United States: Final GILTI Regulations And Proposed Regulations On Subpart F Income And GILTI Bring Relief To Private Equity And Other Non-Corporate Investors

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-101828-19) that will provide significant relief to investors in private equity funds and other domestic partnerships owning interests in foreign corporations, as well as relief to U.S. shareholders in controlled foreign corporations (CFCs). Specifically, the final regulations will impact how U.S. partners in a domestic partnership determine their GILTI inclusions with respect to CFCs owned by the domestic partnerships (and the proposed regulations would have similar impact for the calculation of U.S. partners’ subpart F income from such CFCs), thereby minimizing the need to organize partnerships owning CFCs as foreign partnerships. The proposed regulations also would exclude certain high-taxed income from a U.S. shareholders GILTI calculation. Both corporate and non-corporate taxpayers stand to benefit greatly from the expansion of the high-taxed income exclusion. The final regulations relating to GILTI income inclusions from CFCs owned by a domestic partnership (the “GILTI partnership regulations”) apply retroactively to tax years beginning after December 31, 2017, and taxpayers may apply the proposed regulations on subpart F inclusions from CFCs owned by domestic partnerships (together with the GILTI partnership regulations, the “Partnership Regulations”) retroactively for such years as well.  The GILTI high-tax exclusion expansion may not be applied until tax years beginning after the proposed regulations are finalized.

I. Treatment of Domestic Partnerships

The Partnership Regulations adopt an aggregate approach for domestic partnerships with respect to determining partner-level subpart F and GILTI inclusions with respect to a CFC owned through a domestic partnership. A CFC is a foreign corporation in which U.S. shareholders, who each (directly, indirectly or constructively) own at least 10% of the foreign corporation’s stock (either by vote or value), collectively own more than 50% of the foreign corporation’s stock. Such U.S. shareholders of a CFC are subject to current income inclusion of their share of a CFC’s subpart F income and GILTI.

Historically, if a private equity fund or other partnership was organized as a U.S. partnership, it would be treated as a single U.S. shareholder so as to cause the foreign corporation to be a CFC if the partnership owned more than 50% of the stock of the foreign corporation. Furthermore, because the domestic partnership was treated as a U.S. shareholder, all of the U.S. taxable partners of the partnership would have income inclusions under the subpart F rules, even if such partner indirectly owned less than 10% of the stock of the foreign corporation. Because of this rule, many private equity funds and other partnerships were organized outside of the United States because a foreign partnership is not treated as a single U.S. shareholder for these purposes. By being organized as a foreign partnership, the foreign corporation in most instances would not be a CFC. In some instances, a foreign corporation could still have technically been classified as a CFC, but in those instances, only a U.S. partner or other shareholder of the foreign corporation that directly, indirectly or constrictively owned 10% of the stock of the foreign corporation (by either vote or value) would have subpart F and (more recently, GILTI) income inclusions.

Prior to the introduction of the GILTI regime, some private equity funds and other taxpayers continued to operate as domestic partnerships, assuming that the foreign corporation could manage its operations to minimize subpart F income. However, the introduction of the GILTI rules greatly expanded the possible income inclusions and potentially virtually all of the income of a foreign corporation could be subject to current taxation under one of the subpart F income or the GILTI rules. This has caused more funds to consider organizing as foreign partnerships or spinning off their foreign corporations into a foreign partnership.

The Partnership Regulations generally eliminate this disparity between domestic and foreign partnerships in determining the tax treatment to partners under the subpart F rules and GILTI rules. Now, a partner of a domestic partnership that does not directly, indirectly or constructively own 10% of the stock of the foreign corporation will not have subpart F and GILTI inclusions as a result of its indirect investments in CFCs through the domestic partnership. A domestic 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 foreign corporation is a CFC and whether the domestic partnership is a “controlling domestic shareholder.” Accordingly, a partner of a domestic partnership that indirectly owns 10% of the stock of the foreign corporation through a domestic partnership owning more than 50% of the foreign corporation (as well as other 10% U.S. shareholders of the foreign corporation such as rollover shareholders) will continue to be subject to subpart F and GILTI inclusions, even if less than 50% of the foreign corporation’s stock is indirectly owned through the domestic partnership by U.S. shareholders that indirectly own 10% or more of the foreign corporation’s stock. Thus, in  instances in which a U.S. partner would indirectly own at least 10% of the foreign corporation, it may still be advantageous to organize the fund as a foreign partnership (if the foreign corporation would not be a CFC if the fund is organized as a foreign partnership).

