On June 14, the Treasury Department and the Internal Revenue Service released over 400 pages of regulations – some final and some proposed – addressing a number of issues regarding Global Intangible Low Taxed Income (GILTI) and Subpart F. In large part, these regulations were taxpayer-friendly and provided welcome relief to a challenging area of provisions recently enacted within Internal Revenue Code.
The GILTI regime (Internal Revenue Code Section 951A) was enacted as part of the Tax Cuts and Jobs Act (TCJA) of 2017 and was intended to currently tax earnings in offshore companies that were subject to a low tax rate rather than allow deferral of tax on that income. Despite the name, GILTI is not necessarily limited to taxing income from intangible assets. Essentially, the GILTI tax regime is a worldwide minimum tax on overseas earnings resulting in a current U.S. tax on U.S. shareholders of controlled foreign corporations (CFCs) to the extent those earnings exceed a 10 percent return on tangible assets of the CFC (plus certain interest expense.) For certain shareholders, a 50% deduction is available (through 2025) which results in a net effective corporate tax rate of 10.5% on GILTI income.
The regulations discussed here refer to partnerships, but the rules are intended to apply to other pass-through entities. For purposes of Subpart F and GILTI, Internal Revenue Code Section 1373 treats S corporations the same way as partnerships. Therefore, any references to a partnership or partner in this alert should be considered to broadly apply to an S corporation and its shareholder(s).
Entity versus Aggregate Approach for Partnership Items
In the past, the IRS has taken the position that a domestic partnership should be treated and respected as a separate entity for Subpart F purposes. In other words, it is the partnership – and not the partners – that own the partnership assets. In such case, if a domestic partnership owns more than 50% of a foreign corporation, then that foreign corporation will be a Controlled Foreign Corporation (CFC), regardless of whether the partners themselves are U.S. persons. This would be the case even if all the partners of the U.S. partnership were foreign nationals or minority (less than 10%) owners, and would not be U.S. shareholders otherwise.
Under this entity approach, the partners of a domestic partnership with a Subpart F inclusion would pick up their proportionate share of the total Subpart F income, regardless of their status. This result is in contrast to the aggregate approach applied to foreign partnerships. Here the partnership would be treated as an aggregate of its owners – as if the partners owned the partnership assets on a look-through basis. This rule was designed to prevent a foreign partnership from being used as a blocker to prevent Subpart F income from being taxed to its partners. Since a foreign partnership itself cannot be a U.S. shareholder for Subpart F purposes, one must look through to the partners to determine whether the foreign corporation is a CFC. Only those partners that individually meet the definition of a U.S. shareholder would recognize Subpart F income on their proportionate share.
The final GILTI regulations adopted an aggregate approach to be applied to domestic partnerships, the same as has been applied previously to foreign partnerships, and in contrast to the original proposed regulations that suggested a hybrid of both the entity and aggregate approaches discussed above. Because of the switch to the aggregate approach with the final GILTI regulations, a domestic partnership is not considered to own the foreign corporation stock for purposes of GILTI, but rather the partners of that partnership do. If a partner does not meet the definition of a U.S. shareholder – owning less than 10% of the shares – then there is no GILTI inclusion on that partner’s tax return. In addition to the relief for GILTI, the newly released proposed regulations generally apply the aggregate approach to Subpart F such that a minority partner would not recognize a Subpart F pickup if not a U.S. shareholder.
Each U.S. shareholder (10% or more owner) of a CFC will pick up its pro rata share of the GILTI inclusion items (tested income, etc.) which is generally based on how a hypothetical distribution of the CFC’s E&P would be treated. This should be good news for partners who would not be U.S. shareholders in that no GILTI inclusion will apply. However, partnerships and S corporations will need to consider this change in preparing their 2018 tax returns and K-1s due in the near future. The K-1 information will need to include the information that would permit the partner (or shareholder) to compute their GILTI. This may result in filing superseded or amended returns for those partnerships that have been filed previously.
