The code changes made by the Tax Cuts and Jobs Act (P.L. 115-97) have wreaked havoc on international rules, creating taxpayer uncertainty in how to apply the law and headaches for the government in how to write interpretive rules. Much of the complexity comes from a single source: the delineation of global intangible low-taxed income as a separate basket under section 904(d). That construct brings expense allocation rules into play, potentially restricting U.S. multinationals’ ability to claim foreign tax credits on GILTI in unexpected ways. When combined with the restriction on FTC carryovers attributable to GILTI inclusions (section 904(c)), it also raises questions about the interaction of the other rules of section 904 that were designed to limit taxpayers’ use of foreign taxes paid as an offset against U.S.-source income. And yet those rules are less relevant if much of the foreign income of controlled foreign corporations of U.S. companies is currently includable and attributable FTCs can be used only in the year incurred.
The surprising impact of the interaction of the expense allocation rules and the inclusion required under section 951A is evident in recent restatements of earnings guidance from a few public companies.
The Expense Allocation Problem
The problems with allocating U.S. shareholder-level expenses to income includable under section 951A are legion, and a recent New York State Bar Association report on GILTI describes many of them. The report provides a useful simplified example of how, if a CFC’s foreign tax rate is at least 13.125 percent, every dollar of U.S. shareholder expense allocated to GILTI gives rise to additional U.S. tax on that income — regardless of how high above 13.125 percent the foreign tax rate goes. Those types of oddities resulting from the application of the section 904(d) FTC limitation baskets might not have been so consequential when FTCs could be carried forward or back to smooth out discrepancies, but they matter a lot when foreign taxes attributable to GILTI can be credited only in the year incurred.
The NYSBA report discusses many other hot topics regarding calculating the section 951A amount, including whether the gross-up of taxes on section 951A inclusions required by section 78 belongs in the GILTI section 904(d) basket (allocating the amount to the general limitation basket also limits the creditability of taxes associated with GILTI, resulting in a higher overall effective rate). And there’s a fundamental question whether the GILTI calculation applies on a U.S. shareholder-level basis or a consolidated group basis. The calculation of the section 250 deduction raises similar questions. Although the statute isn’t ambiguous, requiring the inclusion to be calculated on a separate U.S. shareholder basis leads to traps for the unwary and many planning opportunities, which the government would like to minimize. Basketing of interest, rents, and royalties is also an unresolved matter.
Whether one considers an overallocation of U.S. shareholder-level expenses to the GILTI basket problematic depends on one’s perspective of the policy behind the GILTI tax, the appropriateness of any minimum tax on foreign earnings, the morality of taxing foreign earnings at a rate lower than domestic earnings, and congressional intent in enacting the tax. At the American Bar Association Section of Taxation’s annual meeting in Washington, many practitioners emphasized how overallocating U.S. shareholder expense to foreign earnings and further limiting the FTC are unwarranted and unintended policy results. Many academics, including some who testified at an April 24 Senate Finance Committee hearing, think Congress didn’t go far enough in attempting to tax foreign earnings of U.S. companies.
In drafting guidance for the new law, Treasury is guided by principles of administrability and fairness consistent with the Trump administration’s overall policy goals, informed by legislative intent, and bound by specific statutory language.
TCJA Policy Goals
Some rationales for changes made by the tax law can be gleaned from statements released by the White House and Congress. According to a broad policy statement released last July by White House and congressional representatives, the goal of tax reform was to “create a system that encourages American companies to bring back jobs and profits trapped overseas.” The group said it developed “a viable approach for ensuring a level playing field between American and foreign companies and workers, while protecting American jobs and the U.S. tax base.”
In September members of the Trump administration, House Ways and Means Committee, and Senate Finance Committee released a more detailed outline for reform. Among the principles in the unified framework for tax reform are making the United States a jobs magnet by leveling the playing field for U.S. businesses and workers as well as bringing back trillions of dollars kept offshore to reinvest in the U.S. economy. The framework says territorial taxation will end “the perverse incentive to keep foreign profits offshore by exempting them when they are repatriated to the United States” and “replace the existing, outdated worldwide tax system with a 100 percent exemption for dividends from foreign subsidiaries.” To stop companies from shipping jobs and capital overseas, the framework includes rules to protect the U.S. tax base by taxing the global foreign profits of U.S. multinationals at a reduced rate.
According to policy highlights released by the House and Senate conference committee after the bill passed, the TCJA modernized the U.S. international tax system so that U.S. global businesses would no longer be held back by an outdated worldwide system that resulted in double taxation for many job creators; made it easier for U.S. businesses to repatriate foreign earnings to invest in growing local economies; and prevented U.S. jobs, headquarters, and research from moving overseas by eliminating incentives to shift jobs, profits, and manufacturing plants abroad.
GILTI’s Legislative Intent
Language from a Senate Budget Committee report explaining the TCJA as passed by the Finance Committee, as well as from the conference committee report, helps show how Congress thought its policy goals were being translated into specific provisions.
