The Tax Cuts and Jobs Act contained numerous reforms to the U.S. tax code. Among these reforms were several changes to the international tax system.
Implementing these reforms has been a complex process. To its credit, the Treasury Department has done a good job mitigating some of the more problematic aspects of this transition. However, there is more that can be done to promote American competitiveness and offer relief to businesses.
One of the major changes to the international tax system was the creation of the Global Intangible Low-Taxed Income (GILTI) provision. GILTI was designed to prevent taxpayers from eroding the U.S. tax base by assigning income to low tax jurisdictions.
However, GILTI was based off the pre-TCJA tax system which required companies to allocate a portion of domestic expenses to foreign income calculations. This resulted in a post-TCJA tax code where American businesses faced additional foreign tax liability because GILTI inadvertently taxed high-tax foreign income that was previously exempt from U.S. taxation.
To resolve this problem, Treasury has proposed rules that allow businesses to elect a high-tax exclusion (HTE) for a Controlled Foreign Corporation’s (CFC) income if this income is subject to foreign taxes above 90 percent of the corporate rate (18.9 percent based on the 21 percent corporate rate). This HTE ensures the integrity of the new, territorial tax system in a way that protects the U.S. tax base without subjecting taxpayers to double taxation or creating perverse incentives for businesses to restructure.
However, there are ways to improve this rule.
For one, the effective date of the HTE should be available back to when the GILTI provision first took effect. The proposed rule applies “beginning on or after the date that final regulations are published.” Ideally, this rule should also apply for 2018 and 2019 – the years that GILTI has been in effect.
Second, the ability to elect the HTE should be available year-to-year. Under the proposed rule, any HTE election must be retained for five years, an unnecessary limitation that can lock taxpayers into an election that can result in increased taxes due to the complex interaction of various credits and deductions at the international level. Ideally, the HTE should be made on a year-to year basis.
There should be little concern that a taxpayer could use this flexibility to game the system as that would require a taxpayer to go through the complex task of manipulating income in multiple foreign jurisdictions and across multiple taxable systems with different anti-abuse regimes.
As it stands, a five-year limitation requires a taxpayer to project business changes, changes to tax law, and economic trends over this five-year period – a difficult, if not impossible task. Companies are already required to report financial information and file taxes ever year, so all the information to model and comply with electing into the HTE should already be available.
Third, the GILTI HTE determination made at the QBU (Qualified Business Unit) level should be relaxed. While Treasury decided on the QBU-by-QBU approach to prevent blending low-tax and high-tax income within a CFC, the existing approach is too stringent.
Taxpayers often do not have readily available information broken down at the QBU level so this could create extensive compliance burdens for taxpayers. In some cases, a taxpayer may have hundreds of QBUs in a single country.
A solution to this complexity could be allowing a taxpayer to aggregate QBUs in a single country for purposes of determining whether income is high-taxed. This solution would still uphold the integrity of the tax law as it would be difficult to blend high and low-tax income when aggregating income from the same country. Moreover, this approach is consistent with legislative intent of lawmakers to prevent allocating income to low-tax jurisdictions.
Lastly, the “All or nothing rule” should be removed from the proposal. The proposed rule applies the HTE broadly to each CFC in a group of commonly controlled CFCs. Like the QBU-by-QBU application, this all or nothing rule can result in extensive compliance burdens as it would require a taxpayer to compile (and the IRS to audit) new QBU-level data across all operations.
A better alternative is to follow the precedent set under the existing Subpart F high-tax exclusion. Under this exclusion, a taxpayer can make the election on an item-by-item basis. This will also significantly lessen compliance burden on taxpayers as reporting only has to be made on relevant QBUs.
To be clear, Treasury’s proposed GILTI rule is on the right path. A high-tax exclusion will mitigate unnecessary double taxation while upholding the integrity of the TCJA.
However, there remains some outstanding issues with the rule that should be resolved. Doing so will dramatically improve the GILTI high-tax exclusion to promote flexibility, ease compliance burdens, and ensure the international tax system remains strong.