Proposed regs explain & clarify new global intangible low-taxed income (GILTI) regime

Preamble to Prop Reg REG-104390-18; Prop Reg § 1.951A-1, Prop Reg § 1.951A-2, Prop Reg § 1.951A-3, Prop Reg § 1.951A-4,  Prop Reg § 1.951A-5, Prop Reg § 1.951A-6

Proposed Regs, Guidance Related to Section 951A (GILTI)

IRS has issued proposed regs on the new global intangible low-taxed income (GILTI) regime enacted as part of the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017). This article provides a background on GILTI and covers definitions, guidance on how various income items are determined at the controlled foreign corporation (CFC) level, rules for determining the U.S. shareholder’s pro rata share of these CFC-level items, and aggregation rules for determining the shareholder’s GILTI inclusion amount set out in the proposed regs.

For coverage of the proposed regs on the application of the GILTI rules to consolidated groups, see here.

Background.  The TCJA established a “participation exemption system” under which certain earnings of a foreign corporation can be repatriated to a corporate U.S. shareholder without U.S. tax. (Code Sec. 245A) The TCJA also added Code Sec. 951A—effectively, a base protection measure that subjects GILTI earned by a CFC to U.S. tax on a current basis, similar to the treatment of a CFC’s subpart F income under Code Sec. 951(a)(1)(A).

Specifically, under Code Sec. 951A(a), a U.S. shareholder of any CFC for a tax year must include in gross income its GILTI for that year. A GILTI inclusion is treated in a manner similar to a Code Sec. 951(a)(1)(A) inclusion of a CFC’s subpart F income for many purposes of the Code, but a GILTI inclusion is determined in a fundamentally different way.

The determination of a U.S. shareholder’s GILTI inclusion amount begins with the calculation of certain items of each CFC owned by the shareholder, such as tested income, tested loss, and qualified business asset investment (QBAI). Under Code Sec. 951A(e)(1), the U.S. shareholder then determines its pro rata share of each of these CFC-level items in a manner similar to a shareholder’s pro rata share of subpart F income under Code Sec. 951(a)(2), except that the U.S. shareholder’s pro rata shares of these items are not amounts included in gross income, but rather amounts taken into account by the shareholder in determining the GILTI included in the shareholder’s gross income.

The U.S. shareholder aggregates (and then nets or multiplies) its pro rata share of each of these items into a single shareholder-level amount.The ultimate GILTI inclusion amount is the excess (if any) of: (A) the shareholder’s net CFC tested income for the tax year, over (B) the shareholder’s net deemed tangible income return (net DTIR) for the tax year. (Code Sec. 951A(b))

A U.S. shareholder does not compute a separate GILTI inclusion amount with respect to each CFC for a tax year, but rather computes a single GILTI inclusion amount by reference to all its CFCs. (Code Sec. 951A(f)(2)) Because a U.S. shareholder’s GILTI inclusion amount is determined based on the relevant items of all the CFCs of which it is a U.S. shareholder, the effect of the provision is generally to ensure that a U.S. shareholder is taxed on its GILTI wherever (and through whichever CFC) derived.

General rules and definitions. The proposed regs provide the following definitions:

