“Oh, how I long for the good ‘old days’ (just 2016, not far back)”
For those that remember, the subpart F rules were introduced in 1962 when statutory rates were extremely high and, until December 31, 2016, we all knew the rules of the game, so to speak.
The last major tax reform was in 1986 and took two (2) years to pass Congress but did so with broad bipartisan support and public hearings. The result was that lawmakers knew and understood the details and what they meant to taxpayers. In 2016 and 2017, we saw “batty” (no pun intended) ideas being promoted by Congress and, in very late 2017 (with adrenalin running high), The Tax Cuts and Jobs Act (“TCJA”) was passed and signed into law.
The end results? More complexity; increased compliance costs for anyone having foreign operations; and an overstretched Treasury and IRS trying their best to decipher what Congress passed since the lawmakers did not have a clue.
For the sake of simplicity (and without going into detailed definitions), the term “CFC” refers to a foreign corporation wholly owned by a US corporation (for individuals, the rules are even more complex and we leave that for another day).
“Old” Law: Earnings and profits (“E&P”)
Again, for the sake of simplicity and comparison, we restrict the number of E&P pools under pre-TCJA rules to three (3), i.e.,: (1) amounts arising from §956 (most common being a loan from a CFC to the US shareholder and characterized as a deemed dividend); (2) income inclusions due to subpart F; and (3) income deferred from US tax since from an active business. Pools (1) and (2) were referred to as “previously taxed income” or “PTI” since taxed in the US shareholder’s hands in the year earned.
Accompanying the above, were two (2) foreign tax credit (“FTC”) baskets: general and passive.
The TCJA introduced four (4) major changes (which, of course, resulted in further expansions, as seen later): (1) Amended §965; (2) Global Intangible Low-Taxed Income (“GILTI”); (3) dividend-received deduction for certain earnings (§245A); and, of course, (4) an expansion of the FTC baskets.
While much has been written about §965 and GILTI, a short recap may be appropriate: §965 is commonly known as the “transition” tax since all post-1986 earnings in “old” law pool (3) became taxable in 2017 since, allegedly, the US was moving to a “territorial” system. The concept/principle of “territoriality” diminished (in some cases, disappeared) with GILTI. In essence, for the most part, active business income which was subject to deferral under old law will become taxable every year from the 2018 tax year forward. In addition, the rules are, of course, complex and fraught with traps for the unwary. This brings us to §245A which, on paper, represents the earnings not subject to tax under subpart F and GILTI. Unless a CFC has substantial depreciable assets used in its business, practically all of its earnings will be considered to be GILTI (if not caught under the subpart F rules).
On November 28, 2018, proposed regulations governing FTCs were issued which have both new and, by necessity, transitional rules. Some of the major items addressed in the guidance are:
- GILTI and branch income categories.
- Changes to the rules governing the passive category for, inter alia, high-taxed income; income resourced under a treaty; assigning the gross-up for taxes under §78; and assigning §986(c) gain or loss to a separate category. [§986(c) deals with foreign currency gains and losses on distributions of PTI.]
- Allocation and apportionment of deductions under §§861 through 865.
- Adjustments to the FTC limitation under §904(b)(4).
- Transition rules for the overall foreign loss, overall domestic loss, and separate limitation loss categories.
- Calculation of the high-tax income exception from subpart F income.
- How to determine the §960 deemed paid credits and the gross-up under §78.
PTEP: The Basics (nothing “basic”, by the way)
For each FTC basket and for each taxable year, PTI must be divided into the following groups.
- §956 inclusions. Note: Not to be confused with §965, below.
- §965(a) [reclassified from §959(c)(2)]. Note: While §965(a) PTI is placed in a single PTEP group, there may be multiple groups if there are CFCs and domestic partnerships with different applicable percentages.
3. §965(b) [reclassified from §959(c)(2)].
4. GILTI [reclassified from §959(c)(2)].
5. Subpart F [reclassified from §959(c)(2)]. Note: The TCJA, in essence, created three (3) new types of subpart F PTI: Items 2, 3, and 4 above.
§959(c)(2) Group: §965(a); §965(b); GILTI; and subpart F.
Note: Only after the PTEP in the above 2 groups is exhausted do you get to the §959(c)(3) Group, which is the non-PTEP E&P.
PTEP: Some of the issues
Phantom earnings: Here we will use a simple §965 example.
Assume the following: USP wholly owns CFC1 and CFC2 (CFC1 and CFC2 are brother-sister). CFC1 has $100 of E&P and $50 of taxes while CFC2 has an E&P deficit of $20 with $5 of taxes. As a result:
- USP’s §965 amount is $80, i.e., CFC1’s E&P of $100 less CFC2’s E&P deficit of $20.
- Only $40 [(80/100) x 50] CFC1’s taxes are deemed paid by USCO.
- Three (3) categories of PTI and earnings: (A) §965(a) PTI of $80 in CFC1. (B) §965(b) PTI of $20 in CFC1 [§965(b)(4)(A)], i.e., in essence CFC 2’s used deficit (if there were multiple CFCs with deficits, such deficits are shared ratably by CFCs with positive E&P). (C) Phantom earnings of $20 [§965(b)(4)(B)].
- Taxes on §965(a) earnings have a haircut.
- Taxes on §965(b) earnings are disallowed.
- Taxes lost forever: (a) CFC1’s remaining $10; and (b) CFC2’s $5.
Currency in which must be maintained: USD which, of course, gives rise to the §986(c) gains and losses.
Ordering rules for distributions of PTI and non-PTI [§959(c)] given that a CFC may generate more than one type of PTI in the same year.
- §951(a)(1)(B) / §956 PTI on a LIFO basis.
- §951(a)(1)(A) / subpart F and GILTI PTI on a LIFO basis.
- Non-PTI on a LIFO basis.
Conclusions (more as reminders to practitioners and taxpayers)
- All of the aforementioned (except for the FTCs) apply to individuals holding interests in CFCs directly or through any form of a disregarded entity (e.g., LLC; “S” Corp.; and partnerships); and,
- The compliance costs will grow exponentially (please, do not blame the messenger, look to Congress).