A&M Tax Advisor Weekly
In the first edition of our ongoing series on tax reform’s most memorable acronym, GILTI, we discussed how expense allocation under IRC Sec. 861 could leave many unsuspecting taxpayers exposed to incremental tax on their foreign earnings. Despite paying a high effective rate of tax overseas that would seemingly offer a full foreign tax credit offset against US tax on GILTI, every dollar of expense allocation may cause an incremental $0.21 of tax, an issue similarly identified in a letter sent by the US Chamber of Commerce to the Treasury Department last week. Whether this is an intentional part of the new law, or simply a side effect of the quick process of drafting and passing the law, many tax professionals are now scrambling to revisit their GILTI estimates and evaluate their potential exposure. Critically, this exercise involves examining how expenses, particularly interest, are meant to be allocated against GILTI for foreign tax credit purposes.
Allocating Interest to Statutory Groupings of Income
The “low-taxed” portion of the GILTI name comes from the presumption that any U.S.-based multinational paying an aggregate effective rate of tax on their foreign earnings of at least 13.125 percent through 2025, and 16.4 percent thereafter, should be able to claim a foreign tax credit to fully offset the resultant U.S. tax. However, as we’ve seen often with the new reform bill, these provisions were designed within the framework of existing law, and are subject to a long-standing body of related rules. For example, the GILTI foreign tax credit mechanism was established via a new income basket under the existing Sec. 904 foreign tax credit limitation rules. Meaning, GILTI is subject to a largely unchanged body of law, including expense allocation rules for Sec. 904 purposes.
Sec. 861, which was largely left alone during the reform process, provides substantial guidance on how a variety of expenses, including interest, should be allocated and apportioned against Sec. 904 income baskets, including GILTI. Domestic corporations are required to use the asset method for allocating interest expense. Under the asset method, the taxpayer allocates interest to the various statutory groupings based on the average total value of assets assigned to each grouping. Assets fall into statutory groupings based on the source(s) and type(s) of income they generate, have generated, or may reasonably be expected to generate. Accordingly, the first step is to identify each of the taxpayer’s assets that generate income and to value such assets. In that regard, assets that produce no directly identifiable income yield or that contribute equally to the generation of all income are not considered. For tax years beginning before January 1, 2018, taxpayers had flexibility in their valuation methodology, generally using either tax basis or fair market value. For subsequent tax years (i.e. for years to which the GILTI provisions apply), the allocation must be determined using tax basis.
Having valued each asset that generates income, taxpayers must then characterize those assets according to the source(s) and type(s) of income they generate. In the case of assets generating foreign source income, this means further “basketing” the assets to one or more of the various Sec. 904 baskets. Taxpayers are then left with various statutory groupings of assets that give rise to the relevant categories of income, and a value prescribed to each grouping based on the value of the assets within each grouping.
Assigning an asset to one or more statutory groupings is not always clear-cut, especially when it comes to stock of a foreign subsidiary. Treasury regulations provide a look-through approach to characterizing stock of a controlled foreign corporation (CFC). Taxpayers look to the underlying assets held by the CFC to determine the character of income they generate. The assets are divided between income characters according to their respective tax basis or according to the gross income they produce, although in many cases, the tax basis approach may be required. Following these rules back up the ownership chain, a U.S. taxpayer’s outside basis in a CFC is therefore characterized according to the income generated by the CFC’s underlying assets, and the taxpayer’s interest expense is allocated to a particular Sec. 904 basket according to that characterization.
Interest Allocation to the GILTI Basket
Nearly every U.S. corporate taxpayer with profitable foreign subsidiaries…