• . . . “GILTI inclusion amount” means, with respect to a U.S. shareholder and a U.S. shareholder inclusion year, the excess (if any) of (i) the shareholder’s net CFC tested income (as defined below) for the year, over (ii) the shareholder’s net DTIR (below) for the year. (Prop Reg § 1.951A-1(c)(1))
• . . . “Net CFC tested income” means the excess (if any) of (i) the aggregate of the shareholder’s pro rata share of the tested income of each tested income CFC (below) for the year, over (ii) the aggregate of the shareholder’s pro rata share of the tested loss of each tested loss CFC (below) for the year.  (Prop Reg § 1.951A-1(c)(2))
• . . . “Net DTIR” means, with respect to a U.S. shareholder and a U.S. shareholder inclusion year, the excess (if any) of (A) the shareholder’s DTIR (i.e., 10% of the aggregate of the shareholder’s pro rata share of the QBAI of each tested income CFC for the year) for the year, over (B) the shareholder’s “specified interest expense” (below) for the year.  (Prop Reg § 1.951A-1(c)(3)(i)) As described above, Net DTIR offsets the shareholder’s CFC tested income for purposes of determining the shareholder’s GILTI inclusion amount.
• . . . “Specified interest expense” means the excess (if any) of (A) The aggregate of the shareholder’s pro rata share of the tested interest expense (as defined in Prop Reg § 1.951A-4(b)(1)) of each CFC for the year, over (B) The aggregate of the shareholder’s pro rata share of the tested interest income (below) of each CFC for the year. (Prop Reg § 1.951A-1(c)(3)(iii))
• . . . A “CFC inclusion year” means any tax year of the CFC beginning after Dec. 31, 2017 for a foreign corporation that is a CFC. (Prop Reg § 1.951A-1(e)(2))
• . . . “Section 958(a) stock” is stock of a CFC owned, directly or indirectly, by a U.S. shareholder within the meaning of Code Sec. 958(a). (Prop Reg § 1.951A-1(e)(3))
• . . . “U.S. shareholder inclusion year” means a tax year of a U.S. shareholder that includes a CFC inclusion date (i.e., the last day of a CFC inclusion year on which a foreign corporation is a CFC) of a CFC of the U.S. shareholder. (Prop Reg § 1.951A-1(e)(4))
• . . . “Tested income” means the excess (if any) of a CFC’s gross tested income for a CFC inclusion year, over the allowable deductions (including taxes) properly allocable to the gross tested income for the CFC inclusion year. A CFC with tested income for a CFC inclusion year is a “tested income CFC.” (Prop Reg § 1.951A-2(b)(1))
• . . . “Tested loss” means the excess (if any) of a CFC’s allowable deductions (including taxes) properly allocable to gross tested income (or that would be allocable to gross tested income if there were gross tested income) for a CFC inclusion year, over the gross tested income of the CFC for the CFC inclusion year. A CFC without tested income for a CFC inclusion yearis a “tested loss CFC.”  (Prop Reg § 1.951A-2(b)(2))
• . . . QBAI means the average of a tested income CFC’s aggregate adjusted bases as of the close of each quarter of a CFC inclusion year in specified tangible property (below) that is used in a trade or business of the tested income CFC and is of a type with respect to which a deduction is allowable under Code Sec. 167.
• . . . “Specified tangible property” means, in general, tangible property (generally, property eligible for depreciation) used in the production of gross tested income (not including tangible property of a tested loss CFC). Special allocation rules apply to “dual use property” used for the production of both gross tested income and gross income that is not gross tested income in a CFC inclusion year. (Prop Reg § 1.951A-3(c), Prop Reg § 1.951A-3(d))
• . . . “Tested interest expense” means interest expense (i.e., any expense or loss that is interest in the general sense, e.g., consideration for the time value of money in a loan, or that is treated as interest expense under the Code or regs) paid or accrued by a CFC, taken into account in determining the CFC’s tested income or tested loss for the CFC inclusion year, reduced by the qualified interest expense of the CFC. (Prop Reg § 1.951A-4(b)(1)(i))
• . . . “Qualified interest expense” means the interest expense paid or accrued by a qualified CFC (i.e., an eligible CFC under Code Sec. 954(h)(2) or qualifying insurance company under Code Sec. 953(e)(3)), taken into account in determining the tested income or tested loss of the qualified CFC for the CFC inclusion year, with certain adjustments.  (Prop Reg § 1.951A-4(b)(1)(iii))
• . . . “Tested interest income” means interest income included in the gross tested income of a CFC for the CFC inclusion year reduced by its qualified interest income. (Prop Reg § 1.951A-4(b)(2)(i)) “Interest income” means income from interest in a general sense (see above) or treated as such under the Code or regs. (Prop Reg § 1.951-4(b)(2)(ii))
• . . . “Qualified interest income” means interest income of a qualified CFC included in its gross tested income for the CFC inclusion year that is excluded from personal holding company income under Code Sec. 954(h) or Code Sec. 954(i). (Prop Reg § 1.951-4(b)(2)(iii))

