Should Companies Plan Into Subpart F Following the TCJA?

Following the enactment of the U.S. Tax Cuts and Jobs Act (TCJA), U.S. multinational companies (MNCs) now face a new anti-deferral provision in the form of global intangible low-taxed income (GILTI). GILTI is an additional category of income, which is taxed on a current basis to U.S. shareholders of controlled foreign corporations (CFCs), even though the income is not distributed.

Depending on the facts, it may be advantageous for a corporate U.S. shareholder to have Subpart F income instead of GILTI. This is especially true for banking and other financial companies, which have a higher interest expense than other industries, leading to a higher GILTI inclusion. The allocation of expenses under Section 861 can reduce the taxpayer’s foreign tax credit (FTC) limitation, leading to a higher U.S. residual tax. Finally, excess credits associated with GILTI cannot be carried forward or back.

Subpart F

In general, U.S. shareholders of CFCs must include in gross income their pro rata share of the CFC’s Subpart F income for the taxable year.¹ U.S. shareholders are U.S. persons that own (or are considered to own under attribution rules) at least ten percent of the total combined voting power or at least ten percent of the total value of shares in the CFC.²  Following the enactment of the TCJA, a corporate U.S. shareholder’s Subpart F income is subject to current tax at twenty-one percent minus applicable FTCs.³

Subpart F income includes a CFC’s foreign base company income (FBCI),⁴ which is the sum of its foreign personal holding company income,⁵ foreign base company sales income, and foreign base company services income. A U.S. shareholder’s Subpart F FTCs are generally placed into either the general limitation basket or the passive limitation basket.⁶ In general, passive income includes dividends, interest, and royalties. Foreign taxes paid or accrued that exceed the FTC limitation⁷ are carried back to the first preceding taxable year and forward to the first ten succeeding taxable years.⁸

An exception to FBCI arises when a CFC’s income was subject to an effective rate of income tax imposed by a foreign country that is greater than ninety percent of the U.S. corporate tax rate (i.e., the high-tax exception).⁹ Therefore, with a U.S. corporate tax rate of twenty-one percent, a CFC’s income that is subject to a foreign effective income tax rate greater than 18.9 percent is not subject to the Subpart F rules.

GILTI

On October 10, 2018, the Federal Register published proposed GILTI regulations under Section 951A.¹⁰ The TCJA requires U.S. shareholders of CFCs to include GILTI in their gross income.¹¹ In general, GILTI impacts U.S. shareholders of CFCs that have large offshore intangible assets. Based on the GILTI calculation, U.S. shareholders could be subject to a minimum residual U.S. tax on their CFC’s active foreign earnings.

GILTI is the excess of a U.S. shareholder’s net CFC tested income across all CFCs for the taxable year over its net deemed tangible income return for that taxable year.¹² The net deemed tangible income return is defined as the excess of “10 percent of the aggregate of such shareholder’s pro rata share of the qualified business asset investment [QBAI] of each controlled foreign corporation … over the amount of interest expense….”¹³ In calculating GILTI, a CFC’s tested income is its gross income without regard to Subpart F income or amounts excluded from Subpart F under the high-tax exception¹⁴ and certain other income.

Domestic corporations are allowed a fifty percent deduction on GILTI.¹⁵ In addition, corporate U.S. shareholders are allowed a deemed paid FTC of eighty percent (i.e., the U.S. corporation shall be deemed to have paid foreign income taxes equal to eighty percent of the product of the corporation’s inclusion percentage multiplied by the aggregate tested foreign income taxes paid or accrued by CFCs).¹⁶

On November 28, 2018, the Internal Revenue Service and Treasury released proposed FTC regulations (hereafter Prop FTC Regs)¹⁷ providing guidance on the application of the FTC rules following the enactment of the TCJA. The Prop FTC Regs include guidance on the expense allocation rules and their effect on the FTC limitation with respect to GILTI. The guidance also includes information on FTC carryovers under Section 904(c) and the Section 78 gross-up for deemed paid taxes under Section 960.

