Corporate Tax

Common GILTI Compliance Errors

January 29, 2020 by Frank Vari, JD. MTax, CPA

In our international tax practice, we both prepare and review a large number of Global Intangible Low-Taxed Income (“GILTI”) tax calculations and US corporate and individual tax returns related to same. As is common with most new tax rules, especially those as complex and wide ranging as GILTI, practitioners and taxpayers stumble until they familiarize themselves with calculation and reporting requirements. It is no different with GILTI and this article will help outline some of the more common errors we’ve come across.

GILTI Introduction

It is no longer news that the 2017 Tax Cuts and Jobs Act introduced a new anti-deferral tax on Controlled Foreign Corporations (“CFC”) known as GILTI. Roughly modeled after the taxation of Subpart F income, a US shareholder of one or more CFCs must include GILTI as US taxable income, in addition to Subpart F and other anti-deferral type income, regardless of whether the US shareholder receives an actual distribution.

The GILTI calculation itself can certainly be complex especially where multiple CFCs are involved. Quite basically, GILTI is the excess of a US shareholder’s pro-rata share of a CFC’s income reduced by an allowable return equal to 10% of the CFC’s adjusted tax basis in certain depreciable tangible property or Qualified Business Asset Investment (“QBAI”). US corporate CFC shareholders are given a 50% deduction via IRC §250 against any GILTI inclusion and can, subject to certain limits, credit IRC §902 taxes paid by the CFC to offset the US tax resulting from the GILTI inclusion.

GILTI certainly aims for technology and pharmaceutical companies with significant overseas low-taxed income and, at least in theory, discourages them from mobilizing intellectual property to shift profits outside of the US. The issue is that, as written, it really doesn’t just address income from identified intellectual property, at least not in a traditional sense, resulting in unintended consequences for corporate and noncorporate taxpayers with operations outside the US. As such, a wide net has been cast and many taxpayers and practioners are working hard to properly address the GILTI rules.

Now that we’ve discussed the basic rules, what are the errors that we most often come across? This is certainly not an exhaustive list and there is no particular ordering here.

No Individual Taxpayer Rate Reduction

As noted above, individual CFC shareholders are not eligible for either the aforementioned IRC §250 deduction or the use of IRC §902 foreign tax credits against their GILTI liability. Both of these generous benefits are afforded to corporate shareholders. Instead, they are subject to US tax at their individual income tax rates up to 37% on their GILTI inclusions. That’s a big deal to US individual CFC shareholders who engaged in sophisticated and expensive international tax planning to avoid Subpart F income only to be hit with similarly taxed GILTI inclusions. As we’ve previously written, these issues can be addressed by proper planning but the law itself is rather unforgiving as it is currently written.

No High Taxed Exception

GILTI is somewhat similar to Subpart F as its anti-deferral brethren. However, the commonalities do not include a high taxed exception which, as of now, only belongs to Subpart F. This rule generally excludes from US taxable income any Subpart F income already taxed at a sufficiently high rate in foreign jurisdictions. The kicker here is that it does not apply to GILTI that is already taxed at a high rate offshore and any related foreign tax credits are useless to individuals or corporate taxpayers in an excess foreign tax credit position. Unintended application of the Subpart F high taxed exception to GILTI is an error until the GILTI proposed regulations containing a GILTI high taxed exception become law.

Consolidated Tax Groups

Consolidated returns for US multinational consolidated corporate tax groups are complicated enough without a GILTI calculation. When one considers the typical reorganizations, mergers, and acquisitions that regularly occur for most consolidated taxpayers, one can easily see the room for error when the time comes for the GILTI calculation. Some of the more common consolidated return errors are related to the following:

The allocation/sharing of tested losses by “loss CFCs” with “income CFCs” owned by other consolidated group members;
The allocation/sharing of the consolidated group’s GILTI attributes to its members;
Consolidated group member share basis adjustments (more on that here) via the offsetting of tested income and utilized tested losses; and
Nonrecognition transactions between related consolidated group members where “loss CFC stock” is transferred.

Due the inherent complexity here, more can certainly be written especially when one has to address the US tax reporting requirements. This is certainly an area where experience with consolidated group reporting, international tax, and the GILTI rules is essential to get it right.

GILTI Basis Adjustments

The GILTI basis adjustment rules are rather simple to understand but are very complex in practice. They require basis adjustments for consolidated group members and any CFC that contributes tested losses to the group. They are intended to prevent the “double dipping” of tax benefits where a member’s GILTI tested loss is used to reduce a current year consolidated group GILTI income inclusion and then again when the contributing member’s outside tax basis remains high when that group member is sold. The rule’s required downward basis adjustment which corresponds with the member’s GILTI tested loss ensures the benefit is only taken once. We’ve written before about this but it remains a complex issue and common error.