“Pro rata share.”  For purposes of determining a U.S. shareholder’s GILTI inclusion amount, the proposed regs would generally incorporate the  pro rata share rules of Code Sec. 951(a)(2) and Reg. §1.951-1(b) and Reg. §1.951-1(e), with appropriate modifications. Thus,a U.S. shareholder’s pro rata share of any CFC item necessary for calculating its GILTI inclusion amount would be determined by reference to the Section 958(a) stock such shareholder owns as of the close of the CFC’s tax year, including Section 958(a) stock treated as owned by the U.S. shareholder through a domestic partnership under Prop Reg §1.951A-5(c). (Prop Reg § 1.951A-1(d)(1))

A U.S. shareholder’s pro rata share of tested income would also generally be determined in the same manner as its pro rata share of subpart F income under Code Sec. 951(a)(2) and Reg. § 1.951-1(b) and Reg. § 1.951-1(e) (that is, based on the relative amount that would be received by the shareholder in a year-end hypothetical distribution of all the CFC’s current year earnings). (Prop Reg §1.951A-1(d)(2)(i))

For purposes of determining a U.S. shareholder’s pro rata share of a CFC’s QBAI, the amount of QBAI distributed in the hypothetical distribution of Code Sec. 951(a)(2)(A) and Reg. § 1.951-1(e) would be generally proportionate to the amount of the CFC’s tested income distributed in the hypothetical distribution. (Prop Reg §1.951A-1(d)(3)(i)) However, Prop Reg § 1.951A-1(d)(3)(ii) provides a “cap,” such that if a CFC’s QBAI exceeds 10 times its tested income, so that the amount of QBAI allocated to preferred stock would exceed 10 times the tested income allocated to the preferred stock under the general proportionate allocation rule, the excess amount of QBAI would be allocated solely to the CFC’s common stock.

In determining a U.S. shareholder’s pro rata share of a CFC’s tested loss, the amount distributed in the hypothetical distribution would be the amount of the tested loss, rather than the CFC’s current earnings and profits, and the tested loss would generally be distributed solely with respect to the CFC’s common stock. (Prop Reg §1.951A-1(d)(4)) Special rules would apply in certain situations, such as dividend arrearages made with respect to preferred and common stock with no liquidation value.

A shareholder’s pro rata share of a CFC’s tested interest expense for a tax year would equal the amount by which the CFC’s tested interest expense reduces the shareholder’s pro rata share of tested income, increases the shareholder’s pro rata share of tested loss, or both. Conversely, a U.S. shareholder’s pro rata share of tested interest income for a tax year equals the amount by which the CFC’s tested interest income increases the shareholder’s pro rata share of tested income, reduces the shareholder’s pro rata share of tested loss, or both. (Preamble)

Foreign currency rules.  Because GILTI is computed at the U.S. shareholder level, the tested income, tested loss, tested interest expense, tested interest income, and QBAI of a CFC that uses a functional currency other than the U.S. dollar must be translated into U.S. dollars. Prop Reg § 1.951A-1(d)(1) would generally prescribe the same translation rule that is used for subpart F income for translating a pro rata share of tested income, tested loss, tested interest expense, tested interest income, and QBAI. Similarly, a U.S. shareholder’s GILTI inclusion amount that is allocated to a tested income CFC under Code Sec. 951A(f)(2) would be translated from U.S. dollars into the CFC’s functional currency using the average exchange rate for the tax year of the tested income CFC. (Prop Reg §1.951A-6(b)(2)(iii))

Determining tested income & loss.  Under Code Sec. 951A(c)(2), tested income and tested loss are determined by beginning with a CFC’s gross income, with certain adjustments. The proposed regs would generally provide that  the determinations of gross income and allowable deductions for GILTI should be made in a manner similar to the determination of subpart F income. Accordingly, Prop Reg § 1.951A-2(c)(2) would require that the gross income and allowable deduction determinations are made under the rules of Reg. §1.952-2.

