New International Regulations Provide Additional Guidance on Tax Reform
The IRS recently issued a new set of final and proposed regulations impacting many international tax concepts introduced as part of the Tax Cuts and Jobs Act (TCJA). As a refresher, the TCJA enacted section 951A, often known as Global Intangible Low-Taxed Income (GILTI), and requires a U.S. shareholder of a Controlled Foreign Corporation (CFC) to include certain income earned by a CFC in taxable income annually. The shareholder’s GILTI inclusion is the sum of the shareholder’s aggregate tested income in excess of tested loss, with certain modifications, calculated based on the proportional interest in all CFCs in which the shareholder held during the tax year.
Below are details regarding final and proposed regulations with respect to the international impact of the business interest limitation (section 163(j)), the expansion of guidance surrounding the section 250 deduction and regulations regarding GILTI income subject to a high effective tax rate in a foreign jurisdiction.
Business Interest Limitation Interplay With International Activities
The TCJA amended section 163(j) in its entirety and created a new interest limitation that limits the amount of deductible business interest expense for a given year to the sum of:
- The taxpayer’s business interest income for the year
- 30% of the taxpayer’s adjusted taxable income for the year
- The taxpayer’s floor plan financing interest expense for the year
Subsequently, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) temporarily increased the section 163(j) limitation from 30% to 50% of adjusted taxable income for tax years beginning in 2019 and 2020. The final and proposed regulations are expansive (over 900 pages of guidance). They incorporate the increased limitation provided by the CARES Act and, among their many provisions, are certain international implications for shareholders of CFCs.
Pursuant to the proposed regulations, a CFC must now consider business interest limitation on a CFC-by-CFC basis. The section 163(j) limitation should be considered when determining the interest expenses allocable and deductible for purposes of calculating subpart F income, tested income for GILTI purposes, and the calculation of effectively connected income (ECI). There is an election available to CFCs with substantial common ownership (more than 80%) to combine net business interest expense for the entire CFC group. The election is revocable subject to a 60-month lockout period.
It is important to note that, pursuant to the final regulations, a U.S. shareholder generally may not include their CFC-deemed income inclusions (subpart F, GILTI, section 78 gross-up) in adjusted taxable income for purposes of calculating the business interest expense limitation under section 163(j). However, the 2020 proposed regulations consider a proportional addition to domestic adjusted taxable income to the extent that a CFC group has excess taxable income at the CFC level and deemed income (excluding section 78-gross up) reflected on the domestic return.
There are also complex ordering rules related to the interplay between section 163(j) and section 250 which were included in the 2018 proposed regulations. The final regulations do not provide additional guidance in this area and reserve the position on the coordination procedures to be addressed in future regulations. Currently taxpayers may use any reasonable approach.
Section 250 Deduction (related to FDII and GILTI Regulations)
The TCJA also introduced section 250, which allows for a deduction against GILTI income in certain circumstances, (mainly in the C corporation context) as well as a foreign derived intangible income deduction (FDII) for U.S. C corporations. FDII income is generally defined as revenue earned by a U.S. corporation from the sale of goods or services (including intangibles) for foreign use by foreign persons.
The final regulations remove the specific documentation requirements for establishing:
- The foreign person status
- Foreign use related to sales of general property
- The location of a consumer of general service
Additionally, the final regulations relax the specific documentation requirements for determining:
- Foreign use for sales of general property for resale
- Foreign use for sales of general property subject to manufacturing, assembly, or processing outside the U.S
- Foreign use for sales of intangible property
- Whether services are performed for business recipients located outside the U.S.
One additional change to note is that the proposed regulations included a recommendation that excess deductions (allocated and apportioned deductions in excess of foreign income) be carried forward to future tax years to allow for an FDII recapture when foreign revenue is profitable. The IRS determined that the purpose of the section 250 deduction is an annual determination and thus a carryforward or carryback would be inconsistent with the purpose of the law and did not include this suggestion in the final regulations.
The final regulations require the annual section 250 deduction must still be substantiated and contemporaneous documentation must be available to the IRS upon request. However, the relaxed documentation requirements ease the administrative burden and compliance costs associated with these two very important deductions.
The final regulations are applicable for tax years beginning on or after Jan. 1, 2021; however, taxpayers can elect to apply the regulations for taxable years beginning on or after Jan. 1, 2018 (as long as they apply the regulations in their entirety).
GILTI High-Tax Exclusion
As noted above, the TCJA implemented a new deemed foreign income regime under section 951A known as GILTI. Although GILTI stands for “global intangible low-taxed income,” the actual calculation has very little to do with intangibles. Section 951A requires a U.S. shareholder of any CFC to include in income the amount of tested income (a modified taxable income concept) in excess of 10% of the adjusted basis in the CFC’s assets and net interest expense. This inclusion is an annual inclusion and is an aggregate calculation that includes all of the U.S. shareholder’s CFCs.
In July 2020, final regulations were issued that allows a U.S. shareholder to make an election to exclude any income earned by the CFC that was subject to a foreign effective tax greater than 90% of the U.S. statutory C corporation rate (currently 18.9%) from the CFC’s gross tested income calculation.
The election for a specific CFC is made by the controlling domestic shareholders of such CFC. However, once made, the election applies to all U.S. shareholders of such CFC – not just the controlling shareholders that made the election. Furthermore, a controlling domestic shareholder that makes the election with respect to a CFC must make the election with respect to all CFCs under their control.
The election is an annual election (which is a change from the proposed regulations where the election was binding unless revoked, leading to a 60-month lockout period). The final regulations also include a combination rule, where tested units within the same foreign country must be combined to determine the foreign effective tax rate.
There have been many changes to the complex international tax regime over the last three months. Some of the changes have helped to reduce complexity and administrative burden and some of the changes have resulted in more uncertainty and complications. It is important to stay on top of and in front of these new and complex regulations. Please reach out to your KSM tax advisor for more information or assistance.
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