The Budget Committee report indicates that GILTI was intended to protect against erosion of the U.S. tax base associated with a move to a territorial system. It states that without any base protection measures, the participation exemption system would create an incentive for U.S. companies to allocate income that would otherwise be taxed at the full U.S. corporate rate to foreign affiliates operating in low- or zero-tax jurisdictions and potentially distribute it back to the U.S. corporation U.S. tax free. “To address this possible source of erosion of the U.S. tax base, and the potential migration of economic activity from the United States to other countries, the provision subjects certain income earned by CFCs to current U.S. tax,” according to the report. “Subjecting that income to current U.S. tax reduces the tax benefit of allocating that income to low- or zero-tax jurisdictions.”
In explaining new section 951A, the conference committee report says that because only 80 percent of FTCs are allowed to offset U.S. tax on GILTI, the minimum foreign rate for that income at which no residual U.S. tax is owed by a U.S. corporate shareholder is 13.125 percent. Further, it states that as the range of foreign tax rates on GILTI varies from 0 to 13.125 percent, the total combined foreign and U.S. tax rate on GILTI ranges from 10.5 to 13.125 percent. The best indication of what Congress thought it was doing in enacting GILTI is perhaps this sentence: “At foreign tax rates greater than or equal to 13.125 percent, there is no residual U.S. tax owed on GILTI, so that the combined foreign and U.S. tax rate on GILTI equals the foreign tax rate.” The report lays out the math in greater detail in note 1526.
The Budget and conference committee reports suggest that GILTI was intended as an anti-base-erosion measure to limit the incentives for U.S. taxpayers to move offshore, especially to low-tax jurisdictions. Congress considered those measures uniquely necessary in transitioning to a participation exemption system. Even so, the legislative intent arguably conflicts with making GILTI a separate FTC basket in section 904(d). As explained, the mechanics of those rules render inaccurate the statement in the conference report about the maximum effective rate on GILTI when there are any allocable U.S. shareholder expenses.
Haircut of Expense Allocation
How to limit base erosion in a territorial system has long been debated. In Taxing International Business Income: Dividend Exemption Versus the Current System (2001), Harry Grubert and John Mutti proposed a dividend exemption system that wouldn’t permit FTCs on repatriated earnings, much like the regime enacted by the TCJA. But it would have disallowed deductions allocable to tax-exempt foreign-source income to remove from the tax base costs connected with exempt income.
Grubert and Mutti considered it important to restrict cross-crediting of excess FTCs, prevent the artificial diversion of technology-exploiting investment to low-tax locations, and disallow deductions incurred in generating exempt foreign-source income. A concern raised about the Grubert-Mutti proposal was the pressure it put on characterizing income as active versus passive, because active income would be permanently exempt and passive investment income would be taxed currently.
More recent proposals, such as the tax bill former Ways and Means Committee Chair Dave Camp introduced in 2014, included a disallowance of an amount of interest considered allocable to exempt income rather than all deductions, and would have limited base erosion by providing for a minimum tax on low-taxed foreign intangible income. It provided for only a 95 percent dividend exclusion, a limitation generally viewed as capturing some domestic overhead expenses (see Jane G. Gravelle, “Tax Havens: International Tax Avoidance and Evasion,” Congressional Research Service R40623 (June 5, 2009)).
The need to balance an exemption from U.S. tax for active foreign earnings with appropriate base erosion safeguards has been a constant theme. A 2015 report by the Senate Finance Committee international tax reform working group says adopting a territorial system without appropriate safeguards could further encourage multinationals to erode the U.S. tax base. The report makes no recommendations, but says that if a minimum tax is adopted in connection with a transition to a territorial system, “the type of income subject to a minimum level of tax and the rate applied to such income should meet the twin goals of preventing base erosion while ensuring that U.S. multinational companies are more competitive vis-à-vis their overseas rivals.”
The policy rationale most closely reflected in the TCJA is buried in a 2014 report by the Republican staff of the Senate Finance Committee. The staff noted that while many countries adopt a 95 percent exemption system as a proxy for home-country expenses incurred in generating exempt income, another mechanism for achieving that result is a current tax on foreign earnings:
Rather than allocating expenses or exempting a portion of any dividend received by a U.S. multinational from its foreign subsidiaries, the simplest approach may be to simply impose a “proxy” tax on the earnings of the foreign subsidiary. The tax would be a proxy for the nonallocation of expenses of the U.S. multinational to the earnings of the foreign subsidiary. The United States could impose the proxy tax on an annual basis on the earnings of the foreign subsidiary. As a result, deferral of foreign earnings would be eliminated and a modest tax could be imposed on such earnings.
Taking at face value the staff’s comments on what the GILTI tax was intended to accomplish in a territorial system is a helpful way to make sense of the apparent discrepancy between the statutory drafting and conference report language regarding the GILTI tax’s intended function. Combined with the new section 163(j) limitation, the GILTI tax reduces base erosion and limits deductibility of U.S. incurred expenses attributable to foreign earned income.