For GILTI purposes,  gross income of the CFC for the tax year is determined without regard to certain items, including gross income excluded from foreign base company income (under Code Sec. 954) or insurance income (under Code Sec. 953) of the CFC by reason of electing the Code Sec. 954(b)(4) “high-tax exception.” The proposed regs clarify that this exclusion does not apply to income that would not otherwise be subpart F income or to categories of income that do not constitute subpart F income due to exceptions other than the high-tax exception.

Another item excluded from gross tested income is gross income taken into account in determining a corporation’s subpart F income. In response to requests for guidance on the interaction between the Code Sec. 952(c) limitations on subpart F income and the determination of gross tested income under Code Sec. 951A, Prop Reg § 1.951A-2(c)(4) clarifies that tested income and allowable deductions would be determined without regard to the application of Code Sec. 952(c).

Prop Reg § 1.951A-2(c) further states that, in determining tested income and tested loss, which Code Sec. 951A(c)(2)(A)(ii) provides is done “under rules similar” to Code Sec. 954(b)(5), allowable deductions determined under Reg. § 1.952-2 would be allocated and apportioned to gross tested income under the principles of Code Sec. 954(b)(5) and Reg. § 1.954-1(c).

Determining QBAI.  Under Prop Reg § 1.951A-3(b),a tested income CFC’s QBAI for any tax year would be the average of the CFC’s aggregate adjusted bases as of the close of each quarter in specified tangible property that is used in a trade or business of the corporation and which is depreciable. In general, the adjusted basis for this purpose would be determined  by using the alternative depreciation system under Code Sec. 168(g) (ADS) and allocating the depreciation deduction with respect to the property ratably to each day during the period in the tax year to which the depreciation relates. (Prop Reg § 1.951A-3(e)) This rule, to use ADS for QBAI purposes, would apply regardless of when the property was placed in service, and regardless of whether the property had been depreciated using ADS. (Prop Reg § 1.951A-3(e)(3))

As Net DTIR is intended to reduce a U.S. shareholder’s GILTI inclusion amount by an annual return on specified tangible property, Prop Reg § 1.951A-3(f) would provide a methodology to reduce the QBAI of a CFC with a short tax year to an amount that, if annualized, would produce an amount equal to the QBAI for a 12-month tax year.

Where a CFC holds an interest in a partnership at the close of the CFC’s tax year, the CFC takes into account under Code Sec. 951A(d)(3) its “distributive share of the aggregate of the partnership’s adjusted bases (determined as of such date in the hands of the partnership)” in specified tangible property in computing its QBAI. Code Sec. 951A(d)(3) further provides that a CFC’s “distributive share of the adjusted basis of any property shall be the controlled foreign corporation’s distributive share of income with respect to such property.” Noting that use of the term “distributive share” in this context is ambiguous (Preamble), Prop Reg § 1.951A-3(g)(3) would determine a CFC partner’s share of the partnership’s adjusted basis in specified tangible property by reference to the partnership’s average adjusted basis in the property as of the close of each quarter of the partnership’s tax year that ends with or within the CFC’s tax year.

Prop Reg § 1.951A-3(h)(1) also provides an anti-abuse rule under which specified tangible property of a tested income CFC would be disregarded for purposes of determining the tested income CFC’s average aggregate basis in specified tangible property if the tested income CFC acquires the property with a principal purpose of reducing the GILTI inclusion amount of a U.S. shareholder and holds the property temporarily but over at least one quarter end. For this purpose, property held for less than a 12-month period that includes at least one quarter end during the tax year of a tested income CFC is treated as temporarily held and acquired with a principal purpose of reducing the GILTI inclusion amount of a U.S. shareholder. Prop Reg § 1.951A-3(h)(2) also would disallow the benefit of a stepped-up basis in specified  tangible property transferred between related CFCs during the period before the transferor CFC’s first inclusion year for purposes of calculating the transferee CFC’s QBAI.

