Innocent Until Proven GILTI – Not Anymore: The New Global Intangible Low Taxed Income Regime
November 14, 2018
By Simcha David, CPA, JD
Many private equity funds have historically invested in foreign operating corporations. The tax issues inherent in such acquisitions and the proper tax structuring surrounding these purchases and dispositions have always been complex. In the past, the actual ownership of the foreign operating entity did not require the inclusion of operating income on a current basis, except to the extent the company paid a dividend. The net income of such operations remained in the corporation and there was no “phantom income” flowing up to the fund. That is no longer the case. Welcome to the new Global Intangible Low Taxed Income (GILTI) Regime.
The Tax Cuts and Jobs Act of 2017 (the “Act”) was the largest overhaul of the Internal Revenue Code (the “Code”) since the Code itself was completely overhauled in 1986. Prior to the Act, business income earned by a foreign corporation overseas was generally not taxed to a U.S. corporate parent until a dividend was paid to the U.S. parent and the cash was repatriated to the U.S. With U.S. corporate taxes being 35%, this caused many multinational corporations to leave the cash earned in the foreign corporate subsidiaries offshore. To prevent this behavior and encourage multinational corporations based in the United States to repatriate cash being held overseas for investment in the U.S., the Act established a participation exemption system under which certain earnings of a foreign corporation could be repatriated to a U.S. shareholder without U.S. tax. This is accomplished by allowing a 100% dividends received deduction (“DRD”) for greater than 10% U.S. corporate partners of controlled foreign corporations. (A controlled foreign corporation [a “CFC”] is a corporation that has greater than 50% of its shares [by vote or value] owned by greater than 10% U.S. shareholders.)
To transition to this new system and to capture repatriation of pre-Act earnings and profits, a one-time repatriation tax was instituted under Code Sec. 965 for the tax year ending December 31, 2017. With the new participation exemption system in place beginning January 1, 2018, however, Congress recognized that without further base protection measures, the new system could incentivize taxpayers to allocate income from intangible property that would otherwise be subject to full U.S. corporate tax rates (now at 21%) to controlled corporations operating in low or zero-tax jurisdictions. Intangible property can be held anywhere in the world, while tangible property is not as mobile or is not mobile at all.
In a simple scenario, a U.S.-based corporation could house its intellectual property licenses in a foreign corporate subsidiary and charge the U.S. parent for use of that intellectual property. The U.S. parent has an expense that reduces the net income otherwise subject to U.S. tax, and the foreign corporate subsidiary picks up the income and, if in a low- or no-tax jurisdiction, pays a lower tax or no tax at all on that income. If under the pre-Act system, the money paid to the foreign corporation was repatriated to the U.S. parent, there would have been full U.S. tax at that time to the extent of the earnings and profits of the foreign corporation. Under the new participation exemption system, the cash related to foreign earnings can be repatriated to the U.S. parent and not be subject U.S. tax. The perfect storm: low taxing jurisdiction with the ability to bring the cash back tax-free. Because of this, Congress enacted additional measures to prevent this type of base erosion.
The name GILTI is a misnomer. While the purpose of this tax is to tax foreign income related to the use of intangible property in low taxing jurisdictions, Congress understood it would be extremely difficult to identify income specifically associated with the use of intangible property and so instead instituted the GILTI tax, with a formulaic approach utilizing certain assumptions about the generation of income. The basics of the calculation is to allow for a return of net operating income equal to 10% on certain tangible assets and to assume that all other net operating income is a return on intangible assets and subject to the GILTI regime. In order not to harm U.S. corporations competing in foreign jurisdictions by saddling them with a full U.S. tax in addition to the foreign tax, the GILTI income is effectively taxed at a lower rate by allowing a U.S. corporation to pay the GILTI tax on only 50% of the GILTI income, and tax credits are allowed for taxes paid to foreign jurisdictions.
GILTI is imposed only on greater than 10% U.S. shareholders (“U.S. Shareholder”) of CFCs. The term U.S. Shareholder includes a U.S. limited partnership. In the partnership context, there are times that the Code views a partnership as the aggregate of its partners and at time views a partnership as an entity. With regard to the 10% ownership rule, the U.S. limited partnership will be viewed as an entity and the ownership test will be at the partnership level rather than at the partner level. What this means for private equity fund investors is that they might very well have a GILTI inclusion even though they indirectly own much less than 10% of the foreign corporation. The Fund would record the GILTI inclusion and allocate this income to its partners.
The GILTI regime introduces many new terms, and the calculation can be quite complex. The IRS issued proposed regulations in October 2018 to help explain some of these complexities. The proposed regulations discuss how to determine a shareholder’s pro rata share of all of the items necessary to perform these calculations. There are specific examples related to corporate partners of U.S. partnerships that own CFCs. The regulations also discuss how to handle preferred shareholders.
The basic calculation is as follows where every defined term has pages of regulations associated with it:
GILTI is the excess of a U.S. Shareholder’s “net CFC tested income” for the tax year over the U.S. Shareholder’s “net deemed tangible income return” for the tax year.