Treasury’s Statutory Authority
Treasury and IRS officials have been circumspect about the direction they might choose in drafting regulations for allocating expenses to GILTI. But they’ve emphasized that the reference to GILTI in section 904(d) shows clear congressional intent to allocate a portion of U.S. shareholder expenses to GILTI, and that the statutory drafting suggests Congress wanted existing regulations to be incorporated. That deference to the statutory language as building on existing administrative guidance stands in sharp contrast to positions they’re taking on other TCJA changes that show they’re much more willing to stretch the limits of regulatory authority to minimize taxpayer harm.
One example is section 958(b), with repeal of section 958(b)(4) having perverse effects, resulting in the creation of CFCs when there’s only very small constructive ownership. Treasury officials have said they don’t think that’s appropriate, and turned off the rule’s application in specific cases. Notice 2018-26, 2018-16 IRB 480, says the government intends to issue regulations that would provide section 965 relief from the broad application of constructive ownership rules for 5 percent partners when downward attribution results in an inclusion. At the ABA meeting, government officials said they’re combing through regulations to see where they can modify guidance to minimize negative — and what they consider unintended — consequences of statutory drafting.
Another example of Treasury’s apparent willingness to stretch its authority despite clear legislative drafting involves whether the section 78 mandatory gross-up of taxes on section 951A inclusions belongs in the GILTI basket. According to Gretchen Sierra of Deloitte Tax LLP, who spoke at the ABA meeting, none of the Big Four accounting firms is willing to sign off on allocating the gross-up that way. (See also this tax correspondence.)
Treasury seems willing to take a position arguably at odds with the statutory language. At the ABA meeting, Lindsay Kitzinger, attorney-adviser, Treasury Office of International Tax Counsel, said Treasury plans to issue proposed regulations confirming that the section 78 gross-up attributable to GILTI belongs in the GILTI basket, which it believes is “the right answer.”
Treasury hasn’t indicated it’s looking for any authority to avoid the harms caused by the interaction of the statutory drafting with its rules for allocating U.S. shareholder expenses in calculating the FTC. Taxpayers have pointed out that there’s plenty of room for Treasury to avoid allocating U.S. shareholder-level expenses to GILTI basket income — for example, interest expense allocable under current regs to CFC stock that produces exempt income. Section 862(b), which gives Treasury the authority to allocate expenses to foreign-source income, simply says that from the section 862(a) items of gross income “there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto, and a ratable part of any expenses, losses, or other deductions which cannot definitely be allocated to some item or class of gross income.” The government has wide leeway — amply evident in existing regulations — to decide what the phrase “properly apportioned and allocated to” means. If the section 163(j) limitation is viewed as a proxy for disallowing a portion of shareholder expenses allocable to exempt income, and the GILTI inclusion reinforces that principle, allocating additional shareholder-level expenses in a way that increases the effective rate on income in the GILTI basket in excess of 13.125 percent seems to conflict with legislative intent. One area where Treasury may have broad latitude in this regard is allocating U.S. shareholder supervisory and administrative expenses. See reg. section 1.861-8(b)(3).
Effects on Taxpayers
Some companies recently updated their earnings guidance to correct their earlier misperceptions about how GILTI would affect their effective tax rates.
In its most recent earnings guidance, Cognizant Technologies said its projected 2018 tax rate will be 2 percentage points higher than expected, primarily because of the updated interpretation of GILTI. The company explained on its earnings call that as a result of the added scrutiny of the GILTI provision, it’s realized that the amount of FTCs it can get is limited.
In its Form 8K released April 9, Tupperware updated its first-quarter guidance to reflect an approximate effect of $0.06 earnings per share from a higher than previously foreseen income tax rate stemming from the TCJA. It pointed to GILTI as a reason for the projected rate change.
Conclusion
Congress’s broad objectives in enacting GILTI can be easily summed up: protect against profit shifting and base erosion in connection with a shift to a territorial system that exempts active business income not associated with intangibles to keep intangibles (and the associated jobs) in the United States. But how those goals can be best achieved given the TCJA’s many code changes is debatable.
That lack of clarity gives Treasury leeway in issuing guidance. It could adopt an approach similar to that in existing regulations for allocating expenses, which would result in U.S. multinationals with any U.S. shareholder-level allocable expense and a foreign tax rate over 13.125 percent paying a rate higher than that outlined in the legislative history. It could decline to allocate interest expense (at least partially) to CFC stock that produces exempt dividends, which would produce a U.S. effective rate more in line with the results described in the legislative history. If Treasury decides to allocate U.S. shareholder expenses to GILTI the same way the section 861 regulations do, it will need to justify that approach in light of both the legislative history and its proactive approach to finding solutions to poor legislative drafting in other areas of the TCJA.
Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, director of its international tax LLM program, and a contributor to Tax Notes International. Email: herzfeld@law.ufl.edu.