July 21, 2020 / North America
Yesterday, the Treasury and the IRS released final high-tax exception GILTI regulations and proposed high-tax exception Subpart F income regulations. While the regulations are favorable in that they allow taxpayers to apply the high-tax GILTI regulations retroactively to taxable years of foreign corporations beginning after December 31, 2017, and are a little more favorable than the proposed high-tax exception GILTI regulations (the 2019 proposed regulations), the regulations will change the tax community’s view of the high-tax exception.
For purposes of computing a controlled foreign corporation’s (CFC’s) foreign base company income and insurance income (components of Subpart F income), a U.S. shareholder can currently elect to exclude any item of income that was subject to an effective rate of foreign tax equal to at least 90 percent of the U.S. corporate tax rate. With the reduction of the corporate tax rate as part of TCJA, the potential for income to be eligible for the high-tax exception dramatically increased.
The 2019 proposed regulations proposed to allow a similar election to exclude certain income items from the calculation of GILTI. However, the proposed methodology for GILTI purposes varied from the well-established methodology that applied to the Subpart F income high-tax exception. Yesterday’s release attempts to harmonize the operation of the two exceptions, largely by proposing amendments to the Subpart F regulations to adopt the concepts of the GILTI regulations. However, it is important to note that the proposed Subpart F regulations are not effective yet, and yesterday’s guidance does not permit taxpayers to rely upon them. Therefore, taxpayers will continue to apply two different rules at least until the Subpart F rules are finalized.
The following is a high-level summary of the notable changes to the high-tax exception rules.
Determination of High-Tax Income
The biggest change to the regulations is the determination of the basic unit to which the high-tax test applies. The 2019 proposed regulations would have required the GILTI high-tax test to be applied separately to each qualified business unit (QBU) of a CFC. Commentators had asked that this QBU-by-QBU approach be replaced with a CFC-by-CFC approach, under which a single effective tax rate would be measured for all the tested income items of a CFC. The final regulations decline to adopt the CFC-by-CFC approach, while also jettisoning the QBU-by-QBU approach. The new approach is to determine whether income is eligible for the high-tax income exception on a “tested unit” basis. The tested unit standard is meant to group income that is likely to be subject to a single foreign tax rate and to reduce opportunities to blend income subject to different tax rates for purposes of the high-tax test. A tested unit may be a CFC, an interest in a pass-through entity (including a disregarded entity) held by a CFC, or a branch of a CFC outside the CFC’s country of incorporation, in each case if certain conditions are met. Tested units that are resident or located in a single foreign country may generally be combined.
The proposed Subpart F regulations would require the Subpart F high-tax test also to be applied on the basis of tested units and would provide grouping rules intended to reduce grouping of high- and low-taxed income items.
A&M Insight: As the name indicates, disregarded payments are payments that are not taken into account for U.S. income tax purposes and possibly not tracked. Based on the adoption of the tested unit approach, it is understandable that Treasury and the IRS would want disregarded payments to be taken into account in order to determine the effective tax rate on a unit. However, this places an onus on U.S. shareholders to determine the amount of disregarded payments and trace their effects on the income of each tested unit…
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