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June 4, 2018

Introduction

As companies are currently preparing for second quarter releases, estimated tax payments and cash tax planning, we are feverishly modeling the impact of Global Intangible Low-Taxed Income (GILTI), revealing several glitches and uncertainties. Among these uncertainties, one nuanced issue generating substantial frustration for companies involves code Section 78. The issue relates to a potential limit on a taxpayer’s ability to use foreign tax credits against GILTI, which may result in significantly raised exposures. Many conservative attest firms have previously concluded that taxpayers are limited. Below we discuss the issue and our view.

In short, our position is in favor of using foreign tax credits. This could reduce the exposure for companies by affecting earnings releases, estimated tax payment obligations and future planning. ​

Purpose of the Section 78 Gross-Up

The deemed paid foreign tax credit provided by Section 960 (and previously by now repealed Section 902) creates a fiction whereby a U.S. parent company is treated as if it directly paid its allocable portion of income taxes paid by its 10 percent or more foreign subsidiaries, for which the parent may receive a foreign tax credit. When a U.S. parent company is deemed to have paid the taxes of its foreign subsidiary(ies), Section 78 requires the U.S. parent to gross-up the income inclusion from its foreign subsidiaries by the amount of the deemed paid taxes. In this way, the parent reports the same amount of income and foreign taxes as it would have reported if it earned the income directly, rather than through a foreign subsidiary.   

Historically, this concept applied when a foreign subsidiary distributed a dividend to its U.S. parent, or when it had subpart F income includible by its U.S. parent. For example, if a foreign subsidiary distributed $75 of its income on which it paid $25 in taxes as a dividend to its U.S parent, the U.S. parent is treated as if it received a $100 dividend and directly paid the $25 in foreign tax itself.

As a result of the Tax Cuts and Jobs Act (TCJA), the application of this deemed paid tax and dividend gross-up concept has been extended to GILTI inclusions. Specifically, a U.S. parent corporation is deemed to have paid an allocable portion of the foreign taxes paid by any “controlled foreign corporations” (CFCs) from which the parent has a GILTI inclusion; and the parent’s income must be grossed up for the taxes paid by the CFC which relate to its GILTI income inclusion (Note: The Section 78 Gross-Up on GILTI represents the full amount of deemed paid taxes, although a foreign tax credit is only allowable for 80 percent of the deemed paid taxes).

Section 78 Gross-Up and the Foreign Tax Credit Limitation

In our first edition of this series, we revisited the foreign tax credit limitation under Section 904 to indicate how expense allocations to the GILTI foreign tax credit basket (created by the TCJA) can affect the amount of foreign tax credits which may be used. Further limitation potentially exists because of an ambiguity within the current statutory language regarding the Section 78 Gross-Up with respect to GILTI inclusions. Specifically, there is current debate regarding whether the Section 78 Gross-Up on GILTI, as discussed above, should be allocated to the GILTI basket or to the general limitation basket for purposes of determining the Section 904 foreign tax credit limitation. A number of our clients have been surprised by the insistence from their auditors (including more than one of the Big 4) that the Section 78 Gross-Up on GILTI must be allocated to the general limitation basket.

Why Does This Matter?

It is clear that both the GILTI inclusion as well as the deemed paid foreign taxes allocated to it belong in the GILTI basket. Therefore, if the Section 78 Gross-Up was to be allocated to the general limitation basket, rather than the GILTI basket; a mismatch between the taxes paid and Section 78 Gross-Up would arise.

For example, assume a taxpayer has an $86,875 GILTI inclusion and the CFC has $13,125 of taxes allocable to the GILTI inclusion. If the Section 78 Gross-Up is allocated to the GILTI basket, the taxpayer would have net taxable income in the GILTI basket of $50,000 ($86,875 + $13,125, less a GILTI deduction of $50,000) and a U.S. tax (before FTC) of $10,500. The taxpayer’s deemed paid foreign taxes would be $10,500 (80 percent of the $13,125 of taxes paid by the CFC), which would exactly offset the U.S. taxes (before FTC) on the GILTI income. This was the result intended by Congress, as evidenced by the legislative history.  

In contrast, if the Section 78 Gross-Up of $13,125 in the above example must be allocated to the general limitation basket, the taxpayer would have net taxable income in the GILTI basket of only $43,437.50 ($86,875 less a GILTI deduction of $43,437.50) and a U.S. tax (before FTC) of $9,121.88. In that case, the taxpayer would have excess (unusable) credits of $1,378.12 in the GILTI basket and it would have $13,125 of foreign source income in the general limitation basket, resulting in $2,756.25 of U.S. tax, with no foreign tax credits available to offset that tax (assuming no excess credits in the general limitation basket attributable to Section 956 or traditional Subpart F income inclusions).[1] This was not the result intended by Congress, and there is no apparent policy justification for that result. To allocate the deemed paid tax gross-up to a different basket than the income and the deemed paid taxes to which the gross-up relates is a patently absurd result.  

Our Verdict: The Section 78 Gross-Up Should Be Included in the GILTI Basket

As we’ve illustrated above, the result of allocating the Section 78 Gross-Up on GILTI to the general limitation basket is so absurd that one must wonder – can this really be? Those who believe that the Section 78 Gross-Up for a GILTI inclusion belongs in the general limitation basket, believe that the relevant statutory language is unambiguous and mandates that treatment, regardless of how absurd the result. We have concluded that the statutory language is ambiguous and that it lends itself to a legitimate alternative interpretation that places the gross-up in the GILTI basket. Fortunately, one of the longstanding canons of statutory construction is that, where a statute lends itself to more than one interpretation; an interpretation that would produce an absurd result is to be avoided because it is unreasonable to believe that a legislature intended such a result. [2]

Alvarez & Marsal Taxand Says:

As U.S. companies continue to model the effects of GILTI and foreign tax credit usage on their existing structures, they should be aware of the potential tax impact should the Section 78 Gross-Up on GILTI be allocated to the general limitation basket. Discussion regarding whether a technical correction or regulatory guidance will be issued to clarify this issue remains prevalent. Even absent such a legislative or regulatory fix, we believe the existing statutory language can and should be interpreted to put the Section 78 Gross-Up on GILTI in the GILTI basket. Reach out to us for the explanation of our verdict on this issue (i.e. for further detail of our alternative interpretation of the relevant statutory language) and to discuss its impact on your fact pattern.


[1] Taxpayers subject to both Base Erosion Anti-Abuse Tax (BEAT) and GILTI should note that additional foreign tax credits taken against GILTI tax liability will, in turn, increase BEAT tax liability dollar for dollar, resulting in a neutral effect.

[2] See, e.g., Church of the Holy Trinity v. United States, 143 U.S. 457, 459 (1892).

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