Determining specified interest expense. Code Sec. 951A(b)(2)(B) provides that 10% of the aggregate of the shareholder’s pro rata share of the QBAI of each CFC be reduced by “the amount of interest expense taken into account under Code Sec. 951(c)(2)(A)(ii)  in determining such shareholder’s net CFC tested income for the taxable year to the extent the interest income attributable to such expense is not taken into account in determining such shareholder’s net CFC tested income”—but fails to define the amount of interest income “attributable” to interest expense. Accordingly, Prop Reg § 1.951A-1(c)(3) would provide that a U.S.  shareholder’s specified interest expense is the excess of its aggregate pro rata share of the tested interest expense of each CFC over its aggregate pro rata share of the tested interest income of each CFC. The proposed regs would also provide a number of specific exclusions from the definition of “tested interest income.”

Domestic partnership-CFC shareholders. Prop Reg § 1.951A-5 provides guidance to domestic partnerships and their partners on how to compute GILTI amounts—which would also apply to S corporations and their shareholders.

Prop Reg § 1.951A-5(b) would provide that, in general, a domestic partnership that is a U.S. shareholder of one or more CFCs (U.S. shareholder partnership) computes its own GILTI inclusion amount in the same manner as any other U.S. shareholder, and each partner takes into account its distributive share of the domestic partnership’s GILTI inclusion amount under Code Sec. 702 and Reg. §1.702-1(a)(8)(ii).

However, a partner that is itself a U.S. shareholder (within the meaning of Code Sec. 951(b)) (U.S. shareholder partner) of one or more CFCs owned directly or indirectly by a domestic partnership (partnership CFC) would be treated as owning proportionately Section 958(a) stock in each such partnership CFC as if the partnership were a foreign partnership. (Prop Reg §1.951A-5(c)) As a result, a partner that is itself a U.S. shareholder of a CFC owned by a domestic partnership would compute its GILTI inclusion amount for a tax year by taking into account its proportionate share of the partnership’s pro rata share of each of the relevant items – tested income, tested loss, QBAI, tested interest income, and tested interest expense – of such CFC. A U.S. shareholder partnership would therefore be required to provide to its partners their distributive share of the partnership’s GILTI inclusion amount, as well as provide to each U.S. shareholder partner the partner’s proportionate share of the partnership’s pro rata share (if any) of each CFC tested item of each partnership CFC of the partnership. Forms and instructions will be updated accordingly. (Prop Reg §1.951A-5(f))

Characterization of GILTI inclusions for other Code purposes.  A U.S. shareholder’s GILTI inclusion amount is not an inclusion under Code Sec. 951(a)(1)(A), but under Code Sec. 951A(f)(1)(A), GILTI inclusion amounts are nonetheless treated similarly to Code Sec. 951(a)(1)(A) inclusions for a number of purposes, including the application of a number of Code provisions. Prop Reg § 1.951A-6(b)(1) also provides that a GILTI inclusion amount should be treated in the same manner as a Code Sec. 951(a)(1)(A) inclusion for purposes of Code Sec. 1411, and IRS stated in the Preamble that it intends to issue separate guidance on the characterization of GILTI inclusions for purposes of determining the unrelated business taxable income of tax-exempt entites.

Interaction with Code Sections 163(e)(3)(B)(i) and 267(a)(3)(B). Under the proposed regs, a deduction would be allowed under Code Sec. 267(a)(3)(B) (which generally bars a deduction for an item payable to a related CFC until paid, except to the extent that an amount attributable to that item is includible in the gross income of a U.S. shareholder) and under Code Sec. 163(e)(3)(B)(i) (which provides a similar rule for original issue discount on a debt instrument held by a related CFC) for an item taken into account in determining the net CFC tested income of a U.S. shareholder, including a U.S. shareholder treated under the proposed regs as owning Section 958(a) stock of a CFC owned by a domestic partnership. (Prop Reg §1.951A-6(c)(1)) In the case of a U.S. shareholder that is a domestic partnership, this rule would apply only to the extent that one or more U.S. persons (other than domestic partnerships) that are direct or indirect partners of the domestic partnership include in gross income their distributive share of the partnership’s GILTI inclusion amount or the item is taken into account by a U.S. shareholder partner of the domestic partnership by reason of Prop Reg § 1.951A-5(c). (Prop Reg § 1.951A-6(c)(2))

