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IRS Issues New Regs Limiting Taxation of Foreign Income

U.S. shareholders of controlled foreign corporations can defer liability on their global intangible low-taxed income.

The Internal Revenue Service recently issued final regulations (final regs) on deductions for taxes paid by U.S. shareholders of controlled foreign corporations (CFCs).

Proposed Regs

Last year, we reported on the publication of proposed regulations (proposed regs) under Internal Revenue Code Section 250, which provides for a 37.5% deduction to domestic corporate taxpayers in the determination of liability to tax on foreign derived intangible income (FDII) and its counterpart, a 50% deduction that can be offset against global intangible low-taxed income (GILTI) attributed from participations in CFCs to their corporate “United States shareholders.” In our article, we focused on the regs’ impact for individual U.S. shareholders of CFCs under the GILTI rules. 

The proposed regs pretty well settled uncertainties surrounding the 50% deduction against GILTI, including the hotly debated question of whether individual U.S. shareholders of CFCs availing themselves of the election to be taxed as domestic corporations in respect of their subpart F and GILTI income under IRC Section 962 could apply the Section 250 deduction in the determination of their liabilities on GILTI. The Treasury Department’s affirmative response ensured that the Section 962 election would become an important planning tool. For example, given the current U.S. corporation tax rate of 21%, with the benefit of the Section 250 deduction, an individual attributed GILTI from a CFC and electing Section 962 will entirely defer liability on the GILTI provided the CFC suffers foreign tax on its income at an effective rate of at least 13.125%. If the individual is resident overseas, this greatly increases the chance of efficient use of foreign tax credits when distributions are received. 

On the other hand, the proposed regs represented only a discussion draft as far as the 37.5% deduction against FDII was concerned, which is why it’s taken 15 months for the entire regulations project to be completed. 

Section 962 Election

Insofar as the Section 962 election is concerned, first and foremost, the final regs confirm the position of the proposed regs that liability under a Section 962 election will be computed on the basis that the notional domestic corporate shareholder of the CFC can claim the Section 250 deduction. The preamble to the proposed regs found its rationale for this position based on the legislative history for the enactment of Section 962 back in 1962 (“to ensure that individuals' tax burdens with respect to undistributed foreign earnings of their CFCs ‘will be no heavier than they would have been had they invested in an American corporation doing business abroad’”). Somewhat unexpectedly, the preamble to the final regs tweaks this rationale, asserting that the Treasury Department had the option under the statute of either allowing or disallowing the Section 250 deduction in the computation of liability under Section 962 (an assertion with which many would disagree) and opted for allowance to save individual CFC shareholders the expense of having to restructure their holdings (for example, by interposing a U.S. holding company for the CFC participation) to mitigate liability under the GILTI rules. Perhaps the Treasury Department wished to keep its powder dry in the event of a future need to interpret Section 962.

Changes From Proposed Regs

The final regulations (and preamble) introduce the following changes from the proposed regs.

  1. The final regs are retroactive to 2018, the first tax year to which the GILTI rules apply. This is hardly surprising and, given the proposed regs’ publication early in 2019, is unlikely to lead to many amended returns.
  1. The preamble announces that, until further notice, amended returns to elect into (but not out of) Section 962 will be permitted.  Given the IRS’ general insistence on making the foreign tax credit rules as inflexible as possible, for example, its indefensible position that a cash method taxpayer can’t elect to accrue FTCs on an amended return, this seems more likely to be a transitional than a final rule. 
  1. The final regs provide a worked example of how the Section 962 election will apply to the shareholder of a CFC generating both subpart F income and GILTI. The example is a logical application of the relevant provisions, and so there are no surprises. 

Learning Curve Ahead

While confirmation of the Section 962/Section 250 interface in the final regs is reassuring, it can’t detract from the severe problems the GILTI rules will pose for some individual taxpayers given, for example, the inability to carry forward a CFC’s losses or a shareholder’s unused foreign tax credits (under Section 962) in the determination of annual liabilities.

Preparers for individuals having exposure to tax on GILTI will have a steep learning curve as the nuances of the Section 962 election reveal themselves. 

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