Internal Revenue Service Notice 2023-80 (hereinafter “the notice”) provides the US government’s view on the foreign tax credit treatment of Pillar Two top-up taxes and makes a clear distinction between qualified domestic minimum top-up tax (QDMTT) and the extra-jurisdictional top-up taxes imposed by an income inclusion regime (IIR) and the backstop undertaxed profits rule (UTPR). The notice also raises the question of whether foreign losses taken into account in determining a jurisdictional effective tax rate (ETR) should be treated as “foreign use” under the dual consolidated loss (DCL) provisions. If so, the loss in question is ineligible for DCL certification that there has been no “foreign use” of the loss, with the result that the loss is disallowed for US tax purposes.
In preparing this article, we surveyed what other commenters had to say about the notice. In total eleven comment letters were filed. View all comments at www.regulations.gov/docket/IRS-2023-0060/comments.
This article focuses on the interplay between Pillar Two top-up taxes and the US international tax regime—specifically the proposed noncreditability of so-called “final top-up taxes.” An important consideration when coordinating these rules is the potential for computational circularity. Computational circularity may occur because the allowance of a foreign tax credit impacts the US tax cost of a global intangible low-taxed income (GILTI) inclusion, and the net GILTI tax cost is a covered tax under Pillar Two.
GloBE Meets GILTI and Potential Computational Circularity
The potential for computational circularity between the Pillar Two charging provisions and controlled foreign corporation (CFC) regimes, including the GILTI provisions, arises because any US tax on GILTI is included in the determination of the jurisdictional effective tax rate for Pillar Two purposes, and foreign income taxes imposed on CFCs are generally creditable against US income taxes. Therefore, if Pillar Two top-up taxes reduce the US GILTI tax cost, and the net GILTI tax cost reduces Pillar Two top-up taxes, then the potential for circularity results.
Recognizing this, the Organisation for Economic Co-operation and Development (OECD) suggested that top-up taxes imposed under an IIR or UTPR ought not to be creditable under a domestic tax regime, as stated below:
It is intended that the GloBE [Global Anti-Base Erosion] Rules apply after the application of the Subject to Tax Rule and domestic tax regimes, including regimes for the taxation of PEs or CFCs. Therefore, to preserve the intended rule order, domestic tax regimes should not provide a foreign tax credit for any tax imposed under a Qualified UTPR or IIR which is implemented in a foreign jurisdiction, otherwise the application of that domestic tax regime would create circularity issues since those taxes have already been determined prior to applying the Qualified UTPR or IIR.1
Note that the OECD specifically refers to IIRs and UTPRs, which are outside of domestic tax regimes. In contrast, QDMTTs are specifically “domestic” in their application and result. Practitioners have therefore generally believed that QDMTTs would be creditable for US purposes and should be treated the same as any other jurisdictional foreign income tax.
Following the OECD guidance and disallowing US foreign tax credits for the extra-jurisdictional IIR and UTPR taxes would resolve the circularity. But the notice disrupts this solution to circularity by introducing a Section 78 gross-up (that is, incremental taxable income) for the final top-up tax. Noncreditable income taxes such as soak-up taxes and subsidies have existed for decades and have not, to our knowledge, been previously treated as income items under Section 78. The result is a different variation on circularity: tax is imposed under an IIR, which increases US taxable income via gross-up, which increases US tax, which diminishes the amount of the IIR liability, which reduces US taxable income, and so on.
Treatment of QDMTTs Under the Notice
Based on the OECD definition, a tax meets the criteria of QDMTT if it:
- determines the excess profits of the constituent entities located in the jurisdiction (domestic excess profits) in a manner that is equivalent to the GloBE rules;
- operates to increase domestic tax liability with respect to domestic excess profits to the minimum rate for the jurisdiction and constituent entities for a fiscal year; and
- is implemented and administered in a way that is consistent with the outcomes provided for under the GloBE rules and the commentary, provided that such jurisdiction does not provide any benefits related to such rules.
There is no cross-border aspect to a QDMTT, and, as a result, such a tax is effectively scoped out of the various special rules that the IRS proposed in the notice. Many of the eleven commenters on the notice requested clarification of this point, and it likely could have been stated more directly.
We believe QDMTTs are generally treated the same as any other jurisdictional income tax and are considered to impact US taxation in the following ways: 1) in determining the effective tax rate for purposes of the subpart F and GILTI high-tax exceptions, 2) by reducing earnings and profits, and 3) by being generally creditable for foreign tax credit purposes.
