The GILTI High-Tax Exception: Is it a Viable Planning Option?
- The IRS issued the Global Intangible Low-Taxed Income (GILTI) high-tax exclusion final regulations on July 20, 2020.
- A U.S. shareholder of a controlled foreign corporation (CFC) can exclude from its GILTI inclusion items of a CFC's gross tested income if the CFC's effective foreign rate on the GILTI gross tested income exceeds 18.9 percent and the U.S. shareholder elects for that year to exclude the high-taxed income.
- A corporate U.S. shareholder can repatriate the excluded income tax-free, while an individual U.S. shareholder can repatriate the excluded income at ordinary income tax rates (37 percent maximum rate or at the qualified dividend rate of 20 percent if the CFC is treaty protected).
- Whether the election is advantageous will require a careful review of the taxpayer's circumstances and tax modeling.
The Global Intangible Low-Taxed Income (GILTI) provisions were enacted as part of the 2017 Tax Cuts and Jobs Act (TCJA). Under the GILTI provisions, a U.S. shareholder essentially is taxed on the active earnings of a controlled foreign corporation (CFC), which, under pre-TCJA law, would have been tax-deferred.1
By way of background, GILTI functions as an anti-base erosion, minimum tax provision intended to discourage multinational corporations (MNCs) from using intangible property (IP) to shift profits out of the U.S.2 Depending on the circumstances, the minimum tax rate (inclusive of U.S. and foreign tax rates) of a MNC on GILTI earnings, ranges from 10.50 percent to 13.125 percent.3
GILTI, however, is not limited to low-taxed income and encompasses income subject to foreign tax rates in excess of 13.125 percent. As a result, double taxation can arise because of the GILTI foreign tax credit (FTC) limitations4 and the absence of a statutory high-tax exception comparable to that contained in the Subpart F provisions (under Section 954(b)(4)). As a result, taxpayers lobbied the U.S. Department of the Treasury and IRS to provide a regulatory high-tax exception.5
The Treasury Department and IRS issued proposed regulations in 2019, which provided a GILTI high-tax exception, as follows:
- The high-tax exception was elective by a CFC's controlling domestic shareholders, binding on all U.S. shareholders of the CFC, and once made or revoked, could not be changed for a 60-month period.
- The high-tax exception applied only if the foreign tax rate was in excess of 18.9 percent (i.e., in excess of 90 percent of the highest U.S. corporate tax rate, which is 21 percent).
- Foreign tax rates were determined separately with respect to each qualified business unit (QBU) of a CFC to foreclose blending of high-taxed and low-taxed income, and could not be applied on a CFC-by-CFC basis.
- The elective high-tax exception was intended to be effective prospectively, for a CFC's tax years beginning on or after the rules were adopted as final regulations.
The IRS issued the GILTI high-tax exclusion final regulations on July 20, 2020, which were published on July 23, 2020, in the Federal Register. Among the key points are:
- Election: Now on an annual basis; 60-month rule dropped.
- Election made on tax return or on amended return by attaching a statement.
- All or nothing approach: Election applies on a consistent basis to all CFCs owned by same domestic controlling U.S. shareholders (more than 50 percent) and to all of a CFC's U.S. shareholders (here, controlling U.S. shareholder notifies non-controlling U.S. shareholders).
- Final regulations did not adopt a CFC-by-CFC approach.
- High tax: foreign tax rate in excess of 18.9 percent rate retained.
- Treasury Department and IRS rejected taxpayers' suggestions to utilize 13.125 percent rate.
- Determination: Now based on "Tested Unit" rather than QBU-by-QBU basis.
- Based on books and records, and gross income determined under federal income tax principles with certain adjustments to reflect disregarded payments, which serves as a reasonable proxy for determining the amount of gross income that the foreign country of the tested unit is likely subject to tax.
- Tested Unit includes 1) a CFC; 2) interest in a pass-through entity (not treated as fiscally transparent under foreign law) held by a CFC; and 3) certain branches of a CFC.
