Lisa Goldman, CPA, TEP, M. Tax and Rebeccah Fontaine, J.D., LL.M.
8.6.19 | Client Alert
Part 1 – Treatment of Domestic Partnerships at the Partner Level
The IRS recently released final and proposed regulations addressing a variety of topics including Global Intangible Low-Taxed Income (“GILTI”), foreign tax credits, the treatment of domestic partnerships for purposes of determining Subpart F income of a partner, and a “GILTI high-tax exclusion.” The final regulations afford much needed certainty to taxpayers, but were largely upstaged by the proposed GILTI high-tax exclusion that could redefine the GILTI planning and structuring. Because some of these rules may affect the 2018 tax year, companies should determine if any aspects of these regulations affect their 2018 tax liability. This 3-part alert will cover three major areas:
- Part 1: Treatment of Domestic Partnerships at the Partner Level
- Part 2: High-Tax Exclusion; and
- Part 3: Mechanics of GILTI – Coordination with Existing Rules
A key component of 2017’s Tax Cuts and Jobs Act (“TCJA”) was the implementation of GILTI as a new taxing regime for controlled foreign corporations. GILTI taxes U.S. shareholders currently on income earned through their Controlled Foreign Corporations (“CFC”) even though profits are not repatriated. Unlike long-standing Subpart F income inclusion, the GILTI inclusion is based on the aggregate of a shareholder’s pro-rata share of GILTI income, rather than a CFC by CFC approach for calculating Subpart F income inclusions. This aggregated approach enables CFC’s with net losses to offset other entities with income within the group.
GILTI Calculation Overview
GILTI is generally defined as the excess of a US shareholder’s aggregated “net tested income” from CFCs over a statutorily defined return on certain tangible assets.
The formula for GILTI is:
GILTI = net CFC tested income – [(10% x QBAI) – Interest Expense]
More precisely, GILTI equals “net CFC tested income” (defined below) minus the shareholder’s “net deemed tangible income return” (net DTIR). The shareholder’s net DTIR equals the excess (if any) of: (1) 10% of the aggregate of its pro rata share of the “qualified business asset investment” (QBAI) of each CFC in which it is a US shareholder, over (2) the amount of interest expense taken into account in determining its net CFC tested income for the year (but only to the extent that the interest expense exceeds the interest income included in CFC tested income).
The calculation of GILTI follows three basic steps and is calculated in the aggregate for a U.S. person with respect to the CFCs for which it is at least a 10% US Shareholder:
Step 1 – Calculating Net Tested Income: “Net tested income” is the gross income of the CFC less allowable deductions. Gross income for this purpose excludes:
- Income that is effectively connected with a US trade or business;
- Subpart F income;
- Income that is excluded from Subpart F income because it is subject to an effective foreign income tax rate greater than 90% of the maximum US corporate income tax rate;
- Dividends received from related persons; and,
- Certain foreign oil and gas income.
If the allocable deductions exceed the CFC’s gross income, the CFC has a “tested loss”.
Step 2 – Calculating the Net Deemed Tangible Income Return (net DTIR): A 10% shareholder’s “net DTIR” is 10% of the adjusted tax basis of the Qualified Business Asset Investment (QBAI). QBAI is the CFC’s quarterly average aggregate adjusted basis of specified tangible property used in the production of CFC tested income. It must be used in a trade or business of the CFC and must be depreciable under US tax rules. DTIR is an aggregate of the QBAI from each CFC with tested income, tested loss CFC’s QBAI are excluded from this computation.
Step 3 – Calculating GILTI: A US shareholder computes GILTI in the aggregate for all its CFCs. Therefore, companies with losses can offset companies with income.
Part I: Treatment of Domestic Partnerships at the Partner Level
The final GILTI regulations adopt an “aggregate” approach to partnerships’ GILTI inclusion. Partners are treated as proportionately owning CFC stock owned by the domestic partnership, just as they would for a foreign partnership. As a result, a partner in a domestic partnership that indirectly owns less than 10% of a CFC (by voting or value) will not have a GILTI inclusion.
Each partner will separately determine if they are considered a US shareholder of the CFC for GILTI inclusions and their pro rata share of the tested items of the CFC (e.g., tested income, tested loss, QBAI). Partnerships report CFC tested items to their partners, who, if they meet the 10% threshold, compute their GILTI income at the partner level based on all the CFCs the partner directly and indirectly owns.
The IRS recognized that this approach to GILTI would be inconsistent with the treatment of Subpart F Income, which has historically been determined at the partnership level. To resolve this, the IRS issued proposed regulations to extend this aggregate treatment of domestic partnerships for the purposes of determining Subpart F and Section 956 inclusions as well. This proposed approach to domestic partnership for Subpart F purposes is a fundamental change to the Subpart F regime.
The aggregate treatment of domestic partnerships is limited to determining which partners have GILTI, Subpart F, or section 956 inclusions. This treatment does not apply for purposes of determining whether a US person is a US shareholder (thus, a domestic partnership can still be a US shareholder), a foreign corporation is a CFC, nor for determining ownership under IRC Section 958(a) for any other provision of the Code.
The final GILTI regulations are retroactive for any CFC tax year that began in 2018. The proposed regulations for Subpart F may also be applied to tax years beginning after December 31, 2017.
This aggregate approach should not result in different tax consequences for partners that meet the 10% shareholder threshold of the underlying CFC. However, the aggregate approach can have a significant effect on partners who do not meet the 10% threshold. Any partner that directly, indirectly, and/or constructively owns less than 10% of a CFC held by a domestic partnership is not considered a “US shareholder” of the CFC and consequently has neither a GILTI nor Subpart F inclusion. However, partners that own less than 10% of a CFC owned through a domestic partnership may be subject to the passive foreign investment company (“PFIC”) rules if the CFC is also a PFIC.
Domestic partnerships should consider the PFIC consequences to their partners before implementing early adoption of the aggregate treatment under the proposed Subpart F income regulations. Under current law, the CFC/PFIC overlap rule generally shields partners from being treated as indirect PFIC shareholders subject to the PFIC regime. However, under these proposed regulations the CFC/PFIC overlap rule no longer protects a partner who is not a US shareholder for Subpart F purposes from being treated as an indirect PFIC shareholder under the PFIC regime.
If you have questions or need advice regarding GILTI and domestic partnerships, contact Lisa Goldman at 212.699.8808 | firstname.lastname@example.org or reach out to your Berdon advisor.
Berdon LLP New York accountants