At the heart of determining the taxable income of a foreign corporation lies an often misunderstood and overlooked Treasury Regulation Section: Treas. Reg. Section 1.952-2 sets the fundamental ground rules for determining taxable income of foreign corporations for purposes of tax code Subpart F and global intangible low-taxed income (GILTI). Prior to the 2017 tax reform, Tax Cuts and Jobs Act, Pub. L. No. 115-97 (Dec. 22, 2017), the infrequently used regulation was applicable only when determining Subpart F income of a foreign corporation.
Its importance was further overshadowed by the limitation on Subpart F in Section 952(c)(1)(A), which limits Subpart F income inclusions by a U.S. shareholder to the extent of a controlled foreign corporation’s (CFC’s) current-year earnings and profits. However, when the GILTI statute was created with the enactment of the Tax Cuts and Jobs Act, the IRS decided to leverage the same regulation, originating over five decades ago, for purposes of computing tested income for GILTI. The IRS did so without any updates or modernizations to the provision, which had gone untouched since 1996. This sprung the outdated and underappreciated regulation to the forefront of international taxation.
It’s rare that a scarcely updated regulation from the ‘60s plays a critical role in determining taxable income, and even more rare when it’s governing the application of a new provision that post-dates that regulation by several generations of the tax code. Nevertheless, this is where we find ourselves today: relying on an outdated regulation from the ‘60s when determining one of the most impactful numbers on a U.S. multinational’s federal income tax return, GILTI.
The TCJA replaced the longstanding system of taxing U.S. multinational corporations on foreign earnings of their foreign corporate subsidiaries only when such earnings were repatriated (or deemed repatriated) with a quasi-territorial system. The new TCJA system generally provides a 100% dividends received deduction for the foreign-source portion of dividends received by a U.S. corporation from a foreign corporation with respect to which the U.S. corporation is a 10% shareholder but also features broader inclusions of foreign income under the new GILTI regime. As a result, a U.S. multinational shareholder of a foreign corporation can avoid tax on the foreign-source portion of income earned by such corporation subject to key exceptions. These exceptions include (1) the Subpart F rules, and (2) the GILTI provisions. A third regime may also apply referred to as the “passive foreign investment company” rules. However, such regime is beyond the scope of this discussion.
The two exceptions to the quasi-territorial system noted above (i.e., GILTI and Subpart F) are so expansive they often swallow the rule. Consequently, even though aspects of a territorial regime exist, most—in some cases all—of a CFC’s income is includible in a U.S. shareholders income under either GILTI or Subpart F and subject to tax at the U.S. multinational level. This makes determining the CFCs’ taxable income critically important to a U.S. multinational’s tax bill. Determining taxable income for both of these provisions shares a common thread: Treas. Reg. Section 1.952-2. Treas. Reg. Section 1.952-2 provides the rules for determining gross income and taxable income of a foreign corporation for purposes of computing Subpart F income of a CFC. The computation of tested income or tested loss of a CFC (a component used in computing the GILTI inclusion) is also determined under the rules of Treas. Reg. Section 1.952-2. (Treas. Reg. Section 1.951A-2(c)(2).) Therefore, every U.S. multinational should be aware of this regulation and the hazards that come with it.
BREAKING DOWN THE REGULATION
Treasury Regulation Section 1.952-2 generally requires that a CFC’s taxable income be determined by treating the CFC as a domestic corporation. Under this approach, gross income of a CFC is determined by treating the CFC as a domestic corporation taxable under tax code Section 11 and applying the principles of tax code Section 61, which provides the definition of gross income generally applicable to domestic corporations. The taxable income of the CFC is then determined by treating it as a domestic corporation taxable under tax code Section 11 and applying the principles of tax code Section 63, which provides (in tax code Section 63(a)) that, except as provided in tax code Section 63(b), the term “taxable income” means gross income minus the deductions allowed by tax code Sections 1 through 1400 (other than the standard deduction). Section 63(b) provides special rules for individuals who do not itemize their deductions. Therefore, only items of deduction that would be allowable in determining the taxable income of a domestic corporation may be taken into account for purposes of determining a CFC’s tested income, tested loss, or Subpart F income. Several special rules also exist for insurance companies, but are beyond the scope of this article.