Basis adjustments for the use of tested losses. In determining a U.S. shareholder’s net CFC tested income, the U.S. shareholder’s pro rata share of a tested loss of one CFC may offset the shareholder’s pro rata share of tested income of another CFC; such a use of a tested loss does not reduce the U.S. shareholder’s basis in the stock of the tested loss CFC, increase the stock basis of the tested income CFC, or affect the earnings and profits of either the tested loss CFC or the tested income CFC. However Prop Reg § 1.951A-6(e) would generally provide that in the case of a corporate U.S. shareholder (excluding RICs and REITs), for purposes of determining the gain, loss, or income on the direct or indirect disposition of stock of a CFC, the basis of the stock is reduced by the amount of tested loss that has been used to offset tested income in calculating net CFC tested income of the U.S. shareholder. The basis reduction would only be made at the time of the disposition and so would not affect the stock basis prior to a disposition. Requiring the basis reduction only at the time of the disposition prevents the use of tested losses alone from causing the recognition of gain if the reduction exceeds the amount of stock basis. The basis adjustments would apply only to the extent a “net” tested loss of the controlled foreign corporation has been used. This limitation is intended to ensure that the reduction applies only to the extent necessary to eliminate the duplicative loss in the stock.

Similar adjustments would apply when the tested loss CFC is treated as owned by the U.S. shareholder through certain intervening foreign entities by reason of Code Sec. 958(a)(2) to prevent the indirect use of the duplicative loss through the disposition of interests in those intervening entities. The proposed regs would provide an exception to these rules in certain cases when the tested loss CFC and the CFC that generated the tested income that is offset by the tested loss are in the same Code Sec. 958(a)(2) ownership chain. Adjustments aren’t appropriate in these cases because there is no duplicative loss to the extent the shares of both CFCs are directly or indirectly disposed of. (Prop Reg § 1.951A-6(e)(1)(ii)

Under the proposed regs, a direct disposition of the stock of a CFC could result in the indirect disposition of the stock of one or more lower-tier CFCs. (Prop Reg § 1.951A-6(e)(6)(ii)(B)) In such a case, basis adjustments may be made to both the stock of the upper-tier CFC and the stock of the lower-tier CFCs. The proposed regs would provide ordering rules for making these adjustments that, in general, are intended to prevent gain resulting from a basis adjustment attributable to the use of a single tested loss from being taken into account more than once. (Prop Reg § 1.951A-6(e)(1)(iv)) The proposed regs would also include rules that take into account certain nonrecognition transactions involving CFCs, such as the acquisition of CFC stock by a domestic corporation and transactions described in Code Sec. 381. (Prop Reg § 1.951A-6(e)(4)(ii), Prop Reg § 1.951A-6(e)(5))

Prop Reg § 1.951A-6(e)(7) would provide a special rule to address dispositions of CFC stock by another CFC that is not wholly owned by a single domestic corporation. Consistent with Prop Reg § 1.961-3(b) and Rev Rul 82-16, 1982-1 CB 106, this rule is intended to ensure that the appropriate amount of subpart F income is taken into account by U.S. shareholders of the CFC as a result of the disposition.

Effective dates. Consistent with the applicability date of Code Sec. 951A, Prop Reg § 1.951A-1 through Prop Reg § 1.951A-6 are proposed to apply to tax years of foreign corporations beginning after Dec. 31, 2017, and to tax years of U.S. shareholders in which or with which such tax years of foreign corporations end.

References: For global intangible low-taxed income under Code Sec. 951A, see FTC 2d/FIN ¶O-2790 et seq.; United States Tax Reporter ¶951A4.