Special Tax Alert
Now in our fourth year under the Tax Cuts and Jobs Act of 2017, we’ve seen the new tax regime stretched to its extreme to accommodate a starkly different economy than that of 2017. A tax system built with an optimistic outlook is now facing an economic crisis, already forcing Congress’s hand earlier this year in the form of the CARES Act, which sought to free up taxpayer liquidity by (among other things) temporarily relaxing the TCJA’s NOL and interest limitation provisions.
While the CARES Act tweaked provisions of the TCJA, fundamental aspects of the new regime remain intact, and carry significant consequences for distressed companies. In this article, we focus on one such topic: the existing rules on cancellation of indebtedness income (“CODI”) and their impact on taxpayers’ global intangible low-taxed income (“GILTI”) profile. For many taxpayers with debt in their international structure, we are already seeing that the intersection of these rules can carry surprising and costly consequences, while advanced modeling and planning can eliminate mistakes that impact stakeholders.
CODI in General
CODI does not only arise where the principal amount is reduced. Rather, it often manifests in far less dramatic cases of taxpayers negotiating new terms of their debt, especially if the debt is publicly-traded. A significant modification of the terms (yield, maturity, security, etc.) is generally treated as a retirement of a debt instrument in exchange for a newly issued instrument. Where the modification results in a reduction of future amounts payable, CODI often arises.
A taxpayer’s gross income includes CODI unless an exception applies. For example, an insolvent debtor (or a debtor in certain bankruptcy proceedings) does not include CODI in gross income to the extent it is insolvent. However, those taxpayers don’t get off scot-free—rather, they pay for the exclusion via a reduction in certain of their tax attributes (e.g., NOLs, tax credits, basis, etc.).
As more and more borrowers face CODI events and are eligible for exceptions, the simple question of paramount importance is: what’s the value of the attributes that will be reduced? An NOL, for example, may not be simply worth 21 cents on the dollar if, perhaps, the lost NOL frees up capacity for an FDII deduction, or releases GILTI foreign tax credits that otherwise would not have carried forward. As a result, taxpayers must, in advance of a CODI event, identify the true value of their attributes in order to preserve that value where possible.
Here, we will focus primarily on the application to GILTI. However, as we discuss, the GILTI consequences stretch beyond a mere income inclusion, effecting future deductible basis, foreign tax credit capacity, interest deductions, and more.
CODI and CFCs
Under the pre-TCJA deferral regime, CODI was of little relevance to controlled foreign corporations (“CFCs”) and their U.S. shareholders. Earnings of such CFCs, other than subpart F and effectively connected income, were only taxable upon a repatriation. For the most part, CODI realized by a CFC does not give rise to subpart F income (save for unusual circumstances). Therefore, for taxpayers availing of deferral, a CFC’s CODI was of little consequence.
However, as part of TCJA, U.S. shareholders now have accelerated income inclusions by virtue of the GILTI regime, which renders CODI (and its associated attribute reduction, if applicable) substantially more relevant. The GILTI regime operates as a tax to U.S. shareholders on the aggregate net current earnings (or “tested income”) of its CFCs, less a deemed return on tangible assets. Tested income generally refers to income calculated under U.S. tax principles as if the CFC were a domestic corporation, with certain exclusions. In practice, this means that every CFC is subject to an annual calculation of U.S. taxable income (including any CODI), and such income is immediately taxable to the CFC’s U.S. shareholders. Such U.S. shareholders may, of course, claim a foreign tax credit against the resulting U.S. tax, subject to a variety of complications and limitations, some of which were discussed in prior alerts: You Don’t Look a Day Over 100: Foreign Tax Credit Gets a Facelift in New Regs and IRS Releases Final and Proposed Foreign Tax Credit Regulations This Week.
Impact of CODI Exclusion on Future GILTI Inclusions
As mentioned above, in certain circumstances (notably, insolvency and bankruptcy), CFCs may be able to exclude their CODI from their calculations of taxable income. In which case, the CFCs are required to reduce their tax attributes. However, in the case of a CFC, the options may be limited. For GILTI purposes, a CFC is not generally entitled to tax credits or, in the IRS’s view, loss carryforwards, possibly leaving only asset basis for reduction. Unlike domestic corporations, which may have some discretion in which attributes are reduced first, a CFC, absent preemptive planning, may have no flexibility in its attribute reduction.
For a CFC facing a potential CODI event, the broader impact on its GILTI profile resulting from attribute reduction must be considered, especially where taxpayers may have flexibility in timing the CODI event. Assuming the CFC has material tax basis in its assets, the reduction of asset basis must be measured against the loss of underlying depreciation and amortization deductions against tested income, as well as any lost basis in tangible assets that shield GILTI inclusions via the deemed tangible asset return.
Planning Strategy: Under the attribute reduction rules, the basis of assets is not reduced until the end of the taxable year in which the CODI is realized. As a result, it may be possible to avoid a reduction in the basis of depreciable assets by transferring them to an affiliate before the end of the taxable year.
CFC CODI impacts US Interest Deductions
Lastly, taxpayers should consider how the elimination or modification of a CFC’s debt alters their broader interest deduction profile. Under the so-called section 163(j) “group election,” U.S. shareholders of CFCs can avail themselves of some or all of a CFCs group’s excess interest capacity. The CODI event, to the extent it results in smaller interest deductions in the CFC group and a larger GILTI inclusion, may increase the interest deduction capacity at the U.S. shareholder level under proposed (but not yet final) regulations.
CFC CODI affects Foreign Tax Credits
As the CFC is subject to both U.S. and foreign law, it is important to consider the local tax treatment of the CODI. Under local tax law, particularly in the case of debt modifications, the CODI may not trigger foreign taxes. Therefore, the resultant GILTI will not carry a foreign tax shield. For taxpayers already in an excess credit position, the increased GILTI may then be offset by credits that otherwise would not have carried forward. Taxpayers may, therefore, be proactive in CODI planning to efficiently utilize foreign tax credits.
In short, the consequences from the cancellation or modification of a CFC’s debt can quickly snowball, with both beneficial and detrimental effects. Depending on a taxpayer’s broader profile, the cumulative effect of a CODI event can be very different.
More Changes Coming…
While taxpayers grapple with the intersection of CODI and GILTI, the tax landscape continues to develop, and may alter the consequences of a CODI event at the CFC level. Some GILTI regulations being considered by the IRS have yet to be finalized. Further, the incoming Biden administration has proposed increases on the tax rate on GILTI inclusions (via a corporate rate increase and reduction to the section 250 deduction) that could increase the tax cost of a CFC’s CODI.
A&M Taxand Says
While CODI and GILTI are familiar topics for most U.S. taxpayers, their overlap poses significant issues that are beginning to manifest on a wide scale. Understanding the immediate relevance of CODI to GILTI is an important first hurdle, but, as shown above, we expect the hidden consequences of CFC CODI level will be even more impactful.
Evaluating these moving pieces in advance of a potential CODI transaction is critical in guiding decision making, and as the GILTI landscape continues to evolve, it’s more important than ever to be equipped with the right tools and work with trusted partners. As companies shore up liquidity and trigger CODI events, we are working with our clients to protect stakeholders from costly missteps and identify planning opportunities around timing CODI.