- All tested units of a CFC located or resident in same country are required to be combined as a single tested unit.
- Generally applies to extent an entity is subject to tax in foreign country and in the Treasury Department and IRS view is more targeted than QBU approach.
- Determinations will be complex.
- Effective date:
- Tax years of foreign corporations beginning on or after July 23, 2020, and for tax years of U.S. shareholders in which, or with which, such tax years of foreign corporations end.
- Taxpayers may elect to apply the final regulations retroactively for tax years beginning after Dec. 31, 2017, and before July 23, 2020, provided certain consistency requirements satisfied.
- Unitary Approach for GILTI and Subpart F: Proposed regulations will require that a single high-tax exception to be applied for purposes of the GILTI and Subpart F regimes6 so as to prevent potentially abusive tax planning and to reduce complexity.
- Effective Date: Proposed to apply to taxable years of a foreign corporation ending on or after July 20, 2020.
- The high-tax exception is another planning tool.
- Taxpayers must closely evaluate whether the GILTI high-tax exception is useful; this generally will require tax modeling.
- If a taxpayer elects the high-tax election, U.S. shareholder no longer can utilize qualified business asset investment (QBAI) or FTCs as GILTI gross income is excluded from gross income.
- For MNCs, excluded income generally should be able to be repatriated tax-free under the dividends received deduction provision.
- For individual shareholders, excluded income is U.S. tax deferred until repatriated. When repatriated, U.S. individual shareholders would be subject to ordinary income taxation up to a maximum rate of 37 percent or reduced qualified dividend 20 percent rate, if CFC were treaty eligible.
- In addition, Net Investment Income Tax imposed at a 3.8 percent rate could apply to high-earner taxpayers.
- Individual shareholders need to evaluate whether a high-tax kick-out election is more beneficial compared to planning under Section 962, use of a domestic corporation (if available and can avoid domestic penalty tax rules) or check-the-box planning where the shareholders elects to treat the CFC as transparent and income and FTCs of the CFC pass through to the shareholders.
For more information on the GILTI high-tax exception, contact the authors.
1 In simple terms, under the GILTI, a U.S. shareholder is taxed on a CFC's earnings that exceed a 10 percent return on invested foreign assets, referred to as QBAI (qualified business asset investment). GILTI excludes limited categories of a CFC's income, to include Subpart F income, foreign oil and gas income, U.S. effectively connected income, high-taxed income excluded from foreign-based company income, and certain dividends received from related persons.
2 GILTI applies not only to MNCs, but closely held corporations as well as individuals as well as other noncorporate U.S. persons owning CFCs.
3 A corporate U.S. shareholder can claim a 50 percent deduction (for tax years through 2025) for any GILTI inclusion, subject to a taxable income limitation, which results in a corporate U.S. shareholder paying an effective federal income tax rate of 10.5 percent on its GILTI inclusion, prior to claiming foreign tax credits. Further, corporate U.S. shareholders may claim an indirect foreign tax credit for 80 percent of the foreign tax paid by their CFC(s) allocable to GILTI income. Thus, if GILTI earnings were subject to a 13.125 percent or higher foreign tax rate, a corporate U.S. shareholder would have no residual U.S. corporate income tax, assuming no allocation or apportionment of expenses.
4 80 percent use of FTCs, separate limitation basket and no carryback or carry forward.
5 To be consistent with the statute, the final GILTI regulations issued on June 21, 2019, provided that the exclusion of high-taxed income from tested income under the GILTI rules applies only with respect to income that otherwise would have been taxed as Subpart F income solely but for the application of the high-tax exception to Subpart F income under Section 954(b)(4).
6 Note, under the current Subpart F high-tax exception, the effective tax rate is determined at the CFC level separately for separate items of Subpart F income. Going forward, the Subpart F high-tax exception will apply on a tested unit basis and can only be made on a "unitary" basis; i.e., both for Subpart F and GILTI purposes.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.