Limitations on Domestic Corporation Treatment
Although Treas. Reg. Section 1.952-2’s mandate to treat foreign corporations as domestic corporations for purposes of determining gross income and taxable income is broad, it is not without bounds. When treating the foreign corporation as a domestic corporation, Treas. Reg. Section 1.952-2(c) provides a number of special rules that limit or modify the application of the general rules discussed above. The more notable modifications are highlighted below.
Nonapplication of Certain Provisions
The first modification is to limit the applicability of certain subchapters of the tax code. While there are open questions on certain areas unaddressed by guidance, some of which are discussed in Part 2, the regulations make it explicitly clear that certain subchapters do not apply in their entirety. These generally include rules that address special situations and industries that would not be relevant for the determination of taxable income under Treas. Reg. Section 1.952-2. These exceptions are:
- Subchapter F — Exempt Organizations (Sections 501–530);
- Subchapter G — Corporations Used to Avoid Income Tax on Shareholders (Sections 531–565);
- Subchapter H — Banking Institutions (Sections 581–601);
- Subchapter L — Insurance Companies (Sections 801–848);
- Subchapter M — Regulated Investment Companies and Real Estate Investment Trusts (Sections 851–860H);
- Subchapter N — Tax Based on Income From Sources Within or Without the U.S. (Sections 861–1000);
- Subchapter S — Tax Treatment of S Corporations and Their Shareholders (Sections 1361–1379); and,
- Subchapter T — Cooperatives and Their Patrons (Sections 1381–1388). (Treas. Reg. Section 1.952-2(c)(1).)
In addition, tax code Section 103 does not apply. Section 103 provides rules that exempt certain interest on state and local bonds from tax.
Application of E&P Principles
The next special rule provides for coordination between the computation of taxable income and the computation of earnings and profits (E&P) provided under Treas. Reg. Section 1.964-1 with respect to the foreign corporation. (Treas. Reg. Section 1.952-2(c)(2).) Specifically, the rule requires consistency between a CFC’s U.S. Generally Accepted Accounting Principles (GAAP) and tax accounting methods employed to compute E&P and to compute taxable income. In other words, the tax and accounting principles used for purposes of E&P control when computing taxable income under (Treas. Reg. Section 1.952-2.) Without this rule, conceivably a CFC’s E&P could be disconnected from its taxable income, which would not be the case for domestic corporations. One of the basic rules of the computation of a domestic corporation’s E&P is that the methods of accounting employed for taxable income purposes generally apply for purposes of computing E&P, unless otherwise modified. (Treas. Reg. Section 1.312-6(a).)
The regulations also require consistency between the principles governing the computation of E&P and taxable income in other areas. For example, Treas. Reg. Sections 1.952-2(c)(2)(i)–(iv) require the taxable income computation follow the same general steps provided in the E&P rules. The annual calculation of a foreign corporation’s E&P is generally based on a three-step approach and provides for special rules for currency translation. (Treas. Reg. Sections 1.964-1(a)(1)(i)–(iii), 1.952-1(a)(3).) These steps are:
- Prepare a local country profit-and-loss statement (P&L) for the year from the books of account regularly maintained by the corporation for the purpose of accounting to its shareholders.
- Make the accounting adjustments necessary to conform the foreign P&L to U.S. GAAP.
- Make the further adjustments necessary to conform the U.S. GAAP P&L to certain U.S. tax accounting standards.
Aligning the approach ensures consistency between the concepts of E&P and taxable income, and ensures that the fundamental connection between the two in the context of domestic corporations also applies for foreign corporations.