Net CFC Tested Income
“Net CFC tested income” is the excess of the aggregate of the shareholder’s prorata share of the “tested income” of each CFC of the U.S. Shareholder over the aggregate of the shareholder’s prorata share of the tested loss of each CFC. “Tested income” of the corporation is the gross income of the corporation less the following: deductions properly allocable to that gross income, income effectively connected with a U.S. trade or business, subpart F income (subpart F income includes foreign personal holding company Income which generally consists of passive income such as interest, dividends, net foreign currency gains, net gains from sales of property that do not generate active income, certain rents and royalties and income from personal services contracts), dividends received from related parties, foreign oil and gas extraction income and gross income excluded due to exception for high foreign taxes. Net CFC tested income is trying to calculate the aggregate annual foreign sourced earnings of the foreign corporations that are due to operations, with some exceptions and adjustments. It is interesting to note that unlike under the subpart F regime where the subpart F income of each foreign corporation owned is viewed on its own and no benefit is allowed for corporations with losses, under the GILTI regime all of the income and losses of the various foreign owned corporations are aggregated at the shareholder level.
Net Deemed Tangible Income Return
“Net deemed tangible income return” is the excess of 10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (“QBAI”) of each CFC over the amount of interest expense taken into account in determining the Net CFC tested income of such corporation. QBAI is the average of the corporation’s aggregate adjusted bases as of the close of each quarter of the tax year in specified tangible property used in a trade or business of the corporation and which is allowed a deduction under Code Sec. 167. In other words, depreciable property. The aggregate adjusted bases must utilize the ADS system of depreciation rather than the Modified Accelerated Cost Recovery System (MACRS) or other system of depreciation. The new regulations clarify that if there is a tested loss corporation (which is a foreign corporation that has “tested income” that calculates to a loss) that is used in the aggregate calculation of Net CFC tested income, the basis of the assets of that corporation are not allowed to be used in determining the net deemed tangible income return. The regulations also note that a foreign corporation needs to recalculate depreciation on all of its assets both pre- and post-Act using the ADS system in determining their QBAI.
Taking a step back, it is important to understand the impact that such income inclusions can have on shareholders of the foreign corporation. Generally, income earned by a corporation is taxed within the corporation, and such income is not deemed to be earned by the shareholder on a current basis. When cash is paid out of the corporation to the shareholders, such income is taxed as a dividend to the extent such corporation has earnings and profits. This is sometimes referred to as a “double level of taxation.” This is in stark contrast to partnerships where the income earned by the partnership is deemed to have been earned by the partners on an annual basis and is not taxed at the partnership level. Under the GILTI regime, the GILTI income earned within the foreign corporation will be taxed on a current basis to the U.S. Shareholders. In many ways, this is similar to the subpart F inclusions that the asset management industry has been dealing with for many years.
Before the Act, the CFC designation was important as it required certain tax reporting on the tax return of the U.S. Shareholder and required the inclusion of subpart F income earned in a CFC to be included in income on a current basis. Subpart F income inclusions from CFCs are commonly referred to as sources of phantom income. It is described as phantom income as the taxable income is generally not caused by an event that generates cash to the shareholder (such as a sale). The GILTI regime may be viewed as a similar provision for the operating (non-passive) income of a foreign corporation attributable to its foreign operations. In the past, if a fund invested in a foreign operating company it would generally not have any current income inclusions for tax purposes unless it was paid a dividend by the foreign operating company or it sold the company. Under the new rules, a portion of this operating income of the foreign company will be subject to U.S. tax on a current basis.
One of the major differences between the GILTI inclusion and the subpart F inclusion is that subpart F inclusion of each specific CFC is calculated on its own. If a U.S. Shareholder owns multiple CFCs, the subpart F inclusion of each CFC is determined separately. Under the GILTI regime, all of the items that are necessary for the calculation are aggregated at the shareholder level prior to the calculation of the GILTI inclusion. In its simplest form, this means that losses can offset income inclusions from other CFCs. So as not to get a double benefit, QBAI of a tested loss CFC does not get included in the aggregate QBAI when determining the 10% benefit.
Another important aspect that is relevant to the asset management industry is the fact that the deduction of 50% of the GILTI inclusion that is built into the system to allow for a lower level of tax is only allowed for U.S. corporate shareholders. In the Fund context, if a private equity fund owns an investment in a foreign corporation that is a CFC, and the Fund is a Delaware Limited Partnership that is a greater than 10% shareholder of the foreign CFC, the Fund will pick up the GILTI amounts and pass those amounts along to its partners. A U.S. partnership is deemed to be a shareholder on its own in this context, and you do not look through to the partners to determine ownership of the CFC. Individuals who will be allocated this GILTI income will have to pay up to the highest rate of federal tax of 37% on the income. A corporation that can deduct 50% of the GILTI income allocated to it will have an effective tax rate of 10.5% (21% (new corporate tax rate) x 50%). There may be a way for individuals to have the lower rate of tax through an election at the individual level or Funds will need to put proper tax structuring in place to accommodate for the new rules.
Overall GILTI is a complex set of rules with a clear mission but an unclear methodology to accomplish that mission. The old way of structuring for efficient tax purposes may no longer work and it is imperative that you discuss this provision as well as all of the other provisions of the Act with your tax service providers.
Asset Management Intelligence – Q4 2018
- AICPA Issues Draft Guidance on Valuing Equity Interests Within Complex Capital Structures
- Innocent Until Proven GILTI – Not Anymore: The New Global Intangible Low Taxed Income Regime
- Asset Management Update: FASB Modifies Fair Value Disclosure Requirements
- Alternative Investment Industry Outlook for Q4 and Beyond
- Disruption: Fintech Companies and Lending Activities