The TCJA created a new FTC basket for foreign taxes associated with GILTI.¹⁸ Unlike excess credits for Subpart F income, GILTI credits cannot be carried forward or back.¹⁹ However, foreign taxes paid or accrued on passive category income that was included in gross income under Section 951A should be in the passive limitation basket.²⁰

According to the Prop FTC Regs, the IRS and Treasury have received comments that a U.S. shareholder’s income derived through a CFC should be exempt from U.S. tax on GILTI if the foreign effective tax rate is at least 13.125 percent. The IRS and Treasury emphasize that the FTC and expense allocation provisions are not consistent with these comments, as these provisions may reduce the amount of taxes that may be credited without regard to the CFC’s foreign effective tax rate. For instance, allocated expenses may reduce the GILTI inclusion below the amount of the foreign base on which the CFC paid at least a 13.125 percent foreign effective tax rate. As a result, the U.S. shareholder’s foreign taxes deemed paid may exceed the pre-credit U.S. tax on its Section 951A category income, resulting in excess credits that may not offset U.S. tax on other income. In addition, Congress did not amend provisions limiting the availability of FTCs or reducing the FTC limitation for GILTI based on U.S. or foreign losses in other separate categories or losses in other years.

Section 951A applies to taxable years of foreign corporations beginning after December 31, 2017. Section 1.904-2(j)(1)(ii) of the proposed regulations provides that if unused foreign taxes paid or accrued or deemed paid with respect to a separate category of income are carried forward to a taxable year beginning after December 31, 2017, those taxes are allocated to the same post-2017 separate category as the pre-2018 separate category from which the unused foreign taxes are carried.

However, it is not possible to reconstruct the amount of unused foreign taxes in a pre-2018 taxable year that would have been assigned to Section 951A category income. Therefore, the Prop FTC Regs do not require or allow taxpayers to assign any unused foreign taxes to the post-2017 separate category for Section 951A category income, which cannot be sheltered from U.S. tax by FTC carryovers.²¹ In addition, the Prop FTC Regs amend Section 1.904-2(a) of the Treasury Regulations to reflect the exclusion of FTC carryovers under Section 904(c) for foreign taxes paid or accrued with respect to Section 951A category income.

Finally, Section 1.904-4(o) of the Prop FTC Regs provides a rule consistent with existing Section 1.904-6(b)(3) of the Treasury Regulations, which assigns the Section 78 gross-up to the same separate category as the deemed paid taxes.

Conclusion

Before the TCJA, U.S. MNCs structured their operations to plan around Subpart F. With the introduction of GILTI, MNCs are going back to the drawing board and are modeling out their tax liability for GILTI and Subpart F. For some taxpayers, it may make sense to “plan into Subpart F,” because, although the income is currently taxed at twenty-one percent, they can use excess FTCs, but credits associated with GILTI will be lost if not used in the current year.

Although it is technically possible for MNCs to reduce their residual U.S. tax on GILTI to zero in situations where the foreign tax rate is at least 13.125 percent (as opposed to greater than 18.9 percent to qualify for the high-tax exception under Subpart F), there is no guarantee. Since a higher interest expense can result in a higher GILTI inclusion for the taxpayer, banking and other financial companies are at a disadvantage. Furthermore, expenses allocated to foreign-source income would reduce the FTC limitation, and the taxpayer will not be able to carry over any excess credits.

Jessica Silbering-Meyer is managing editor, international tax, in the tax and accounting business at Thomson Reuters.

Endnotes

1. Section 951(a).
2. Section 951(b).
3. An individual U.S. shareholder can make a 962 election for the taxable year to have its Subpart F income taxed at the corporate rate (i.e., twenty-one percent).
4. Section 952(a)(2); Section 954(a).
5. Section 904(d)(2)(B)(i); Section 954(c).
6. Section 904(d)(1).
7. Section 904(a).
8. Section 904(c). See also Prop Reg Section 1.904-2(b).
9. Section 954(b)(4).
10. “Guidance Related to Section 951A (Global Intangible Low-Taxed Income), a Proposed Rule by the Internal Revenue Service,” Federal Register (October 10, 2018), www.federalregister.gov/documents/2018/10/10/2018-20304/guidance-related-to-section-951a-global-intangible-low-taxed-income.
11. Section 951A.
12. Section 951A(b)(1).
13. Section 951A(b)(2).
14. Section 951A(c)(2); Section 954(b)(4).
15. Section 250.
16. Section 960(d)(1).
17. Available at www.irs.gov/pub/irs-drop/reg-105600-18.pdf.
18. Section 904(d)(1)(A).
19. Section 904(c).
20. Section 904(d)(1)(A).
21. See Section 904(c).