At a fifteen percent tax rate, QDMTTs should not give rise to circularity because the CFC allocation key threshold for GILTI is set at 13.125 percent. GILTI tested units are measured at the jurisdictional level within a CFC and if the Pillar Two jurisdictional ETR is fifteen percent, it is unlikely that the GILTI tested income ETR would be less than 13.125 percent. Therefore, it is relatively safe to assume that any jurisdiction with a QDMTT would not benefit from GILTI pushdown and would not be subject to an extra-jurisdictional top-up tax under the IIR or UTPR. However, due to differences in the computational base, exceptions may result.
Final Top-Up Extra-Jurisdictional Taxes Under the Notice
The notice defines a “final top-up tax” in this way. A foreign income tax (tested tax) is a final top-up tax if, in computing the tested tax, the foreign tax law takes into account:
- the amount of tax imposed on the direct or indirect owners of the entity subject to the tested tax by other countries (including the United States) with respect to the income subject to the tested tax; or
- in the case of an entity subject to the tested tax on income attributable to its branch in the foreign country imposing the tested tax, the amount of tax imposed on the entity by its country of residence with respect to such income.
Each of these criteria involves someone looking across an international border for tax liabilities that ought to be considered in measuring ETR on the other side. Although the drafters of the notice did not use the term “GILTI pushdown,” there is little doubt that the US tax on GILTI of US CFCs is the focus, and so we refer to it as GILTI pushdown in this article.
Under the notice, a foreign law that permits GILTI pushdown in determining ETR is a “final top-up tax.” In contrast, a foreign law that does not permit GILTI pushdown in determining ETR is not a final top-up tax. An example in the notice posits a foreign law that permits GILTI pushdown for a majority shareholder but does not permit it for a minority shareholder of the same entity. Under the logic of the notice, the same foreign law can generate both a final top-up tax and a nonfinal top-up tax. We are not aware that such a law actually exists. The fact that the OECD issued guidance declaring that implementing jurisdictions should permit GILTI pushdown suggests that the universe of “no-GILTI-pushdown” situations will be small.
There is a very significant US consequence to a tax being final or nonfinal. Final top-up taxes are not creditable under the notice, whereas nonfinal top-up taxes are creditable. In our understanding of the Section 901 rules that define creditability, foreign law (and the intention of a foreign government) is highly significant in determining creditability. Some foreign governments can enact laws that the US considers “off-side,” such as soak-up taxes and giving subsidies in exchange for taxes. Aside from the circularity issue, we do not find it obvious why allowing GILTI pushdown would be considered off-side. Apparently, the drafters of the notice wanted to allow foreign tax creditability for minority shareholders outside of the multinational entity group.
A final top-up tax that considers the GILTI pushdown would be circular if the United States allows a foreign tax credit against the GILTI inclusion. But a foreign tax credit against another foreign tax credit basket would not be circular. In such a case, foreign tax credit relief for final top-up taxes may be achieved without resulting in circularity.
Making the calculation “linear” through ordering was the OECD’s solution to circularity. In isolation, denying the credit for final top-up taxes would achieve a parallel result. However, the decision of the drafters to treat final top-up taxes as income under Section 78 adds its own issues of circularity. For example, if the Section 78 gross-up is allocable to tested income, it may be subject to a Section 250 deduction reducing the net GILTI tax cost and GILTI FTC. Also, the inclusion of the additional Section 78 gross income may have an indirect effect on the net GILTI tax cost by changing the gross income base used for apportioning deductions under Treasury Regulation 1.861-8.
One commenter raised the issue of “circularity” as follows:
It is our understanding, based on both the text of the Notice and public statements made by the Treasury and IRS officials, that the rationale for denying a foreign tax credit for final top-up taxes is to avoid situations in which the determination of the amount of tax to be paid becomes “circular” (i.e., the amount of the tax to be paid to the United States under the subpart F or GILTI regime depends in part on the amount of tax to be paid under an IIR, but the amount of tax paid under the IIR depends in part on the amount of tax paid under the US subpart F or GILTI regime).
One way or another, potential circularity should be eliminated. Either 1) follow the OECD’s suggested ordering construct, with the result that the US return is finalized before liability is determined for any IIR or UTPR or 2) complete the US return, calculate IIR and UTPR on that basis, and declare those liabilities to be final. Then the US return would be adjusted, allowing both credits and Section 78 for any IIR or UTPR liabilities. Either way, someone must “go last.” In either case, the entity paying the final top-up tax should deduct that amount from its earnings and profits as a year-end adjustment.
Mark Gasbarra, CPA, is national managing director, and David Merrick, JD, LLM, is of counsel at Forte International Tax LLC.
Endnotes
- OECD (2022), Tax Challenges Arising from the Digitalisation of the Economy—Commentary to the Global Anti-Base Erosion Model Rules (Pillar Two), OECD, Paris, www.oecd.org/tax/beps/tax-challenges-arising-from-the-digitalisation-of-the-economy-global-anti-base-erosion-model-rules-pillar-two-commentary.pdf.
