Summary of Key Treasury Regulations Impacting International Taxation
The US Internal Revenue Service and the US Department of the Treasury have released a number of final, temporary and proposed regulations implementing and interpreting international tax rules that were enacted as part of the Tax Cuts and Jobs Act (Tax Act). The following key items were included in these regulations:
- Final regulations provide that a US partner of a US partnership will not be taxable on Global Intangible Low-Taxed Income (GILTI, as defined below) allocated from a Controlled Foreign Corporation (CFC, as defined below) owned by such partnership unless such partner itself owns 10% or more of the vote or value (directly, indirectly or constructively) of such CFC. Proposed regulations apply the same rule to Subpart F income (as defined below).
- Proposed regulations introduce a broad exception from GILTI for income of a CFC taxed at a minimum non-US income tax rate. However, final regulations issued simultaneously with the proposed regulations do not yet adopt such an exception.
- Temporary regulations disallow all or a portion of the deduction otherwise allowable to US corporations with respect to actual or deemed dividends from non-US corporations to the extent that such dividends are attributable to earnings generated in connection with certain targeted transactions.
Background on CFCs, Subpart F Income and GILTI
Generally, a CFC is a non-US corporation greater than 50% owned in the aggregate by one or more US persons who each own, directly, indirectly or constructively, at least 10% (by vote or value) of the corporation (US Shareholders). The CFC rules have long provided an anti-tax deferral regime under which certain passive and related party income (Subpart F income) was taxed to the US Shareholders when earned by the CFC, without regard to actual distributions.
The Tax Act expanded these anti-tax deferral rules by creating a new category of income of a CFC called GILTI that is taxable to the US Shareholders of the CFC in a similar manner as Subpart F income (i.e., taxable to a US Shareholder whether or not actually distributed). Generally, GILTI includes the income of a CFC that is not Subpart F income or certain other excluded items (with a deduction generally allowed in an amount equal to a deemed 10% return on the adjusted tax basis of certain depreciable tangible personal property of the CFC).
New Rules Applicable to US Partners of US Partnerships
Historically, US tax law has treated a US partnership as a separate US entity for CFC and Subpart F Income purposes (the Entity Approach), rather than as an aggregate of its partners (the Aggregate Approach). Under the Entity Approach, a US partnership that owned 10% or more of a CFC generally has been treated as a US Shareholder of that CFC. For example, if a US partnership owned 100% of a non-US corporation, that US partnership would have been treated as a US Shareholder of a CFC, and a US partner of that US partnership would have been required to include in income its proportionate share of the Subpart F income from that CFC, even if such partner owned, directly, indirectly and constructively, less than 10% of the CFC.
In the case of GILTI, proposed regulations issued in 2018 (Proposed GILTI Regulations) applied a hybrid Entity and Aggregate Approach with respect to a CFC owned by a US partnership. Under this hybrid approach, (i) the Entity Approach applied to a US partner of a US partnership owning an interest in a CFC if such partner owned, directly, indirectly and constructively, less than 10% of such CFC and (ii) the Aggregate Approach applied to a US partner of such partnership if such partner owned, directly, indirectly and constructively, at least 10% of such CFC. Final regulations issued in June 2019 did not adopt the above-described hybrid approach of the Proposed GILTI Regulations (Final GILTI Regulations).
In a significant change from prior law, the Final GILTI Regulations provide that for purposes of calculating GILTI includable by a US partner of a US partnership owning an interest in a CFC, the US partnership will not be treated as owning stock in the non-US corporation. In other words, the Aggregate Approach, and not the Entity Approach, generally will apply for purposes of determining the GILTI inclusion, if any, of such US partner. Proposed regulations issued in June 2019 (Proposed Subpart F Regulations) apply the same Aggregate Approach for purposes of determining the Subpart F income inclusion for US partners of a US partnership. As a result, regardless of a US partnership's ownership interest in a CFC, a US partner of that US partnership is not required to include his, her or its proportionate share of the Subpart F income or GILTI from such CFC unless such partner owns, directly, indirectly and constructively, at least 10% of the CFC.