State Taxation

This issue is a quagmire especially for multistate taxpayers. We get many questions here and often have many of our own. In many cases, GILTI represents the states’ first significant venture into the taxation of international income. Most state tax systems were not created to accommodate international income and, as such, uncertainly abounds until state legislatures catch up with GILTI. Often, GILTI is not given a preferential rate and some states will tax GILTI but fail to recognize Foreign Derived Intangible Income (“FDII”) as a proper offset.

For corporate consolidated taxpayers, the state GILTI calculation where the states do not recognize the full current US consolidate tax return regulations are particularly troublesome. Corporate taxpayers must also be aware of states not recognizing the IRC §250 deduction. This existing patchwork of state rules is made even more complex when one considers city and other local income taxes.

QBAI Calculation Errors

A CFC’s QBAI is properly calculated as the average of the aggregate of its quarterly adjusted bases in “specified tangible property” used in its trade or business. It is not simply the year-end balance. Furthermore, to calculate the proper asset basis for QBAI purposes, you must use an alternative depreciation system, i.e., the straight-line method. These are both very common mistakes.

Another QBAI error is that specified tangible property, as defined here, means any property used in the production of tested income. The upstart is that CFCs with tested losses may have a business asset investment but since they do not have tested income and they do not hold any specified tangible property they will not have any QBAI. Please note that this exception does not apply to specified interest expense that still must be considered even if attached to a CFC with tested losses. This is especially painful to our investment fund clients with CFC asset related debt and CFC GILTI tested losses.

No Tested Loss Carryforward Provision

The GILTI rules do not permit the IRC §172(a) Net Operating Loss (“NOL”) deduction. This means that tested losses cannot be carried forward or backward to offset current year tested income. If a CFC’s foreign taxing jurisdiction permits the carryforward of losses, the CFC’s local country taxable income may be significantly limited or be reduced to zero in the year when a local country NOL carryforward or carryback is used. This would limit foreign income tax liability while a large balance of GILTI tested income, includible to a US shareholder, remains. As a result, the amount of foreign tax credit available to offset the GILTI inclusion may be limited which raises the GILTI effective tax rate.

Consideration of Anti-Deferral Provisions

The rule is that a CFC’s gross tested income is its gross income determined without regard to:

Effectively connected income;
Subpart F income;
High-taxed Foreign base company income or insurance income which is taxed at a foreign effective tax rate greater than 90% of the US corporate tax rate;
Related party dividends; and
Foreign oil and gas extraction income.

The problem is that many taxpayers and practitioners fail to properly test for these items. This can create a larger problem on audit where a taxpayer may assume that they have a GILTI inclusion that’s taxed at a reduced rate but they actually have a much higher taxed Subpart F inclusion. The bottom line is that one must still test for all of these items as part of any tested income analysis before the IRS tests for it.

Conclusion

The GILTI rules are certainly complex, wide ranging, and continuing to evolve which creates a near perfect environment for calculation and compliance errors. This article is by no means an exhaustive list of every potential GILTI error out these but just some of the most common we see.

If you would like our assistance or thoughts on any GILTI analysis, please visit our website at fjvtax.com or reach us by phone at 617-770-7286 or 800-685-2324.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

Payroll Tax Credits Provide Cash Flow Benefits For Technology Start-Ups With Research Activities

January 14, 2020 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Our practice serves a number of early and mid-stage technology clients and many have significant research and development (“R&D”) activities and expenses but have not generated taxable income either due to tax planning or net operating losses. Conventional wisdom has been that these companies cannot claim any tax benefits related to their R&D related expenses because they have no taxable income. However, these same clients often pay significant payroll taxes and they are often unaware that they can reduce their annual payroll taxes, and improve cash flow, by as much as $250,000 per year by taking advantage of the United States (“US”) R&D payroll tax credit.

Let us explain here how we help our qualifying clients claim these important benefits.

As noted, US businesses historically have not been able to use the traditional US R&D income tax credit in tax years where there was no regular US income tax liability. However, the Protecting Americans from Tax Hikes (“PATH”) Act of 2015 made very favorable changes to the research credit that help mitigate the impact of this limitation. In particular, PATH allows certain small businesses to offset their alternative minimum tax (“AMT”) or payroll tax liability with a research credit. As a result, small businesses in an AMT or net operating loss (“NOL”) position that cannot claim the traditional R&D credit can now claim tax and cash flow benefits.