The regulations extend this consistency between E&P and taxable income for foreign corporations beyond the specific tax and GAAP accounting principles, and also ostensibly incorporate the rule limiting the need for an accounting adjustment when such adjustment lacks a material effect. The material effect rule in Treas. Reg. Section 1.964-1(a)(2) provides that no adjustment shall be required under steps 2 and 3 (U.S. GAAP and tax accounting adjustments) in the E&P process unless material. Whether an adjustment is material depends on the facts and circumstances of the particular case, including the amount of the adjustment, its size relative to the general level of the corporation’s total assets and annual profit or loss, the consistency with which the practice has been applied, and whether the item to which the adjustment relates is of a recurring or merely a nonrecurring nature.
However, the material effect rule has no impact on the computation of tax adjustments required for permanent differences, such as the disallowance for meals and entertainment deductions under tax code Section 274. Section 274(a)(1) generally disallows a deduction for any item with respect to an activity that is of a type generally considered to constitute entertainment, amusement, or recreation. As permanent differences are not E&P adjustments required under Treas. Reg. Sections 1.964-1(b) and 1.964-1(c), the material effect rule would be inapplicable to such adjustments required by application of the general rules of tax code Section 11. For example, meals and entertainment is required when computing taxable income, but is not an E&P adjustment. Thus, the meals and entertainment adjustment would be required irrespective of whether it had a material effect. The application of the material effect rule in Treas. Reg. Section 1.952-2 does entail some ambiguity which will be discussed further in part 2.
If simplification is desired, the IRS may consider extending the material effect rule to permanent adjustments. However, there may be a policy argument for excluding these as they are obviously not a timing difference, and, even if de minimis, would permanently impact the amount of income over time.
This area presents several risks for U.S. multinationals, one being whether a timing difference has a material effect. The lack of guidance makes the decision judgment-based, which could lead to controversy. U.S. multinationals must also pay close attention to permanent adjustments—these are often overlooked but are required no matter their size.
Necessity for Recognition of Gain or Loss and Gross Income and Gross Receipts
The regulation also makes some modifications and provides clarifications related to the necessity for recognition of gain or loss, and they distinguish between gross income and gross receipts. (Treas. Reg. Sections 1.952-2(c)(3), 1.952-2(c)(4).) Further, it provides that a foreign corporation shall not be treated as a domestic corporation for purposes of determining whether tax code Section 367 applies.
Generally, gross income of a foreign corporation includes gain or loss only if such gain or loss would be recognized if the foreign corporation were a domestic corporation taxable under tax code Section 11. (Treas. Reg. Section 1.952-2(c)(3).) An example of the application of this rule is provided for in a now-obsoleted revenue ruling. Rev. Rul. 73-277, obsoleted by Rev. Rul. 2003-99, concerns whether gain from the sale of the stock of a second-tier foreign corporation will constitute FPHCI of its first-tier corporate shareholder for purposes of the foreign personal holding company income (FPHCI) or CFC provisions, when such shareholder has adopted a plan of complete liquidation as described in tax code Section 337(a). The revenue ruling concludes that the gain realized on the sale of the stock, which would not be recognized under tax code Section 337(a) if the first-tier corporation was a domestic corporation, will not be includible in the first-tier corporation’s gross income or constitute FPHCI.
The regulations also clarify that the term “gross income” may not have the same meaning as the term “gross receipts.” For example, in a manufacturing, merchandising, or mining business, gross income means the total sales less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. This provision is relevant for the Subpart F de minimis rule, which provides that if the foreign base company income is less than 10% of gross income (notably distinguishable from gross receipts) of the CFC, no part of the gross income of the taxable year shall be treated as foreign base company income. See Rev. Rul. 83-118 and Rev. Rul. 86-155. While the later ruling revoked the earlier one, both rulings address the question of computing gross income for purposes of the de minimis rule under tax code Section 954(b)(3).
Treatment of Capital Loss and NOL
The final modification of the general rule addresses the treatment of capital losses and net operating losses. (Treas. Reg. Section 1.952-2(c)(5).)