Under the Final GILTI Regulations and the Proposed Subpart F Regulations, a US partnership still is treated as owning stock in a non-US corporation for (i) establishing whether a non-US corporation is a CFC, (ii) determining whether a US person is a US Shareholder for certain purposes, and (iii) ascertaining whether any US Shareholder is a "Controlling Domestic Shareholder" for purposes of the election under the Proposed High Tax Kick Out (HTKO) Regulations (as defined and discussed below).
A number of open issues remain with respect to the implications of applying the Aggregate Approach for determining the Subpart F income and GILTI inclusions of US partners. These open issues include, among other things, the application of the deemed dividend rules (under Section 1248)1 upon the sale of stock of a CFC, the impact to calculating the "inside" tax basis of a partnership in the stock of a CFC and coordination with the "passive foreign investment company" rules.
The Final GILTI Regulations are effective for taxable years of CFCs beginning after December 31, 2017 and to taxable years of US Shareholders in which or with which such taxable years of CFCs end. An IRS notice recently was issued that provides relief to taxpayers meeting certain requirements that already applied the hybrid Aggregate and Entity Approach of the Proposed GILTI Regulations that were not adopted.
The Proposed Subpart F Regulations are proposed to be effective for taxable years of a CFC that begin on or after the date on which such regulations are published as final. However, subject to a consistency rule, US partnerships may optionally rely on the Proposed Subpart F Regulations to report their Subpart F income for taxable years of CFCs that begin after December 31, 2017.
New Rules for High Taxed Income of a CFC
A statutory exception from Subpart F income applies to income of a CFC that is subject to non-US income tax at an effective rate that is greater than 90% of the highest US corporate income tax rate then in effect (the High Tax Kick Out Exception or HTKO Exception). Under current law, the highest US corporate income tax rate is 21%, and, thus, for an item of income to be excluded from Subpart F income under this exception, such income must be subject to non-US income tax at a rate that is greater than 18.9%.
Final regulations were issued in June 2019 (that adopt without change prior proposed guidance) that excluded high-taxed income from GILTI only if such income also was excluded from Subpart F income solely by reason of the HTKO Exception (Final HTKO Regulations). Accordingly, under the Final HTKO Regulations, income of a CFC that is subject to non-US income tax at a rate greater than 18.9% only will be excluded from GILTI if such item of income would have been Subpart F income but for the application of the HTKO Exception. In other words, under the Final HTKO Regulations, high-taxed active income of a CFC, which generally is not Subpart F income, will not be excluded from GILTI. The Final HTKO Regulations apply to taxable years of CFCs beginning after December 31, 2017, and to taxable years of US Shareholders in which or with which such taxable years of CFCs end.
Proposed regulations that were published simultaneously with the Final HTKO Regulations establish a contrary and broader exception that allows a taxpayer to elect to exclude from GILTI all income of a CFC (whether or not such income would otherwise be Subpart F income) that is subject to a non-US income tax at a rate, under current law, greater than 18.9% (Proposed HTKO Regulations). Under the Proposed HTKO Regulations, non-US tax rates are calculated separately with respect to the income of each so-called "qualified business unit" (QBU) of a CFC, which is intended to prevent a CFC from blending high-taxed and low-taxed income of different QBUs of such CFC. A QBU generally is any separate and clearly identified unit of a CFC's trade or business that maintains separate books and records. Additionally, payments between QBUs, that generally are disregarded for US tax purposes, must be taken into account for determining the effective tax rates of the QBUs.
Although the Proposed HTKO Regulations generally are taxpayer friendly, the rules for electing the application of such exception and revoking such election generally are more restrictive than those for the existing HTKO Exception. For example, the proposed election must be made by US Shareholders of a CFC who, in the aggregate, own more than 50% by vote of the CFC (the Controlling Domestic Shareholders). If a CFC's US Shareholders do not, in the aggregate own more than 50% by vote of the CFC, all of the CFC's US Shareholders must make the election. The election is effective for the CFC's taxable year of the election and all subsequent years until the election is revoked. Once made, the election is binding on all US Shareholders of the CFC for which the election is made. Additionally, among other things, there are limitations on when a new election can be made once an earlier election has been revoked.
