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Common GILTI Compliance Errors

by

Frank J. Vari, JD, CPA, MTax

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.

 

 

The Hidden Passive Foreign Investment Corporation Danger & How To Address It

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The Hidden Passive Foreign Investment Corporation Danger & How To Address It 

 Frank J. Vari, JD, MTax, CPA

Passive Foreign Investment Company (PFIC) is a term that many U.S. taxpayers and practitioners do not understand or recognize but it stands as one of the most significant risk exposures to any US taxpayers with foreign investments of any sort.  Many U.S. taxpayers, primarily individual investors, and practitioners are too quick to conclude that they do not own a PFIC interest.  In our experience, this is because they either don’t understand what a PFIC is or they are daunted by the complicated PFIC rules and reporting requirements.  The common results on audit are unexpected severe tax consequences to unsuspecting and unprepared taxpayers.  When one considers that a PFIC could be anything from a small interest in a foreign corporation to a Bitcoin investment it is easy to see how easy it is to come into contact with the complex and punitive PFIC rules.  This article is intended to provide some basic guidance on the PFIC regime and to address some basic issues.

The PFIC rules were enacted in 1986 as a counterpart to the anti-deferral regime of Subpart F with an intended target of U.S. owners of foreign corporations with primarily passive income or assets.  The PFIC rules, unlike the rules in Subpart F, aim to remove the economic benefit of deferral with respect to any and all U.S. PFIC investors and not just those with significant ownership interests.  Extremely broad and complex, the PFIC rules discourage U.S. taxpayers from investing in PFICs assuming that they can identify whether their foreign investment is a PFIC in the first place.

The PFIC rules are primarily contained within IRC §§1291, 1297, 1298 and related authority.  Primary technical guidance has historically been provided by IRS Notice 88-22 which continues to provide significant guidance to this day.

Generally defined, a PFIC is a foreign corporation that has, during the tax year, at least 75% passive income (“Income Test”) or at least 50% of assets that produce passive income (“Asset Test”).  Passive income is any income that would be Foreign Personal Holding Company Income (“FPHCI”) as defined by the Subpart F provisions in IRC §954(c).  Many conclude that unless the investment is considered a Controlled Foreign Corporation (“CFC) there is no PFIC exposure.  This is an incorrect and false analysis that confuses PFIC with Subpart F.  This is an especially dangerous conclusion when one recognizes that the PFIC rules don’t apply to a CFC after 1997 as part of the PFIC/CFC overlap rule of IRC §1297(d) exempting CFC shareholders from the PFIC regime.

Here for example, are common PFIC investments that we regularly see in our international tax practice.  In any of these or similar situations PFIC testing is required:

Foreign Mutual Funds

The primary investments of a mutual fund are most often passive or generate passive income qualifying the mutual fund itself as a PFIC.

Foreign Holding Companies

Many foreign holding company investments by U.S. shareholders are tailored to avoid CFC rules due to passive share investments.  However, there is often PFIC exposure which often goes untested.  This is a very common PFIC scenario.

Foreign Hedge Funds

Like a mutual fund, a hedge fund is an entity often engaging in passive investment activity.  We work with a number of foreign hedge funds and any U.S. investor in a foreign hedge fund has potential PFIC exposure.

Foreign Trusts

A foreign trust is most often a foreign entity consisting of passive investments generating passive income.  We often see U.S. beneficiaries of foreign trusts, many of which are family trusts established many years ago, that qualify as PFICs and carry significant past tax liabilities with them.

Foreign Bank Accounts

A bank account might also be a PFIC if that account is a money market type investment rather than simply a deposit account as many money market investments are equivalent to fixed income mutual funds.

Foreign Pension Funds

PFIC rules can and do apply to passive investments held inside foreign pension funds unless those pension plans are recognized by the U.S. as “qualified” under the terms of a double-taxation treaty between the U.S. and the host country.

Bitcoin / Cryptocurrency

If cryptocurrency is held in via a foreign fund or it is held via a foreign entity maybe a PFIC investment.  The passive nature of these investments always require PFIC testing.

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As noted above, the PFIC regime is essentially an anti-deferral regime intended to remove any advantage of income deferral provided by a non-CFC offshore investment.  PFIC taxation falls into three elective categories.  First, income can be currently taxed as a Qualified Electing Fund (“QEF”) under IRC §1293 where a U.S. shareholder elects to have their PFIC income taxed annually.  Second, the IRC §1291 “interest on deferral” regime allows annual U.S. taxes on PFIC income to be deferred but requires the U.S. shareholder to pay any tax plus interest on the deferred PFIC income when the shareholder ultimately receives their PFIC income via distribution or disposition.  Third, there is the IRC §1296 mark-to-market regime where the shareholder recognize gains and losses from marketable stock on an annual basis.  The most common taxing regime chosen is a QEF election if PFIC treatment cannot be avoided altogether.

One notable rule around PFICS is the “once a PFIC always a PFIC” rule.  This rule states that if stock in a foreign investment meets the PFIC definition at any time during the shareholder’s holding period it continues to be treated as a PFIC forever even after it no longer meets the PFIC definition.  This requires a lookback for many taxpayers to see if their investment has been tainted as a PFIC at some point in the past even if it clearly no longer qualifies as a PFIC today.  This is not an uncommon event.

This article is not intended to be and should not be treated as a complete description of the PFIC testing and treatment rules.  There is much more to this regime including complex Foreign Account Tax Compliance Act (FATCA) reporting rules which include filing Form 8621 for each PFIC investment.