The R&D Credit

The R&D credit was enacted back in 1981 to stimulate US R&D activities by helping businesses offset some of the costs associated with their qualified R&D activities. Quite basically, a qualified R&D activity expense qualifying for the credit is one where:

The expense is incurred in a trade or business which represent R&D costs in the experimental or laboratory sense;
The research is technical in nature including bioscience engineering, computer science including software, chemical/polymer design, manufacturing processes, and other similar activities;
The research contains aspects of experimentation related to a new or improved design, function, or performance; and
The research is intended to result in a new or improved product or business element for the taxpayer.

Today, there is a regular R&D credit and an alternative R&D simplified credit (“ASC”) option to calculate the benefits. Qualifying businesses can compare the two methods and choose the more favorable one by making an annual election on a timely filed federal return. Businesses that have not claimed a regular credit in a prior year may make the election on an amended return for that year.

PATH significantly expanded the R&D credit by allowing certain businesses to claim R&D tax benefits in years when they had no regular US income tax liability. In other words, before 2015, if a business didn’t have US taxable income, there was no way to claim an R&D credit. Now, the R&D credit can be used to reduce AMT or payroll tax liabilities.

Although AMT liabilities may also be reduced, our discussion here will focus on the payroll tax R&D credit.

Learn More About Our Tax Planning Practice

Which Businesses Qualify For Payroll Tax R&D Credits

In order for a business to offset its payroll tax liability with the R&D credit, the taxpayer must be a Qualified Small Business (“QSB”). A QSB may be a corporation, partnership, or even an individual with gross receipts of less than $5 million for the current tax year and no gross receipts for any tax year preceding the five tax year period ending with the current tax year.

Example: For the first five years of its existence, Corporation A had gross receipts of $1,000,000, $7,000,000, $4,000,000, $3,000,000, and $4,000,000. Corporation A is a QSB for year 5 because its gross receipts are less than $5,000,000, even though its gross receipts exceeded the limitation for a prior year. However, Corporation A is not a QSB in year 6 due to having gross receipts in year 1.

Gross receipts here are reduced by returns and allowances but also include non-sales related items such as interest, dividends, rents, royalties. These receipts must also be adjusted to account for predecessor entities meaning that past mergers and acquisitions are relevant to this calculation. One must also adjust for any entities or individuals treated as a single taxpayer meaning that gross receipts must be aggregated for a controlled group of corporations or for trades or businesses under common control.

Claiming Benefits

A QSB may elect to claim the R&D credit against the Old Age, Survivors, and Disability Insurance (“OASDI”) portion of the employer’s Federal Insurance Contributions Act (“FICA”) payroll tax liability for up to five tax years. The election to claim the payroll R&D credit must be made on a timely filed US tax return including extensions (please note this differs from the regular R&D credit which can be claimed on an amended return). The election is reported in Section D of Form 6765 as part of the aforementioned return. Special rules apply for partnerships and S corporations.

The election must indicate the amount of the research credit that the QSB intends to apply to the expected payroll tax liability. This amount is the smaller of:

A $250,000 cap;
The amount of the research credit for the tax year (without regard to the election); or
The amount of any business credit carryforward under IRC §39 carried from the tax year of the election, without regard to the election, but only for QSBs that are not partnerships or S corporations.

A QSB that files quarterly payroll tax returns may apply the credit on its payroll tax return for the first quarter beginning after it files the federal return appropriately reflecting the election. For these quarterly payroll taxpayers, a QSB seeking benefits related to 2019 R&D activities that files that timely files their US income tax return by April 15, 2020 will be able to claim these benefits beginning in the second quarter of 2020 but not before. If the return is extended, then the timing of the benefits extends as well. Accordingly, a QSB that files annual payroll tax returns may apply the credit on the first quarter beginning after the date on which the business files its US income tax return containing the election.

When filing the payroll tax return, Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, must be completed and attached to the payroll tax return to ensure that the amount of the previously elected credit is limited to the employer portion of the Social Security tax for the period. Any excess may be carried forward pursuant to future periods. The credit does not reduce the QSB’s deduction for payroll taxes which provides an additional benefit.

Next Steps

The best next steps for any start-up with R&D activities is to take the following steps along with a qualified tax adviser:

Determine qualification as a QSB;
Identify qualifying research activities;
Calculate the amount of the R&D credit and the corresponding payroll tax offset;
Make the appropriate elections and file the requisite income tax and payroll tax forms using the most beneficial methodologies; and
Organize supporting documentation in case of a tax authority examination.

In summary, any tech start-up not claiming these cash flow benefits should be paying attention.

Please let us know how we can help you plan for your tax planning and compliance needs. Learn more about our business tax practice or our firm by contacting us at FJVTAX.com.