Among the myriad changes made by the Tax Cuts and Jobs Act (TCJA) in 2017 was a move from a worldwide system of taxation with deferral to a quasi-territorial system. The product of years of debate, the change meant that companies were no longer penalized when they looked to bring overseas profits back to the United States, increasing America’s competitiveness. However, the new system and its implementation hasn't been perfect, due to some unanticipated interactions with existing law. The Treasury Department has made a herculean attempt to limit the damage from the underlying issues, but their proposed regulations need a few more tweaks.
The new international tax system, in effect, says that companies are not taxed on their overseas income, bringing U.S. tax policy in line with most other developed countries. But to prevent companies from abusing the rules and shifting all their income into low-tax jurisdictions, the United States has put in several guardrails. One in particular, Global Intangible Low-Taxed Income (GILTI), has been the subject of intense debate.
The GILTI provision functions as a minimum tax to ensure that companies are not moving their intellectual property to low-tax countries to escape taxation. Moving intellectual property is, naturally, much easier than moving a plant or a piece of equipment, so extra precautions should be taken.
Because of GILTI, companies must do a complicated tax calculation related to their foreign income. If the effective tax rate is more than 13.125 percent, it is exempt from U.S. taxation. But if it isn’t, the U.S. government will tax the income. Or so was the idea.
But it doesn’t quite work that way due to a decades-old provision in the tax code known as the expense allocation rule. Companies with expenses are required to allocate part of those expenses against their foreign income. Allocating those expenses can result in GILTI liability even when the company’s foreign effective tax rate exceeds 13.125 percent because those allocated expenses eliminate part of the company’s ability to use some of its foreign tax credits. In some cases, companies have effective tax rates as high as 30 percent, but still had to pay taxes related to GILTI.
In their recent proposed regulations, the Treasury Department helped fix part of this problem. They created a high-tax exemption (HTE): in essence, if a company’s foreign income was taxed at a rate higher than 18.9 percent, the income is exempt from taxation under GILTI. This is a worthwhile change. Subjecting high-taxed income to another layer of taxation in GILTI was clearly not the intent of Congress when it adopted the tax reform law. The TCJA’s conference report plainly states, “the minimum foreign tax rate, with respect to GILTI, at which no U.S. residual tax is owed by a domestic corporation is 13.125 percent.”
While Treasury made big strides on the issue, several of the finer details to Treasury’s high-tax exemption should be reconsidered. First, Treasury’s HTE applies to future tax years. Ideally, it would also apply to the 2018 and 2019 tax years, the first years that GILTI was in effect.
Second, Treasury should reconsider its decision on using qualified business units (QBUs), instead of controlled-foreign corporations (CFCs), as the basis for GILTI calculations. When an American company opens operations in another country, it might be involved in many different projects with many different organizational functions, such as research and development, marketing, and finance. . For legal or regulatory reasons, the company might put those separate business functions into distinct groups, known as QBUs. In some cases, a large company could have dozens of QBUs within one country.
Under Treasury’s rules, GILTI calculations for the HTE would be based on these QBUs. But that is quite different than other parts of the U.S. tax code, which are calculated at the broader CFC level.
Because of the long-standing approach to use CFCs as the basis of taxation, many companies don’t have the necessary internal information to even calculate their taxes using a QBU approach. Requiring QBUs to be used would increase compliance costs for companies and necessitate large investments in internal tax tracking. Ironically, the Treasury Department actually notes that the Internal Revenue Service (IRS) doesn’t have existing tax data at the QBU level either, suggesting that it would also stretch the IRS’ internal capacity.
Additionally, for internal structuring reasons, companies might split their income-generating activities and their expenses into different QBUs. To arrive at a better measure of income, those expenses should be available to offset the income.
Finally, Treasury should consider reforms to its so-called “all or nothing” rule. As written, the regulations require that if companies have multiple CFCs, all of their CFCs are subject to the same election. Imagine a company with CFCs in many parts of the world. It’s quite possible that some of their CFCs would be taxed at a rate above the HTE levels. But that same company might have CFCs with tax rates below the HTE level. This approach is different than the approach used since the 1960s in other areas of the tax code. In fact, adopting the all-or-nothing rule will likely result in higher compliance costs and more aggressive tax planning, as firms look to lower their liabilities through other tax vehicles.
The Treasury Department eased the burden on taxpayers by creating the high-tax exemption to GILTI, a welcome step to reduce compliance costs. Ideally, Congress will revisit its handiwork on GILTI and will resolve many of these issues legislatively. But until these changes can be passed, Treasury’s regulatory actions help to limit the impacts. However, Treasury should reconsider several of the decisions made in its proposed regulations to ensure that its work is complete.