The bottom line to any U.S. taxpayer or practitioner who believes that a foreign investment is or was a PFIC should immediately research or seek out an experienced international tax practitioner with PFIC experience to help them navigate and limit their PFIC tax exposure.

Please let us know how we can help you plan for your international investments.  Learn more about our international tax practice or our firm by contacting us at FJVTAX.com.

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.

 

 

Has Subpart F Been Greatly Expanded?

by

Frank J. Vari, JD, MTax, CPA

 For many years, international tax planners took great care to design global tax structures to avoid Subpart F.  Now, in what is perhaps an unintended error, Subpart F appears to have been greatly expanded for many multinationals and particularly private equity investors.  This potential expansion of Subpart F is a result of new share ownership attribution rules under the Tax Cuts and Jobs Act (TCJA) where U.S. taxpayers that were not considered U.S. Shareholders of certain foreign corporations for purposes of Subpart F may now be liable for those foreign corporation’s Subpart F income beginning in 2017.

The issue that is causing such concern is the repeal by the TCJA of IRC §958(b)(4).  Prior to repeal, this Code section prohibited “downward” attribution of stock ownership from a foreign person to a U.S. person.  This prevented what would otherwise be Subpart F income being attributed to a U.S. Shareholder via a foreign parent.

How exactly did IRC §958(b)(4) operate prior to repeal?  Here is a quick example.  In a typical Subpart F avoidance structure, foreign parent (FP) owns 80% of a foreign corporation (FORCO) and 100% of a U.S. corporation (USCO).  USCO owns the remaining 20% of FORCO.  Prior to repeal, USCO would not be considered a U.S. Shareholder of FORCO for purposes of Subpart F.  As such, USCO never considered or included any of FORCO’s income that would have qualified as Subpart F income had FORCO been owned directly by USCO.  Quite simply, the IRC §958(b)(4) rules prevented FORCO from ever being a Controlled Foreign Corporation (“CFC”) for U.S. tax purposes.

What has changed?  After repeal of IRC §958(b)(4), USCO is, for purposes of determining U.S. Shareholder and CFC status, treated as owning all of FORCO’s stock.  USCO now owns 20% directly and 80% constructively (via FP) under newly enacted IRC §318(a)(3) making it a U.S. Shareholder of FORCO and also making FORCO a CFC.  As such, USCO is now liable for U.S. tax on 20% of FORCO’s Subpart F income.  That’s a really bad answer from both an income inclusion and information reporting standpoint.

This example is not the only situation where this may cause a significant expansion of Subpart F.  There are many others out there.  In practice, every foreign structure involving a U.S. owner needs to be tested.  That’s a tall order, but when the scope of how the repeal of IRC §958(b)(4) operates is considered it’s not something that can be reasonably ignored.

As if Subpart F expansion is not enough to worry about, this also impacts whether a taxpayer is a 10% or more U.S. Shareholder for purposes of calculating the Global Intangible Low Taxed Income (GILTI) inclusion.

The biggest problem is that we simply don’t know if this expansion has really taken place.  We certainly do know that IRC §958(b)(4) is gone and we also know the statutory language of IRC §318(a)(3).  Thus, the statutes tell us downward attribution is now the rule.

However, the legislative history behind the TCJA states that the repeal of IRC §958(b)(4) was not intended to cause a foreign corporation to be a CFC with respect to any U.S. Shareholder as a result of downward attribution under section 318(a)(3) to any U.S. person that is not a “related person” (as defined by IRC §958(d)(3)) to such U.S. Shareholder.  This means that Congress intended this to apply solely to related parties, particularly those involved in inversion transactions, and not to unrelated parties.  That’s both logical and simple enough to understand but it is not part of any statute, regulation, or even authoritative guidance for that matter.

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Why hasn’t this been resolved by now?  One could reasonably theorize that Treasury feels it lacks authority to limit the scope of these rules via regulation and that a legislative correction, i.e., congressional action, is required to implement the result described in the legislative history.  Congress, on the other hand, will find it difficult to enact a comprehensive technical corrections bill in short order considering the scope of the TCJA.  In the absence of regulations, technical corrections, or some authoritative guidance, it is extremely difficult to reconcile the statutory language with the intent articulated in the legislative history.

One piece of guidance by the IRS has been regarding Form 5471.  You can see where that would be a nightmare under these rules.  IRS Notice 2018-13 provides an exception to filing Form 5471 for certain U.S. Shareholders considered to own stock via downward attribution from a foreign person.  The Notice also states that they intend to modify the instructions to the Form 5471 as necessary which has not yet occurred.

The uncertainly outlined above has left taxpayers searching for the right approach here.  To say there is no good approach is an understatement.  For now, here are some of the choices:

  • Wait for a technical correction, regulation, or other clarifying authority to make clear the intent of these new rules.
  • File 2017 returns taking a technical position in favor of the legislative intent – on the basis that no other guidance currently exists – and keep your fingers crossed that the position outlined in such legislative authority is ultimately adopted.
  • Liquidate, or check-the-box, on your U.S. C Corporation that’s contributing to the CFC attribution to have it treated as a disregarded entity.
  • Liquidate, or check-the-box, on the foreign subsidiary creating the Subpart F income to have it treated as a disregarded entity.

Not a lot of great choices there.  However, one could have reasonably anticipated that there would be problems like this as a result of the speed at which the TCJA was enacted.  In the meantime, taxpayers must make a choice and prepare for the possibility that these rules may stand as such.

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.