Treasury and IRS Issue Final and Proposed Regulation on Domestic Partnerships - Treatment of GILTI and Subpart F Income and Expanded High Tax Exception for GILTI
July 03, 2019
By Harold Adrion and Charles Brezak
On June 14, 2019, the IRS and Treasury finalized the global intangible low-taxed income (GILTI) regulations (T.D. 9866) and issued proposed regulations (Reg. 1018281-19).
The regulations attempt to address many of the issues surrounding domestic partnerships investing in controlled foreign corporations (CFCs). In addition, the proposed regulations exclude certain high tax income from U.S. shareholder’s GILTI computation.
There has been a significant difference in the way a foreign corporation is treated if owned by a domestic or foreign partnership. A foreign partnership was looked through to test the status of a foreign company as a CFC, while a domestic partnership was not looked through in making this determination. There was no good policy reason for this discrepancy and it forced many partnerships (particularly private equity funds) to establish partnerships offshore. Also, many companies that were CFCs because of being owned by U.S. partnerships avoided Subpart F income through either active trades or business or availing themselves of the high tax exception.
The 2017 Tax Act compounded the problems that existed under prior law by enacting the GILTI provision. The GILTI provision significantly expanded the types of income subject to this the new anti-deferral provision and did not provide for a general high tax exception similar to the Subpart F provision. This forced taxpayers and their advisors to consider migrating U.S. partnerships to foreign jurisdictions and creating Subpart F income in jurisdictions where the income would qualify for the high tax exception. All of this was very counter intuitive.
The IRS and Treasury acknowledged this quagmire in the regulations and attempted to correct in the final and proposed regulations. In brief, the regulations:
- Adopt a high tax exception for GILTI;
- Treat U.S. partnerships as an aggregate of partners for GILTI purposes; and
- Treat U.S. partnerships on an aggregate basis for purposes of IRC Sec. 951.
The final and proposed regulations are welcome relief to U.S. individuals, companies, and partnerships (particularly private equity funds with U.S. partners).
High Tax Exception in Proposed Regulations
The Proposed Regulations contain an elective high-tax income exception from gross tested income subject to foreign tax at an effective tax rate that is higher than 90% of the highest applicable U.S. tax rate imposed on a corporation or 18.9% (90% x 21%). In a number of developed countries, the effective tax rate is in excess of 19.8%, so the breadth of the high tax exception is notable broad.
Principal features of GILTI high tax exception include:
- The income taxed at a greater than 18.9% rate is determined on a QBU-by-QBU basis.
- The election is made by a controlling shareholder.
- There is a 60-month wait period to re-elect.
- There is an all-or-nothing election for all CFC’s within a controlling domestic shareholder group.
The effective date of the high-tax exception is not clear.
- The high-tax exception is proposed to apply to tax years of foreign corporations beginning on or after the date of publication of the final regulations. As a result, the high-tax exception election would be available for calendar year foreign corporations and U.S. shareholders in 2020 at the earliest, if the final regulations are published prior to January 1, 2020.
- There has been speculation that the high-tax exception may apply retroactively. Speaking June 25 at an event sponsored by the District of Columbia Bar Taxation Community in Washington, Daniel McCall, IRS deputy associate chief counsel (international-technical), did not indicate whether the high-tax exception might apply retroactively once in final form. However, he explained that the prospective date was chosen to provide opportunity to assess how the exception would operate. It would appear that the effective date in the proposed regulations is simply a placeholder until IRS and Treasury can evaluate the benefits and burdens of applying the high-tax exemption retroactively.
- As noted below, the effective date of the proposed and final regulations on treating partnerships on an aggregate basis for the purpose of computing U.S. partners, GILTI and Subpart F income is retroactive to tax years beginning after December 31, 2017. From a policy perspective, a strong argument could be made for applying the high-tax exception retroactively, similarly to the treatment of U.S. partnerships which have GILTI or Subpart F income.
Final Regulations Provide for Aggregate Treatment of U.S. Partnerships for GILTI Purposes
The GILTI final regulations apply an aggregate approach for purposes of determining a partner’s GILTI inclusion amount with respect to CFC ownership by a domestic partnership.
A U.S. partnership will continue to be treated as a single U.S. shareholder for purposes of determining whether the partnership and its partners are U.S. shareholders, whether the partnership is a controlling domestic shareholder and whether the foreign company is a CFC.*
The final regulations under IRC Sec. 951A apply to tax years beginning after December 31, 2017.
The Proposed Regulation Expand the Aggregate Approach to Partnerships in the Context of Income Inclusions Under IRC Sec. 951
The proposed regulations also extend the aggregate approach to IRC Sec. 951. The preamble provides that “Congress intended for the Subpart F and GILTI regimes to work in tandem.” Consequently, for purposes of determining the Subpart F inclusions of U.S. partners of a domestic partnership which is the U.S. shareholder of a CFC, an aggregate approach will apply – the U.S. partners will be treated as proportionately owning the CFC stock that is held by the U.S. partnership.
The proposed regulations are proposed to apply to taxable years of foreign corporations beginning on or after the date of publication of these rules as final regulations; however, domestic partnerships may rely on the proposed aggregate treatment rules with respect to taxable years beginning after December 31, 2017 provided that the proposed rules are consistently applied by certain related persons.
Summary and Observations
- With the reduction in the corporate tax rate to 21% and expansion of the number of countries now considered high tax jurisdictions, the new high tax exception should benefit many CFCs and U.S. shareholders or partners in U.S. partnerships owning CFCs.
- U.S. partners in domestic partnerships that constructively own less than 10% of a CFC would in general not be required to include GILTI or Subpart F income.
- U.S. partnerships and partners who have filed 2018 tax returns using the 2018 Proposed Regulation may need to file amended returns.
- The incentive for moving a U.S. partnership to a foreign jurisdiction or forming a new partnership in a foreign jurisdiction has been significantly reduced.
*In addition, the status of a foreign company as a CFC for use of the “portfolio interest” exception should not be impacted. The preambles to the final and proposed regulations also provide that the aggregate treatment does not apply for other purposes of the Code including IRC Sec. 1248.