Global Intangible Low Tax Income, Foreign Derived Intangible Income, and IRC Sec. 250
On March 4, 2019, the U.S. Treasury issued proposed regulations to determine deductions provided by IRC Sec. 250 related to global intangible low tax income (“GILTI”) and foreign derived intangible income (“FDII”). Highlights of the regulations are listed below, but first a short history.
In December 2017, Congress enacted the Tax Cuts and Jobs Act (“TCJA”), arguably the largest piece of tax legislation in over 30 years. There was a complete overhaul of U.S. international tax rules with a move toward a quasi-territorial tax system.
Prior to the TCJA, U.S. corporations were allowed to defer U.S. tax on foreign business income earned by controlled foreign corporations (“CFCs”). To incentivize these U.S. corporations to repatriate the foreign business earnings of the CFCs, Congress enacted a participation exemption system that allows a U.S. corporation to repatriate earnings as tax-free dividends.
However, standing alone, the participation exemption would incentivize U.S. corporations to allocate foreign business income to low tax or no tax jurisdictions (by transferring income producing assets to the foreign corporation) and then repatriate the earnings totally tax free. To combat this perceived abuse, a new anti-deferral tax regime was enacted, known by its acronym GILTI. Under GILTI, a U.S. corporation would theoretically pay a minimum tax on the foreign business earnings of its CFCs regardless of distributions. To be competitive with other nations who do not tax the business earnings of CFCs, Congress enacted IRC Sec. 250 to allow for a 50% deduction on GILTI allowing for an effective corporate tax rate of 10.5% before reduction by foreign tax credits.
GILTI in turn could incentivize U.S. corporations to move foreign business profits to CFCs to take advantage of the lower corporate tax rate. To neutralize the effect of the low tax on GILTI, IRC Sec. 250 also provides a 37.5% deduction for a U.S. corporation’s foreign-derived intangible income, also known as FDII, effectively reducing the U.S. corporate tax rate on FDII to 13.125%. Only U.S. C corporations are allowed a deduction for FDII.
The above-mentioned regulations provide guidance for calculating the IRC Sec. 250 deduction for both GILTI and FDII and provide an ordering rule for its interplay with other sections of law such as the business interest limitations under IRC Sec. 163(j) and net operating loss deductions under IRC Sec. 172(a).
Of great importance to non-corporate taxpayers is the IRS decision to allow the IRC Sec. 250 deduction for individuals making an election to be treated as a corporation for purposes of GILTI (see below for more detail).
In particular, the regulations provide for the following;
- Rules related to the computation of a domestic corporation’s FDII;
- Guidance in computing a domestic corporation’s taxable income limitation for both GILTI and FDII;
- IRC Sec. 250 deductions are subject to a taxable income limitation. If in a given year, the sum of a domestic cooperation’s GILTI and FDII exceeds taxable income, the excess will reduce the corporation’s GILTI and FDII prorata for purposes of computing the IRC Sec. 250 deduction.
- Rules for determining gross FDII from the sale of property to foreign persons for use outside the U.S.;
- Rules for determining gross FDII from the provision of services to persons located outside the U.S. and with respect to property located outside the U.S.;
- Rules relating to the sale of property and the provision of services to related parties.
- That the IRC Sec. 250 deduction is available to individuals making an IRC Sec. 962 election to be taxed as a corporation, including an individual that is a shareholder in an S corporation or a partner in a partnership. Note that an IRC Sec. 962 election can only be made by an individual U.S. shareholder, as defined by IRC Sec. 958(b), that owns directly or indirectly 10% or more of a CFC by vote or value;
- An ordering rule for applying the interest limitation rules of IRC Sec. 163(j) and the net operating loss rules of IRC Sec. 172(a) in conjunction with IRC Sec. 250;
- In essence, the regulations provide that a domestic corporation’s taxable income for purposes of determining the IRC Sec. 250(a)(2) income limitation is determined after all other deductions are taken into account. Accordingly, taxable income for IRC Sec. 250(a)(2) is taxable income without regard to IRC Sec. 250 but taking into account the IRC Secs. 163(j) and 172(a) limitations, including amounts to be carried forward to such taxable year. The regulations provide a five-step calculation to carry out the ordering rule.
- That an IRC Sec. 78 gross up for foreign taxes is a dividend for purposes of FDII and is not eligible for the IRC Sec. 250 deduction.
- That, for purposes of allocating expenses and deductions for purposes of computing FDII, regulations 1.861-8 through 1.861-1T and 1.861-17 are to be used.
- That a domestic partner of a partnership will take into account its distributive share of the partnerships FDII attributes such as deductible eligible income (“DEI”) qualified business asset investment (“QBAI”) etc. That a downward basis adjustment will apply to a domestic corporation’s partner’s interest in a partnership for its IRC Sec. 250 deduction as it is not exempt income to the partnership.
- Guidance on the application of IRC Sec. 250 to consolidated groups.
- Guidance on documentation needed to prove foreign status of a recipient of a sale of goods and where the property is treated as for foreign use and the location of a recipient of services. The regulations allow small taxpayers to rely on billing addresses in certain circumstances.
The proposed regulations are generally effective for tax years beginning on or after March 4, 2019. For purposes of making an IRC Sec. 962 election, taxpayers may rely on the regulations for years prior to March 4, 2019.