In this series of blog posts I try to explain GILTI (Global Intangible Low Taxed Income) in simple terms. In the first post I discussed a public comment made on behalf of the Israeli Ministry of Finance on the recent proposed GILTI regulations. My second post explained the rationale behind GILTI. In this post I’ll discuss how GILTI is measured in non-technical terms. For those of you who want to get into the detail, there’s a technical appendix on our wiki. This post will focus on the general rules applicable to Apple and Google and other US domestic corporations that are US Shareholders in Controlled Foreign Corporations (CFCs). In my next post I’ll discuss the differences that apply when the US Shareholder is not a domestic corporation.
As we saw in the last post, the idea behind GILTI is to ensure that globally mobile intangible income (e.g. return on intellectual property or IP) is not hidden away in tax havens to escape tax altogether. There are two aspects to this – 1) identifying the problem intangible income; and 2) ensuring that “sufficient” tax has been paid. Both of these problem must be solved in a way that’s easy to administer and not subject to aggressive tax “planning” by large multinational corporations (MNCs) with highly paid tax lawyers on staff.
Before we get too far into the problem, though, let’s start by making sure we understand these defined terms from the Internal Revenue Code:
US Shareholder: A US person (any US taxpayer – citizen, resident, corporation, partnership, etc.) that owns 10% or more (by either value or voting power) of a foreign corporation is a US Shareholder of that foreign corporation and is required to disclose their ownership on Form 5471 (the extent of disclosure will depend on how much is owned and whether the foreign corporation is a CFC). While beyond the scope of this post, there are attribution rules to keep shareholders from splitting ownership between related parties to artificially stay below the 10% threshold.
Controlled Foreign Corporation (CFC): If more than 50% of a foreign corporation is owned by US Shareholders (as defined above), that foreign corporation is a CFC, which triggers not only increased disclosure on Form 5471, but also potential liability to the US Shareholder for US tax on undistributed income of the CFC.
Identifying Problem Income
In drafting GILTI, Congress didn’t even attempt to specifically identify problem income. Instead the rules make a rough guess at what might be intangible income and treat all of this measured “intangible” income as GILTI. Roughly, GILTI is computed as Tested Income less Deemed Tangible Income Return. Tested income is essentially all of the CFC’s income that isn’t already taxed currently by the US (see technical appendix for details).
When computing the deemed tangible income, the rules essentially look at tangible assets owned by the CFC and assume (out of thin air) that those tangible assets will earn a 10% return. As discussed in my earlier post, tangible/intangible is really a false dichotomy, and not all measured intangible income will be income from IP and other forms of globally mobile income. But, leaving that aside for the moment, there are some issues with the way the tax code computes tangible income. The first issue is how tangible assets are measured. The code uses the concept of QBAI (Qualified Business Asset Investment) to measure tangible assets. QBAI is defined as the book value (net of accumulated depreciation computed under US tax rules) of all depreciable assets owned by the CFC. While all depreciable assets are tangible, it does not follow that all tangible assets are depreciable. Land, for example, is not a depreciable asset. Furthermore, the tax book value of depreciable assets will not reflect market value. For assets that have been in place for several years, book value will be close to zero, even though those assets continue to provide a return to the business. On balance, it would appear that QBAI under-estimates the value of tangible assets held by the CFC by ignoring non-depreciable assets, and by using book value under US tax rules.
To estimate deemed tangible income, Congress has applied an arbitrary return of 10% on QBAI. Some commentators have compared this to current interest rates and argued that 10% is too high. That comparison fails to consider the risks involved in owning tangible assets. It is a basic premise of finance that higher risk investments should generate higher returns. Asset returns vary widely by industry and over the economic cycle. While setting a single rate is easier to administer (and harder for taxpayers to game), it does not reflect economic reality.
Finally, any interest expense paid by the CFC (unless paid to a related party) is deducted from 10% of QBAI to get the Deemed Tangible Income Return. This further reduces the amount of income allocated to tangible assets (and exempt from current US taxation) as it does not consider whether the interest expense was incurred in the acquisition of QBAI.
Has “sufficient” tax been paid?
GILTI stands for Global Intangible Low-Taxed Income. We’ve seen where the Intangible portion of the acronym comes from. What about “Low-Taxed”? The conference report indicates that Congress intended that GILTI should apply to top up worldwide taxation of GILTI when the effective foreign tax rate is less than 13.125%. But how do they get there?
Since GILTI was mainly aimed at MNCs, Congress set up the corporate rules to get to the 13.125%[1], then modified the rules for individual US Shareholders without much thought as to the effect on the effective tax rate on GILTI. In this post I’ll focus on the corporate rules, and in my next post I’ll demonstrate the impact of the differences between the rules for US Shareholders that are domestic corporations and those who are individuals.
When TCJA was first passed, some commentators saw §951A(c)(2)(A)(i)(III) as applying to all CFC income. However, this is not what the proposed regulations say. This is the issue that I explore in the first post in this series.
Instead, under the rules applicable to corporations, GILTI is essentially a minimum tax. Under §250 corporate US Shareholders get an automatic deduction of 50% of their GILTI inclusion. This reduces the US tax on GILTI from 21% to 10.5%. Corporate US Shareholders are also allowed (§960) to use foreign taxes paid by their CFCs as foreign tax credits (FTC) to offset their US tax liability. However, the GILTI rules state that only 80% of those foreign taxes can be used as FTC to offset GILTI. The net result is that a corporate US Shareholder will only pay additional US tax due to GILTI if the effective foreign tax rate paid on GILTI is lower than 13.125%.[2] Because GILTI is meant to be a minimum tax, and because 80% of the foreign tax paid is allowed to offset US tax on 50% of GILTI, Congress didn’t want shareholders to be able to game the FTC rules to offset other US taxable income. To avoid this problem, the FTC limit on GILTI is calculated separately and no carryforward or carryback is allowed for FTC related to GILTI. This could be a problem when there are timing differences between when GILTI income is recognised under US tax rules and under the CFC’s local tax rules. For MNCs with multiple CFCs, Congress has mitigated this issue somewhat by allowing US Shareholders to compute GILTI and the associated FTC on an aggregate basis, averaging out any timing differences. This also averages the effective foreign tax rate paid, allowing MNCs to continue putting intangible income in tax havens as long as they have enough GILTI in high tax countries as well.
Given the broad definition of GILTI, the net effect on taxes paid by MNCs may be minimal. The effect on small businesses, however, could be devastating – we’ll explore how the rules differ for individual US Shareholders in my next post.
This series consists of the following posts:
- Explaining GILTI
- Explaining GILTI – Rationale
- Explaining GILTI – Measurement (this post)
- Explaining GILTI – Individual Shareholders
UPDATE 7 December 2018:
John Richardson and I have done a series of three videos on GILTI. The second is based on this post.
[1] There are many other complicated rules that are more likely to affect corporations than individuals. One of these is the way US and foreign source income must be computed when calculating the FTC limitation. Recently released proposed regulations describe how those rules apply when computing FTC for GILTI.
[2] For those who want to see how it all fits together, there’s a numerical example in the technical appendix.