The GILTI High-Tax Exception: Is it a Viable Planning Option?

The Global Intangible Low-Taxed Income (GILTI) provisions were enacted as part of the 2017 Tax Cuts and Jobs Act (TCJA). Under the GILTI provisions, a U.S. shareholder essentially is taxed on the active earnings of a controlled foreign corporation (CFC), which, under pre-TCJA law, would have been tax-deferred.¹

By way of background, GILTI functions as an anti-base erosion, minimum tax provision intended to discourage multinational corporations (MNCs) from using intangible property (IP) to shift profits out of the U.S.² Depending on the circumstances, the minimum tax rate (inclusive of U.S. and foreign tax rates) of a MNC on GILTI earnings, ranges from 10.50 percent to 13.125 percent.³

GILTI, however, is not limited to low-taxed income and encompasses income subject to foreign tax rates in excess of 13.125 percent. As a result, double taxation can arise because of the GILTI foreign tax credit (FTC) limitations⁴ and the absence of a statutory high-tax exception comparable to that contained in the Subpart F provisions (under Section 954(b)(4)). As a result, taxpayers lobbied the U.S. Department of the Treasury and IRS to provide a regulatory high-tax exception.⁵

The Treasury Department and IRS issued proposed regulations in 2019, which provided a GILTI high-tax exception, as follows:

• The high-tax exception was elective by a CFC's controlling domestic shareholders, binding on all U.S. shareholders of the CFC, and once made or revoked, could not be changed for a 60-month period.
• The high-tax exception applied only if the foreign tax rate was in excess of 18.9 percent (i.e., in excess of 90 percent of the highest U.S. corporate tax rate, which is 21 percent).
• Foreign tax rates were determined separately with respect to each qualified business unit (QBU) of a CFC to foreclose blending of high-taxed and low-taxed income, and could not be applied on a CFC-by-CFC basis.
• The elective high-tax exception was intended to be effective prospectively, for a CFC's tax years beginning on or after the rules were adopted as final regulations.

Final Regulations

The IRS issued the GILTI high-tax exclusion final regulations on July 20, 2020, which were published on July 23, 2020, in the Federal Register. Among the key points are:

• Election: Now on an annual basis; 60-month rule dropped.
• Election made on tax return or on amended return by attaching a statement.
• All or nothing approach: Election applies on a consistent basis to all CFCs owned by same domestic controlling U.S. shareholders (more than 50 percent) and to all of a CFC's U.S. shareholders (here, controlling U.S. shareholder notifies non-controlling U.S. shareholders).
• Final regulations did not adopt a CFC-by-CFC approach.
• High tax: foreign tax rate in excess of 18.9 percent rate retained.
• Treasury Department and IRS rejected taxpayers' suggestions to utilize 13.125 percent rate.
• Determination: Now based on "Tested Unit" rather than QBU-by-QBU basis.
• Based on books and records, and gross income determined under federal income tax principles with certain adjustments to reflect disregarded payments, which serves as a reasonable proxy for determining the amount of gross income that the foreign country of the tested unit is likely subject to tax.
• Tested Unit includes 1) a CFC; 2) interest in a pass-through entity (not treated as fiscally transparent under foreign law) held by a CFC; and 3) certain branches of a CFC.
• All tested units of a CFC located or resident in same country are required to be combined as a single tested unit.
• Generally applies to extent an entity is subject to tax in foreign country and in the Treasury Department and IRS view is more targeted than QBU approach.
• Determinations will be complex.
• Effective date:
• Tax years of foreign corporations beginning on or after July 23, 2020, and for tax years of U.S. shareholders in which, or with which, such tax years of foreign corporations end.
• Taxpayers may elect to apply the final regulations retroactively for tax years beginning after Dec. 31, 2017, and before July 23, 2020, provided certain consistency requirements satisfied.
• Unitary Approach for GILTI and Subpart F: Proposed regulations will require that a single high-tax exception to be applied for purposes of the GILTI and Subpart F regimes⁶ so as to prevent potentially abusive tax planning and to reduce complexity.
• Effective Date: Proposed to apply to taxable years of a foreign corporation ending on or after July 20, 2020.

Conclusion

• The high-tax exception is another planning tool.
• Taxpayers must closely evaluate whether the GILTI high-tax exception is useful; this generally will require tax modeling.
• If a taxpayer elects the high-tax election, U.S. shareholder no longer can utilize qualified business asset investment (QBAI) or FTCs as GILTI gross income is excluded from gross income.
• For MNCs, excluded income generally should be able to be repatriated tax-free under the dividends received deduction provision.
• For individual shareholders, excluded income is U.S. tax deferred until repatriated. When repatriated, U.S. individual shareholders would be subject to ordinary income taxation up to a maximum rate of 37 percent or reduced qualified dividend 20 percent rate, if CFC were treaty eligible.
• In addition, Net Investment Income Tax imposed at a 3.8 percent rate could apply to high-earner taxpayers.
• Individual shareholders need to evaluate whether a high-tax kick-out election is more beneficial compared to planning under Section 962, use of a domestic corporation (if available and can avoid domestic penalty tax rules) or check-the-box planning where the shareholders elects to treat the CFC as transparent and income and FTCs of the CFC pass through to the shareholders.

For more information on the GILTI high-tax exception, contact the authors.

Notes