Managing the US tax impact of highly-taxed foreign subsidiaries

by Bergin Fisniku

Summary

The IRS recently issued final regulations with respect to global intangible low-taxed income (GILTI) provisions regarding the treatment of income subject to a high rate of foreign tax.

The final regulations provide for an election that allows a taxpayer to exclude gross income subject to foreign income tax at an effective rate that’s greater than 18.9% (90% of the rate that would apply if the income were subject to the U.S. maximum tax rate (currently 21%).

Taxpayers may elect the GILTI high-tax exclusion on an annual basis, starting with taxable years of foreign corporations that begin on or after July 23, 2020. However, as the election can be made on an amended return, a taxpayer may choose to apply the GILTI high-tax exclusion to taxable years of foreign corporations that begin after December 31, 2017, and before July 23, 2020 as well.

The retroactive GILTI high-tax exception election may be an opportunity to obtain refunds for GILTI tax paid in prior years.

Background:

Many manufacturers employ the use of foreign subsidiaries to support their businesses’ global supply chain. The 2017 Tax Cuts and Jobs Act implemented a new tax regime, the GILTI regime, whereby earnings of a foreign subsidiary could be currently taxable in the United States, regardless of whether those earnings were repatriated on an annual basis. Thus, for many manufacturers, the GILTI regime yielded a markedly new effect on the U.S. shareholders of these controlled foreign corporations.

While the GILTI regime attempted to impose a global minimum tax on US shareholders and their foreign subsidiaries, many U.S. taxpayers found that the implementation of the GILTI regime, by virtue of its calculation mechanics, created residual tax in the U.S.– even when a foreign subsidiary was already subject to a high rate of tax in its local country. As a result, many U.S. Taxpayers appealed to the IRS to implement a ‘high tax exception,’ allowing for the exclusion within the GILTI regime of certain foreign earnings to the extent they were taxed in their local country at a sufficiently high rate.

2019 proposed regulations

Sec. 951A, enacted as part of the Tax Cuts and Jobs Act, requires a U.S. shareholder of a controlled foreign corporation (CFC) to include in gross income the shareholder’s GILTI inclusion for a tax year. The determination of a U.S. shareholder’s GILTI inclusion begins with the calculation of “tested items” of each CFC owned by the shareholder. These include tested income, tested loss, and qualified business asset investment.

In 2019, the IRS issued proposed regulations that provided an election to exclude the following from gross tested income: gross income subject to foreign income tax at an effective rate that’s greater than 90% of the rate that would apply if the income were subject to the U.S. maximum tax rate. (This is the GILTI high-tax exclusion.)

The CFC’s controlling domestic shareholders could make the election for the CFC by attaching a statement to an original or amended tax return for the inclusion year. The election would be revocable but, once revoked, a new election generally couldn’t be made for any CFC inclusion year that begins within 60 months after the close of the CFC inclusion year for which the election was revoked. (This is referred to as the “60-month restriction.”)

The 2019 proposed regulations applied based on the effective foreign tax rate imposed on the aggregate of items of tentative net tested income of a CFC attributable to a single qualified business unit (QBU) of the CFC that would be in a single tested income group. Furthermore, the regulations applied on a QBU-by-QBU basis to minimize the “blending” of income subject to different foreign tax rates, as well as to more accurately identify income subject to a high rate of foreign tax such that low-taxed income continues to be subject to the GILTI regime in a manner consistent with its underlying policies.

Last, the 2019 proposed regulations contained proposed rules under Sec. 951, Sec. 956, Sec. 958 and Sec. 1502 for determining stock ownership and GILTI for partners of domestic partnerships that are U.S. shareholders of a CFC.

Final regulations

The final regulations retain the basic approach and structure of the 2019 proposed regulations. However, while these final regulations finalize the portion of the 2019 proposed regulations under Sec. 951A and Sec. 954 regarding the treatment of income subject to a high rate of foreign tax, they don’t finalize the portions of the 2019 proposed regulations under Sec. 951, Sec. 956, Sec. 958 and Sec. 1502 regarding the treatment of domestic partnerships. The IRS plans to finalize those regulations separately.

Also, the final regulations don’t include the 60-month restriction. Generally, taxpayers may elect the GILTI high-tax exclusion on an annual basis. Therefore, if an entity revoked a GILTI high-tax exclusion election for one year, it can elect the GILTI high-tax exclusion the following year.

Furthermore, the final regulations replace the QBU-by-QBU approach in the 2019 proposed regulations with a more targeted approach based on “tested units” and permit some additional blending of income under the “tested unit combination rule.”

Applicability dates

The final regulations are consistent with the applicability date in the 2019 proposed regulations. Thus, they provide that the GILTI high-tax exclusion applies to:

  • Taxable years of foreign corporations beginning on or after July 23, 2020, and
  • Tax years of U.S. shareholders in which or with which such taxable years of foreign corporation’s end.

In addition, the final regulations permit taxpayers to choose to apply the GILTI high-tax exclusion to:

  • Taxable years of foreign corporations that begin after December 31, 2017, and before July 23, 2020, and
  • Tax years of U.S. shareholders in which or with which such taxable years of the foreign corporation’s end.

Any taxpayer that applies the GILTI high-tax exclusion retroactively must consistently apply the final regulations to each taxable year in which the taxpayer applies the GILTI high-tax exclusion. Thus, the opportunity presents itself for taxpayers to look back to previously filed returns to determine whether the GILTI high tax elections would allow for refund of previous taxes paid on GILTI that were subject to a high rate of tax but were still subject to residual GILTI in the United States.

New proposed regulations

The IRS issued proposed regulations, contemporaneously with the final regulations discussed above, to generally conform the rules implementing the Sec. 954(b)(4) subpart F high-tax exception to the rules implementing the GILTI high-tax exclusion. In addition, the proposed regulations provide for a single election under Sec. 954(b)(4) for purposes of both subpart F income and tested income.

We Can Help

If you need assistance with highly-taxed foreign subsidiaries, please contact us. We will connect you with one of our advisors.

The information provided in this communication is of a general nature and should not be considered professional advice.  You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.