax rate would be measured for all the tested income items of a CFC. The final regulations decline to adopt the CFC-by-CFC approach, while also jettisoning the QBU-by-QBU approach. The new approach is to determine whether income is eligible for the high-tax income exception on a “tested unit” basis. The tested unit standard is meant to group income that is likely to be subject to a single foreign tax rate and to reduce opportunities to blend income subject to different tax rates for purposes of the high-tax test.  A tested unit may be a CFC, an interest in a pass-through entity (including a disregarded entity) held by a CFC, or a branch of a CFC outside the CFC’s country of incorporation, in each case if certain conditions are met. Tested units that are resident or located in a single foreign country may generally be combined. 

The proposed Subpart F regulations would require the Subpart F high-tax test also to be applied on the basis of tested units and would provide grouping rules intended to reduce grouping of high- and low-taxed income items. 

A&M Insight: While the adoption of the tested unit approach allows for some blending of income, it is much more complex and permits less blending than a CFC-by-CFC determination. In order to identify a tested unit, a U.S. shareholder will have to examine the CFC’s activities. As a result, a U.S. shareholder that has a minority interest in a CFC will have to negotiate access to the required information.

Determination of Effective Tax Rate

In addition to providing guidance as to how to group income for purposes of determining eligibility for the high-tax exception, the new regulations make three significant changes to the method for determining the effective tax rate on that income:

• The effective tax rate is determined at the CFC level, as opposed to at the U.S. shareholder level (by reference to the indirect credit associated with a hypothetical income inclusion). 
• The effective tax rate is determined by reference only to the CFC’s income and taxes paid for the current year, with no allowances for timing differences between the U.S. and foreign tax law.
• Disregarded payments between tested units of the same CFC will be taken into account in calculating effective tax rates.

The IRS received comments that local country NOL carryforwards should be taken into account when determining the effective rate of tax of a CFC. Unfortunately, the IRS did not accept these comments. As a result, foreign law NOL carryforwards can create low-taxed GILTI, even in jurisdictions with a high statutory rate of tax.

A&M Insight: As the name indicates, disregarded payments are payments that are not taken into account for U.S. income tax purposes and possibly not tracked. Based on the adoption of the tested unit approach, it is understandable that Treasury and the IRS would want disregarded payments to be taken into account in order to determine the effective tax rate on a unit. However, this places an onus on U.S. shareholders to determine the amount of disregarded payments and trace their effects on the income of each tested unit.

So You Think You Want to Make an Election

In considering whether you want to make the election, it is important to determine whether you are a controlling domestic shareholder (which is generally a shareholder or group of shareholders that owns at least 50% of the CFC’s voting power directly and undertake to act on behalf of the CFC). This determination is essential because the controlling domestic shareholders dictate whether a high tax election is made with respect to a particular CFC’s (or CFC group’s)  tested units. With that said, Treasury may revisit proposed regulations under which a domestic partnership is treated as owning CFC stock for purposes of determining who is a controlling domestic shareholder. 

Additionally, the regulations require that an election is either made or not made with respect to all CFCs included in a CFC group (which is generally a group of CFCs connected by common ownership of more than 50% (with section 318 attribution)).

Lastly, the proposed regulations provide for a single, annual election to apply the high-tax exception for purposes of both Subpart F income and GILTI. The 2019 proposed regulations provided that this election would continue unless revoked, and once revoked, could not be made again for five years.

A&M Insight: The ability to elect the high-tax exception on an annual basis allows for some level of tax planning in that a taxpayer can analyze its tax position each year to determine whether the election is beneficial, which was not possible under the 2019 proposed regulations. As part of that analysis, taxpayers will need to factor in the fact that the election would apply to both Subpart F and GILTI. As a result, the determination whether to make the election may not be as straightforward as one would like. For example, a taxpayer may currently choose to elect the Subpart F income high-tax income exclusion for simplification (to avoid having to determine the exact amount of income and foreign taxes that would have otherwise been taken into account). However, once the subpart F high-tax regulations are finalized, taxpayers will need to consider the implications for GILTI purposes as well, including the impact on foreign tax credits (as GILTI has its own foreign tax credit basket). In addition, under the current subpart F regime, taxpayers can cherry-pick items to exclude in order to achieve an optimal effective foreign tax rate. This is not possible under the GILTI regulations and will not be possible once the proposed subpart F regulations are finalized.

Other Important Items

• The final regulations provide that items of income and deduction are attributed to tested units initially based on their books and records, with modifications to address items that are taken into account currently for U.S. tax purposes but not under the applicable financial standards, and subject to an anti-abuse rule. However, the proposed regulations would replace the reference to “books and records” with a standard based on applicable financial statements, although U.S. tax rules would still apply to determine the amount of deductions allocated to gross income items on those financial statements.
• The final regulations do not include a de minimis rule for tested income items. However, the proposed regulations contain a de minimis rule that requires small tested units to be combined.
• The proposed regulations provide that items determined to be subject to a negative or undefined tax rate (generally because net income is negative or zero) will be deemed to be high-taxed, and that no credit will be allowed for foreign taxes allocated and apportioned to such items.

A&M Taxand Says

The ability to apply the GILTI high-tax exception retroactively may be a welcomed benefit if taxpayers can amend previously filed tax returns to claim a refund. This is especially the case for taxpayers that have utilized net operating losses to offset GILTI inclusions, who may now be able instead to carry back those net operating losses under the CARES Act as discussed previously. However, the determination whether to apply the GILTI high-tax exception retroactively should also consider the implications it has on other Code sections. For example, electing the GILTI high-tax exception may reduce a taxpayer’s ability to deduct business interest expense if it made a CFC group election (discussed in greater detail here). Additionally, the election causes CFCs to have untaxed earnings and profits, as opposed to characterizing the income as previously taxed earnings and profits, or PTEP (discussed in greater detail here), which may subject subsequent distributions or dispositions to taxation. A&M is happy to discuss the implications of the regulations, as well as the determination of whether a particular taxpayer should apply the GILTI high-tax exception retroactively or prospectively.