The Proposed HTKO Regulations only will be effective for tax years beginning on or after the date such exception is adopted in final regulations and cannot be relied upon by taxpayers until such time. Accordingly, under current law, taxpayers must apply the Final HTKO Regulations and cannot yet apply the Proposed HTKO Regulations. However, it is possible that the Treasury ultimately will adopt the Proposed HTKO Regulations in final regulations and make such regulations apply retroactively.
New Limitations on Amounts Eligible for the Dividends Received Deduction Under Section 245A
The Tax Act enacted Section 245A, which provides for a 100% dividends received deduction (DRD), subject to certain requirements and limitations, for the non-US source portion of dividends distributed by a non-US corporation (a Specified Foreign Corporation or SFC) to a US corporate shareholder owning at least 10% (by vote or value) of the distributing SFC. To transition to this new so-called "participation exemption" regime, the Tax Act also established a mandatory one-time taxable deemed repatriation of certain accumulated earnings and profits (E&P) of non-US subsidiaries to certain corporate US shareholders (the Repatriation Tax).
Temporary regulations issued in June 2019 introduced additional limitations on the amount of the DRD allowable in connection with certain transactions that the Treasury believed could be used by taxpayers to inappropriately avoid US tax on earnings of an SFC that also is a CFC. These transactions are grouped into two categories, so-called (i) "extraordinary dispositions" and (ii) "extraordinary reductions."
As a result of the effective dates under the Tax Act, there may be a period between when the GILTI rules first apply to a US Shareholder with respect to a CFC and the last date on which the E&P of the CFC is measured for purposes of the Repatriation Tax (the Gap Period). The Treasury was concerned that CFCs may have engaged in certain sales or dispositions outside the ordinary course of business with related parties during the Gap Period (an extraordinary disposition) with a goal of creating stepped-up basis for the related buyer. These transactions could generate E&P for the selling CFC that was not subject to any current US tax and a corporate US Shareholder of such CFC may otherwise be eligible for the DRD under Section 245A when such E&P ultimately is distributed. Under the temporary regulations, subject to certain E&P allocation and ordering rules, a DRD under Section 245A with respect to a distribution of E&P attributable to such an extraordinary disposition is limited to 50%, which is meant to approximate the 50% deduction US corporations generally are eligible for if such earnings were includable as GILTI.
Transactions included in the extraordinary reduction category include a corporate US Shareholder's transfer of CFC stock where a deemed dividend under Section 1248 (that otherwise would qualify for the DRD under Section 245A) reduces, under Section 951(a)(2)(B), a US buyer's share of Subpart F income or GILTI includable in the year of such sale. The rule is intended to prevent a double benefit but generally only applies to a US Shareholder that is a US corporation owning directly or indirectly more than 50% (by vote or value) of the stock of the CFC. An extraordinary reduction generally occurs when such a corporate US Shareholder reduces its ownership of the CFC by more than 10% (by value) and at least 5% (by vote). The disallowed amount generally is the lesser of (i) the dividend or (ii) the shareholder's pre-reduction pro rata share of the CFC's Subpart F income and so-called "tested income" for GILTI purposes. Similar rules also apply in the case of transactions between tiered CFCs.
As an exception, a DRD for a dividend attributable to earnings from an extraordinary reduction is not disallowed if an election is made under the temporary regulations to close the CFC's tax year as of the date of the extraordinary reduction. This election effectively requires the corporate US Shareholder of the CFC to include in its gross income its share of the CFC's Subpart F income and GILTI tested income as of the date of the extraordinary reduction. This election may be advantageous for a selling corporate US Shareholder that would be able to exclude Subpart F income under the HTKO Exception or deduct 50% of the GILTI that is recognized as a result of such an election.
Under de minimis exceptions, amounts only are subject to the above-described DRD disallowance rules, (i) in the case of gains from extraordinary dispositions, if the sum of the net gains from extraordinary dispositions exceeds the lesser of $50 million or 5% of the gross value of the CFC's property held immediately before the extraordinary disposition and, (ii) in the case of extraordinary reductions, if the sum of the Subpart F income and GILTI tested income of the CFC for the taxable year exceeds the lesser of $50 million or 5% of the CFC's total taxable income for the applicable year.
The temporary regulations apply to actual or deemed dividends made after December 31, 2017.
© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.