By Anthony Diosdi
For many years, U.S. multinational corporations were able to utilize a high-tax election to defer Subpart F income. However, when the global intangible low-tax income (or “GILTI”) taxing regime was announced in late 2017, a corresponding high-tax election was not available. Shortly after the enactment of the GILTI taxing regime, U.S. multinational corporations and their advisors began lobbying the Department of Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) to issue regulations to permit the use of a high-tax election for GILTI income. On July 20, 2020, the Department of Treasury (“Treasury”) promulgated final regulations which permit a high-tax election for global intangible low-taxed income (“GILTI”). This was welcome news to many U.S. multinational corporations and their advisors. In general, the Final Regulations enable U.S. multinationals to exclude amounts that would otherwise be tested income from its GILTI computation if the foreign effective tax rate on such amounts exceeds 90 percent of the top U.S. corporate tax rate (currently 18.9% based on the current 21 percent corporate tax rate). This article discusses how the GILTI high-tax election operates for U.S. multinationals and the benefits associated with making such an election. With that said, the Final Regulations for the GILTI high-tax election contains some unwelcome surprises for the unwary. For the U.S. multinationals and their advisors who welcome the issuance of the Final Regulations to excluded amounts that would otherwise be tested income from its GILTI computation under the high-tax election.
Introduction to the GILTI Taxing Regime and the New GILTI High-Tax Exclusion
A number of years ago, Congress recognized that the tax system in place incentivized U.S. multinational corporations to shift inherently mobile income to low-tax jurisdictions to avoid U.S. tax. Congress also understood that the existing Subpart F rules were not enough to protect the U.S. tax base. Consequently, the Tax Cuts and Jobs Act was enacted to prevent multinationals from shifting mobile income to low-tax jurisdictions and repatriating the same income back to the U.S. without U.S. tax. As part of the Tax Cuts and Jobs Act, Congress added Section 951A to the Internal Revenue Code which resulted in the GILTI tax regime.
However, at the time GILTI was enacted, Congress was concerned that the GILTI taxing regime would place U.S. multinationals at a disadvantage to their foreign competitors. As a result, Congress initially set the GILTI tax rate at one-half the federal corporate tax rate, which is currently 10.5 percent. This favorable rate is possible as a result of 50 percent deduction of a GILTI inclusion permitted by Internal Revenue Code Section 250.
Shortly after the Tax Cuts and Jobs Act was enacted, multinational corporations and their advisors began to urge the Treasury and the IRS to permit the same high-tax election to GILTI income as is permitted under the Subpart F income rules. Internal Revenue Code Section 954 has long permitted a high-tax exception, the exclusion of Subpart F income which is 90 percent of the maximum U.S. Federal corporate rate. On June 21, 2019, Treasury and the IRS responded to these requests by proposing regulations that would also allow a high-tax election for GILTI income. On July 20, 2020 the Treasury and the IRS issued final regulations for making a high-tax or 954 election for GILTI income.
The Required GILTI High-Tax Election Threshold Rate
The 2019 Proposed Regulations and the 2020 Final Regulations set the threshold rate for claiming the GILTI high-tax election at 90 percent of the U.S. federal corporate tax rate. This is currently 18.9 percent (90 percent of the highest U.S. federal corporate tax rate, which is 21 percent). Anytime a high tax election is considered, future corporate tax rates must be considered. There has been a lot of talk in Washington about increasing the U.S. federal corporate tax rate. If the U.S. corporate tax rate is increased, the minimum threshold rate necessary for claiming the GILTI high-tax election would also increase and international tax planning in certain cases would need to change.
Tested Unit Standard
We will begin our discussion with the “tested unit standard.” The effective foreign tax rate for purposes of the high-tax exclusion is calculated on a tested-unit basis. The tested unit approach applies to the extent an entity, or the activities of an entity, are actually subject to tax of a foreign country as a tax resident or permanent establishment. The final regulations define three categories of tested units:
1. A controlled foreign corporation (“CFC”);
2. An interest that the CFC holds directly or indirectly in a passthrough entity that: a) is a tax resident of a foreign country, or b) is not subject to tax as a resident but is treated as a corporation for purposes of the CFC’s tax law;
3. A branch of the CFC that either: a) gives rise to a taxable presence in the country in which the branch is located, or b) gives rise to a taxable presence under the owner’s tax law, and the owner’s tax law provides an exclusion, exemption, or other similar relief (such as a preferential rate) for income attributable to the branch. See Treas. Reg. Section 1.951A-2(c)(7)(iv)(A).
Finally, the regulations provide that multinationals are generally required to combine tested units that are attributed gross income less than the lesser of 1 percent of the gross income of the CFC or $250,000. This proposed de minimis combination rule would apply to combine tested units that are not residents of, or located in, the same foreign country.
Calculating the Effective Foreign Tax Rate
In order to make a GILTI high-tax foreign election, the multinational must be subject to an effective foreign tax rate of 18.9 percent. This is calculated by dividing the U.S. dollar amount of foreign income taxes paid or accrued by the U.S. dollar amount of the tentative tested income item increased by the U.S. dollar amount of the relevant foreign income tax. Such a calculation requires determining the tentative gross tested income and the tentative tested income.
