In my last post I discussed a public comment made on behalf of the Israeli Ministry of Finance on the recent proposed GILTI regulations. GILTI is quite complex, and that post may have thrown some readers into the deep end. In this post I go back to the beginning and try to explain why the US Congress felt that the GILTI provision was an essential part of the 2017 Tax Cuts and Jobs Act (TCJA). Subsequent posts will cover more detail about what GILTI actually measures and how the GILTI computations are supposed to work.
When Congress passed TCJA, it was hailed as major international tax reform that would make US multinationals more competitive with their international counterparts. The US corporate tax rate was reduced from 35% to 21% and with much fanfare, the US moved from taxing the worldwide income of corporations to a (not quite) territorial taxation system. Now that the bill has been signed and taxpayers, the IRS, and the tax compliance industry have had some time to study it, the reality doesn’t quite live up to the hype. For non-resident individual US taxpayers, the problem could be even worse! The transition/repatriation tax (§965) and GILTI (Global Intangible Low Taxed Income – §951A) have been drafted to apply to all US shareholders of Controlled Foreign Corporations (CFCs), not just the US domestic corporations that benefit from the modified territorial tax system. Once again, Congress has failed to consider the implications of their actions on non-resident US taxpayers.
What was the idea?
Under the old rules, US corporations were not subject to US tax on active business income generated inside foreign subsidiaries until that income was “repatriated” to the US by way of a dividend or distribution. Big multinational corporations were hoarding cash in their offshore subsidiaries, but Congress wanted them to repatriate the money to the US to stimulate the US economy. Under TCJA, US taxation of corporations has moved to a supposedly territorial tax system. What does that mean? A territorial tax system is one where only income sourced inside the country is taxed – for US corporations that would mean that only US-source income would be subject to US tax. However, the new US system has essentially expanded the types of income that are taxed currently to US multinationals, while exempting them from US tax on what’s left over.
GILTI acts as a minimum tax to ensure that big multinational companies don’t stash their income in countries with zero or ultra-low tax rates. Using tax havens to reduce taxes really isn’t new. For decades manufacturers have attempted to “manage” their tax liability by manipulating the prices paid between subsidiaries to “move” profits into the country with the lowest tax rates. This has led to the development of a vast ecosystem of laws aimed at ensuring that “transfer pricing” between related corporations was done at an “arms length” price. Transfers between related parties are a particular problem when it comes to income from intellectual property (IP) and other intangible assets that can be easily moved from one country to another without affecting the economic substance of the ultimate product transaction. For example, a software company can sell its IP to its wholly owned Irish subsidiary and that subsidiary can charge licensing fees to the parent, moving profits to the low taxed Irish company. The perceived abuses of the transfer pricing system by large multinational corporations led to the development of the OECD’s Base Erosion and Profit Sharing (BEPS) program.
Under the new US tax rules, any “foreign-source” profit earned in foreign subsidiaries can be distributed to the US parent company tax free, while “US-source” and passive income is taxed to the US parent as earned. This provides a challenge: How does the US ensure that the profit properly allocable to US-generated IP is allocated to the US parent company (taxable in the US), and not to some foreign subsidiary with a very low tax rate?
GILTI to the rescue. The underlying idea starts with the false dichotomy between tangible and intangible income. Income that can be traced to tangible assets can’t be allocable to US-source IP. So, Congress decided to arbitrarily determine any income earned inside a Controlled Foreign Corporation (CFC) in excess of an arbitrary “reasonable” return on tangible assets must really be income from globally mobile intangible income. And, since the CFC is US-owned, any income from intangible assets MUST be due to US-generated intangibles.
There are (at least) two flaws in this chain of reasoning. First – there are more ways to generate income than the two identified – using fixed assets and easily mobile intangible assets. Consider a small Australian retail store owned by a US taxpayer. Often premises are leased rather than owned and the only fixed assets are shop fittings. The income is earned from investment in inventory, which is not a depreciable fixed asset. It would be hard to argue that the income of an Australian milk bar or mixed business consists of US-source intangible income that has been moved to Australia to avoid tax. Similarly, income in a service business, like a hairdresser or accountant, is earned from the labour of the proprietor and employees, not really from the investment in fixed assets. Clearly, the concept of intangible vs. tangible income is a false dichotomy.
The second flaw is the implicit assumption that any IP or other intangible asset owned by a “US-owned” business is properly treated as income that should be taxed currently by the US if an “insufficient” foreign tax rate applies. Google, for example, have engineers working in several countries generating IP. Google Maps was developed by two Danish brothers working for a company in Sydney, Australia, which was subsequently acquired by Google. Further development of Google Maps was done in Google’s Sydney office. Even if you could disentangle intangible and tangible income, the assertion that the US has the right to set the minimum tax rate on all intangible income of “US-owned” foreign corporations is an arrogant overreach by the US Congress. Given the intricacies of the recently proposed regulations (as well as the forthcoming proposed regulations covering foreign tax credits) GILTI can easily override legitimate tax concessions offered by sovereign nations in a bid to stimulate their own economies.
This post looked at the rationale behind GILTI. In the next post I’ll explore how GILTI is actually measured – and where the “low-taxed” part of the acronym fits into the picture. This series consists of the following posts:
- Explaining GILTI
- Explaining GILTI – Rationale (this post)
- Explaining GILTI – Measurement
- Explaining GILTI – Individual Shareholders
UPDATE 7 December 2018:
John Richardson and I have done a series of three videos on GILTI. The first is based on this post.