These GILTI partnership regulations apply retroactively for taxable years of a foreign corporation beginning after December 31, 2017 (and for taxable years of a domestic partnership in which or with which such taxable years of the foreign corporation end), and the proposed partnership regulations for determining subpart F income may also be applied to such taxable years provided that the domestic partnership applies the proposed regulations to all foreign corporations in which it owns stock. Careful consideration should be given to the application of such rules for state tax purposes, especially in those states which do not adopt the most recent federal income tax laws.

II. GILTI High Tax Election

The proposed regulations would also expand the scope of the subpart F “high-tax kickout” in section 954(b)(4) to permit taxpayers to elect to exclude high-taxed income from the computation of the taxpayer’s GILTI. The GILTI regime was enacted with the goal of taxing foreign earnings (not including earnings already subject to U.S. tax such as subpart F income) at a minimum rate, thereby eliminating potentially indefinite deferral of U.S. taxation of foreign earnings. The minimum rate is accomplished generally by allowing U.S. corporate shareholders a deduction equal to 50% of their GILTI for a taxable year, thereby reducing the effective rate on GILTI of U.S. corporations to 10.5%. Additionally, U.S. corporations are eligible for a foreign tax credit equal to 80% of the foreign taxes imposed on GILTI income (subject to application of the section 904 foreign tax credit limitations). However, U.S. non-corporate taxpayers are not eligible for either the 50% deduction or the 80% tax credit; consequently, non-corporate taxpayers are placed in a worse position than a corporate taxpayer with respect to GILTI. Under previously proposed regulations, U.S. individuals may elect under section 962 to be taxed on their GILTI in substantially the same manner as a U.S. corporation.

With this change to the scope of excluded high-taxed income, taxpayers subject to GILTI, including partners in partnerships, family offices, or direct individual investors in CFCs, would be able to elect to exclude all high-taxed income from the GILTI rules.

This proposed regulation may be beneficial to non-corporate U.S. shareholders as well as corporate U.S. In particular, corporate shareholders should generally not be subject to U.S. tax on GILTI income so long as the foreign tax rate is greater than or equal to 13.125% (10.5% divided by 80%) due to the foreign tax credit that is available for 80% of foreign taxes that are imposed on GILTI income. However, if a U.S. corporation is not permitted to fully offset U.S. tax on its GILTI with foreign tax credits due to the application of the foreign tax credit limitation (or, potentially, for other reasons, such as application of the base erosion anti-abuse tax (“BEAT”)), it may pay U.S. tax at a 10.5% rate on its GILTI income and also pay foreign tax on the same income. Accordingly, in order to avoid such a situation, a corporate U.S. shareholder may elect to exclude high-taxed GILTI income from the GILTI rules.

An election to exclude high-taxed income received by a CFC may apply if the taxpayer establishes that such income was subject to an effective tax rate in the relevant foreign country greater than 90% of the maximum rate specified under U.S. federal income tax law, calculated at the qualified business unit (QBU) level. With current corporate income tax at a rate of 21%, such foreign income must be taxed at a rate of 18.9% or higher in the foreign jurisdiction to be eligible for such exclusion. An election to exclude such high-taxed income is made by the controlling domestic shareholders of a CFC. Such election applies to every CFC that is a member of a controlling domestic shareholder group (i.e., a group of CFCs controlled by the same U.S. shareholder(s)) and is binding on all U.S. shareholders of the CFC. Such election remains effective for all subsequent years unless the controlling domestic shareholder revokes such election. Under the proposed regulations, once the election is revoked, it may not be made again for 60 months.  U.S. shareholders in CFCs should consider whether it is advisable to include language in shareholders agreements that requires that the controlling domestic shareholders of a CFC elect to exclude high-taxed income from GILTI.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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