The rule provides that neither the NOL deduction under tax code Section 172(a) nor the operations loss deduction under tax code Section 812 are allowed when computing taxable income. (Treas. Reg. Section 1.952-2(c)(5)(ii).) The NOL limitation should not come as a surprise. The Subpart F rules already have special rules addressing prior-year losses, referred to as “qualified deficits.” (Tax code Section 952(c)(1)(B).) Many U.S. multinationals have expressed their desire to see NOLs allowed for GILTI. However, the annual nature of the computation, as evidenced by the lack of carryforward of foreign tax credits related to GILTI, among other things, would seem to support the inapplicability of the NOL rules.
When determining taxable income of a foreign corporation, the capital loss carryback and carryover provided by tax code Section 1212(a) is also not allowed. (Treas. Reg. Section 1.952-2(c)(5)(i).) However, tax code Section 1211 still limits capital losses to capital gain. Prior to the TCJA’s addition of GILTI, this limitation was much less relevant. Despite the limitation for taxable income, the earnings and profits (E&P) limitation in tax code Section 952(c) allows some benefit of the capital loss, as Subpart F income is limited to current E&P (subject to recaptures). E&P is reduced by capital losses, irrespective of the taxable income limitation. (Treas. Reg. Section 1.312-6(b).) Prior to the TCJA’s adding of tax code Section 245A to the Code, this may also have had the tangential benefit of reducing E&P that would have been subject to tax when repatriated. However, GILTI is not limited by E&P, and, post-TCJA, the E&P reduced by the loss may have been eligible for the 100% dividends received deduction under tax code Section 245A. Thus, the loss could now go unutilized, and may actually be detrimental in that it reduces tax code Section 245A eligible earnings.
A capital loss could be generated at the CFC level in several different scenarios, some of which are depicted below:
In such a case, even though the CFC may be in an overall loss, perhaps a significant loss, the U.S. shareholder may be otherwise subject to GILTI if the CFC has positive tested income. If a U.S. multinational is considering capital transactions such as these, it should plan and act accordingly by, for example, timing the loss to occur in the same period as a capital gain.
RISKS, OPPORTUNITIES, AND FINAL THOUGHTS
Although these regulations are foundational, they nevertheless present opportunities and traps. U.S. multinationals should carefully consider these rules when planning and analyzing the U.S. tax impact of their foreign subsidiaries. Understanding the building blocks is important, but savvy U.S. multinationals may view aspects of these rules as powerful tools in their toolbox.
One of the key elements is the incorporation of accounting methods. Accounting methods present numerous opportunities to defer revenue and accelerate expenses, or vice versa. If a U.S. multinational is in an excess foreign tax credit position, it could consider accelerating income and deferring deductions. However, if it finds itself in an excess foreign tax credit limitation position, it could defer income and accelerate deductions.
Contrary to popular belief, deferral of income is not always the most ideal outcome. With the passage of the GILTI system, and the lack of any foreign tax credit carryover mechanism, the timing of income recognition is critical. U.S. multinationals may be better suited accelerating income in some cases when it means aligning the timing of their U.S. income with the timing of income for local country tax purposes. Without the ability to smooth GILTI foreign tax credits with a carryover or carryback mechanism, deferring income could mean disconnecting the foreign tax credit from its associated income. Although this might provide a short-term benefit, in may come at a long-term cost. The other timing aspect to consider is the state of politics. In the near future, the 21% corporate rate may increase, and the tax code Section 250 deduction may decrease or be repealed. Thus, deferring income may come at a risk—particularly when that income may be offset by a foreign tax credit in the current period. These risks need to be weighed when evaluating accounting method changes at the CFC level.
The capital loss limitation rules also present a trap for the unwary. If entities are looking to dispose of a lower-tier CFC, or liquidate such a CFC in a taxable liquidation, the timing of the capital loss becomes immensely important. If a company doesn’t have capital gains in the year of the loss, the capital loss may be permanently lost.
All taxpayers with CFCs should familiarize themselves with this misunderstood and overlooked Treasury regulation in order to unlock its benefits and avoid its pitfalls.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Cory Perry is an International Tax Senior Manager in Grant Thornton LLP’s Washington National Tax Office.
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