Note that the regulations do not alter the entity approach for purposes of determining whether a foreign corporation is a CFC of a domestic partnership.
P is a domestic partnership and owns 100% of the stock of FC, a foreign corporation. All of FC’s activities are in a foreign country. P is owned 91% by X, a U.S. corporation and 9% by A, a U.S. citizen. In this case, FC would be treated as a CFC owned by P. X would be subject to a GILTI inclusion and Subpart F inclusion based on its share of those items from FC. Partner A would not be considered a U.S. shareholder of FC because A owns less than 10% and would thus have no GILTI or Subpart F inclusion with respect to FC.
The new rules as they apply to GILTI are effective for taxable years beginning after December 31, 2017, whereas the new rules as they apply to Subpart F are effective for tax years of CFCs beginning on or after the date final regulations are published. However, the regulations provide that a taxpayer can adopt the proposed regulations early so that this could be applied to a tax year beginning after December 31, 2017. The partnership would elect the early treatment and the partners must file their tax returns consistently.
Where a partner’s interest in a domestic partnership is less than 10% and is not subject to a GILTI or Subpart F inclusions, it is possible the partner will instead be subject to the passive foreign investment corporation (PFIC) rules. Thus, a less than 10% partner could be subject to tax under the PFIC rules (instead of Subpart F). In such case, the partner should consider making a QEF election for the first year the regulations are effective to avoid some of the tax consequences of holding an investment in a PFIC.
Because a partnership’s GILTI inclusions and Subpart F inclusions disappear under the new regulations, it would appear that these items would no longer be within the scope of a partnership-level audit (one subject to the new centralized partnership audit regime) where an audit would be limited to partnership-level items.
If a partnership has filed its return without consideration of the new regulations, an amended return may be in order. If the partnership is subject to the centralized partnership audit regime, it might be possible to correct this return without filing an amended return by filing a superseding return.
If a partner receives a K-1 that shows distributive GILTI or Subpart F information and they are not considered a U.S. shareholder (own less than 10%), the partner may need to file with their tax return notice of inconsistent treatment (Form 8082) with a statement explaining that contrary to the K-1 form, there is no GILTI or Subpart F inclusion for such minority partners.
For partners that would be considered U.S. shareholders and thus subject to reporting inclusions under GILTI and Subpart F, those partners should ensure that the partnership provides to them the same type of information that would have been required as if the partnership were the owner of the CFC shares.
GILTI High Tax Exclusion
Something of a surprise from the IRS included in the proposed regulations is a provision that would significantly change the landscape for the GILTI tax regime. The GILTI high-tax exclusion described in the proposed regulations would provide for a broad exclusion of income in a CFC if that income were subject to a tax rate of higher than 90% of the U.S. tax rate (i.e. 18.9%). This would remove the income of certain CFCs from the GILTI calculation altogether that is not otherwise kicked out by existing exclusions.
Important: The high tax exclusion for GILTI is in the proposed regulations and would only apply prospectively once the regulations are made final. In other words, this exclusion is not yet available and would not apply for the 2018 tax year.
The impact of the final and new proposed regulations have created significant complexity and uncertainty related to reporting of this information, as some of the new the tax forms and instructions were prepared well in advance of the release of these regulations. Among the items to consider:
- Whether a partnership must file Form 8992 in light of the migration to the aggregate approach
- How to track earnings and profits (“E&P”) and previously taxed earnings and profits (“PTEP”) attributed to potential GILTI inclusions, and how to report that information on Schedule J and Schedule P (new) on Form 5471 for the partnership when a partnership may not have the information available when filing its return.
- How to track earnings and profits (“E&P”) and previously taxed earnings and profits (“PTEP”), and how to report that information Schedule I, Schedule J, and Schedule P (new) on Form 5471 for the partnership when a partnership may not have the information available when filing its return.
We can help
If you need assistance in evaluating how these new regulations on GILTI and Subpart F may affect your tax picture, please contact your Elliott Davis tax advisor for assistance.