To determine the tentative tested income, the tentative gross tested income of each tested unit first must be established. This requires that the items of gross income of a CFC are attributable to a tested unit of the CFC to the extent that they are properly reflected on a separate set of books and records of the tested unit. See Treas. Reg. Section 1.951A-2(c)(7)(ii)(B). Also, tentative gross tested income of a tested unit is adjusted by disregarded payments made between tested units of the CFC. In addition, if gross income is attributable to more than one tested unit, the item will be considered attributable to the lowest-tier tested unit. See Treas. Reg. Section 1.951A-2(c)(7)(iv)(B).
To calculate the tentative tested income, a determination is made by allocating and apportioning current-year deductions for the CFC to the tentative gross tested income item under the principles of Treasury Regulation 1.960-1(d)(3). As stated in Treasury Regulation 1.960-1(b)(4), current-year tax is the foreign tax paid or accrued by a CFC in a current year. Thus, the U.S. dollar amount of the CFC’s current-year taxes may be apportioned to the tentative tested income. In addition, the effective foreign tax rates are determined separately with respect to the income of the various branches, disregarded entities, and other “tested units” of the CFC. This means, certain portions of a CFC’s income may qualify for the GILTI high-tax election while other portions do not.
High-Tax Exclusion Election
The high-tax election must be made by the “controlling domestic shareholders” of a CFC, which are generally the 10 percent U.S. shareholders that, in the aggregate, own more than 50 percent of the the total combined voting power of all classes of stock and undertake to act on the CFC’s behalf. If U.S. shareholders do not, in the aggregate, own more than 50 percent of the total voting power of the CFC, the controlling domestic shareholders are all 10 percent U.S. shareholders who own stock of the CFC. The election made by the controlling U.S. shareholder is binding on all U.S. shareholders of the CFC. Controlling domestic shareholders must notify the other 10 percent U.S. shareholders of the election and any revocation. In light of these rules, it is expected that shareholder agreements may provide mechanics for decisions relating to the making or revocation of high-tax elections, as well as information rights for minority U.S. investors. The GILTI high-tax election applies on an elective basis.
The regulations also permit multinationals to retroactively make a GILTI high-tax exclusion election or revocation on an amended tax return for a prior year so long as the amended return is filed within 24 months of the unextended due date of the original return of the controlling domestic shareholder’s inclusion year and so long as all other US shareholders of the CFC file amended returns within a single 6-month period which is within the 24-month period referenced above. If an election or revocation is made, the regulations require controlled domestic shareholders to provide notice of such election or revocation to each US shareholder that is not a controlling domestic shareholder. The final regulations apply to tax years beginning on or after July 23, 2020 and allow multinationals to retroactively apply the high-tax election to tax years that began after December 31, 2017.
The High-Tax Election Can be Made for the First Time in an IRS Examination
As discussed above, the regulations to Section 954 permit multinationals to retroactively make a GILTI high-tax exclusion election on an amended tax return. Case law also supports the proposition that a Section 954 election is timely even if made during an examination. For example, in Dougherty v. Commissioner, 60 T.C. 917 (1973), a taxpayer was assessed additional amounts of tax under Section 951(a)(1)(B) of the Internal Revenue Code for an earlier year due to inclusions under Section 956 resulting from intercompany indebtedness. As soon as the IRS informed the taxpayer in Dougherty that it planned to assess such amounts, the taxpayer filed an election under Internal Revenue Code Section 962. Doughterty supports the proposition that a Section 962 election is timely if made when the election first becomes significant to the taxpayer as a result of an assessment of tax on amounts includible under Internal Revenue Code Section 951(a) or Subpart F income. The IRS acquiesced in Dougherty with respect to the Section 962 issue in GCM 36325. The holding in Dougherty and GCM can be applied to making a Section 954 election in an IRS examination by analogy.
Be Careful When Making a GILTI High-Tax Election
The GILTI high-tax election will permit US multinationals to defer current GILTI inclusions. However, the final regulations do not allow U.S. multinationals that own CFCs in different jurisdictions to participate in CFC-by-CFC planning. In other words, making a high-tax election reduces the opportunity to effectively blend high-taxed and low-taxed income. A high-tax election will also eliminate a multinational corporation’s ability to cross-credit foreign taxes paid on such high-taxed income against other low-taxed income in the same basket. Finally, the high tax exception will likely result in the CFCs of the multinational corporation retaining undistributed profits as earnings and profits (or “E&P”). This means a subsequent distribution of this E&P will be taxable income. If Congress raises the corporate and individual income tax rates in the future, a future distribution of E&P (the amount E&P deferred from U.S. tax as a result of the high-tax election) could be taxed at higher tax rates than if the E&P was currently distributed.
In sum, the GILTI high-tax election can be a valuable resource in certain situations. Before making a high-tax election, careful modeling of the consequences of making a high-tax election should be done on an annual basis before deciding to make a GILTI high-tax election.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.