September 17, 2021
House Ways and Means Committee Chair proposes comprehensive international tax changes for reconciliation bill
In the tax portion of its budget reconciliation bill (released September 13, 2021), Chairman Neal of the House Ways and Means Committee proposed significant changes and additions to US international tax rules (the HW&M Proposal). Provisions potentially affected by the HW&M Proposal include the foreign tax credit (FTC), the global low-tax intangible income (GILTI) regime, the base erosion and anti-abuse tax (BEAT), and the interest expense limitation under Internal Revenue Code (IRC) Section 163,1 among others. With important exceptions, most of these changes would be effective for tax years beginning after December 31, 2021.
To supplement the HW&M Proposal, the House Ways and Means Committee also released a section-by-section summary, and the Joint Committee on Taxation released a description of the proposed changes (the JCT report).
In this Alert, EY provides a detailed discussion of the proposed modifications to the US international tax provisions in the HW&M Proposal. For discussion of prior releases of tax proposals and draft legislative text as part of the Build Back Better Plan, please refer to our prior Alerts on the Biden Administration's Green Book proposal and Senate Finance Committee Chair Ron Wyden's proposal.
Corporate tax rate
The HW&M Proposal would increase the federal corporate income tax rate to 26.5%. Specifically, this rate would apply to the highest bracket of a new graduated corporate income tax rate, starting at 18% on taxable income of $400,000 or less, then 21% on income from $400,000 to $5 million, and finally 26.5% on income over $5 million. For corporations whose taxable income exceeds $10 million, the benefit of the lower rates would be effectively phased out through a top-up tax to equal the 26.5% rate on all income.
Proposed changes to the foreign tax credit
Changes impacting the FTC limitation
Country-by-country FTC limitation and repeal of foreign branch income category
In a major change, the HW&M Proposal would compute a taxpayer's FTC limitation on a country-by-country basis based on taxable units (the CbC FTC Limitation), thus preventing excess FTCs from high-tax jurisdictions from being credited against income from low-tax jurisdictions. Accordingly, the HW&M Proposal would require each separate limitation category (category), for purposes of IRC Sections 904, 907 and 960, to be applied on a per-country basis. Taxpayers would take into account the aggregate income and foreign income taxes properly attributable to or otherwise allocable to taxable units that are tax residents of the same country. The HW&M Proposal would eliminate the foreign branch income category, and the remaining categories — GILTI, general and passive — would each be subject to a country-by-country application. The HW&M Proposal would therefore significantly limit the blending of high- and low-taxed income within each separate limitation category.
The HW&M Proposal would provide four types of taxable units: (1) the taxpayer itself; (2) each CFC with respect to which the taxpayer is a US shareholder; (3) an interest in a pass-through entity (e.g., a partnership or disregarded entity) that the taxpayer or a CFC holds directly or indirectly if the pass-through entity is a tax resident of a different country; and (4) a branch of the taxpayer or a CFC if the branch gives rise to a taxable presence in a different country. The term "tax resident" generally means a person or arrangement subject to tax as a resident, or a person or arrangement that gives rise to a taxable presence by reason of its activities. If an entity is organized or resident in a country that does not impose an income tax, that entity would be treated as subject to tax, unless otherwise provided.
Rules for attributing income and foreign income taxes to each taxable unit would be left to Treasury and the IRS to address by regulation.
The CbC FTC Limitation and repeal of the foreign branch category would apply to tax years beginning after December 31, 2021. The HW&M Proposal would not make any conforming amendments to the cross-reference in IRC Section 904(d)(2)(H)(i) regarding base differences. Thus, if left unchanged, foreign taxes on base differences would be treated as imposed on passive category income.2
Changes to the GILTI FTC
In a welcome change, the current 20% haircut under IRC Section 960(d) for foreign income taxes deemed paid on GILTI inclusions (GILTI FTC) would decrease to 5% under the HW&M Proposal.3 Additionally, tested foreign income taxes that may be deemed paid under IRC Section 960(d) would include foreign income taxes attributable to a tested loss.
For example, USP owns 100% of the stock of CFC1 and CFC2. CFC1 and CFC2 are the only CFC taxable units of USP that are residents of Country A. CFC1 has 961$100x of net tested income and incurs $20x of tested foreign income taxes for the current year. CFC2 has a <$40x> net tested loss and incurs $10x of tested foreign income taxes for the current year. CFC1 and CFC2 do not own any QBAI. Accordingly, USP's country A GILTI is $60x ($100x - $40x) and USP's inclusion percentage is 60% ($60x / $100x). Under the HW&M Proposal, USP would have a Country A deemed paid credit under IRC Section 960(d) of $17.1x of tested foreign income taxes incurred by CFC1 and CFC2 (95% x (60% x $30x)). If CFC1 was a tested loss CFC for the current year such that USP would not have a Country A GILTI amount, none of the tested foreign income taxes incurred by CFC1 and CFC2 would be deemed paid by USP under IRC Section 960(d).
The combined effect of the changes to the US corporate rate, the reduced IRC Section 250 deduction percentage, and the rule to limit expenses allocable to the GILTI category (discussed later) is that taxpayers subject to an effective foreign tax rate of 17.43% in any given country generally would have no residual US tax on GILTI from that country.
These changes would apply to tax years beginning after December 31, 2021.
Changes to FTC carryover rules
IRC Section 904(c) currently permits a 1-year carryback and 10-year carryforward for non-GILTI FTCs. Excess GILTI FTCs can neither be carried back nor carried forward under current law. The HW&M Proposal would repeal the FTC carryback and allow only a 5-year FTC carryforward. Further, the HW&M Proposal would allow taxpayers to carry forward excess GILTI FTCs. A conforming amendment would be made to IRC Section 907 (foreign oil and gas taxes).
These changes to the FTC carryover rules would apply to foreign income taxes paid or accrued in tax years beginning after December 31, 2021. If the HW&M Proposal is enacted, Treasury and the IRS would likely need to issue guidance to provide transition rules for pre-2022 excess FTCs that are (1) in the foreign branch, general and passive categories, (2) carried forward to 2022, and (3) subject to the CbC FTC Limitation that would no longer include the foreign branch category.
Repeal of current IRC Section 904(b)(4) and treatment of IRC Section 245A dividends as tax-exempt
Under current law, IRC Section 904(b)(4) requires domestic corporations to disregard, for purposes of determining their FTC limitation, both the foreign-source portion of any dividend income from a "specified 10%-owned foreign corporation" and any deductions that are attributable to producing that income. The HW&M Proposal would repeal current IRC Section 904(b)(4) and amend IRC Section 864(e)(3) to favorably treat IRC Section 245A-eligible dividends as "tax-exempt income" (and the corresponding portion of stock of the foreign corporation that relates to the IRC Section 245A-eligible dividend as a "tax-exempt asset") for purposes of allocating and apportioning expenses.
These changes would apply to tax years beginning after December 31, 2021.
Deductions allocable to the GILTI category
The HW&M Proposal would also introduce a change providing that only the IRC Section 250 deduction would be allocable against a taxpayer's GILTI inclusion. Therefore, none of the taxpayer's other expenses (such as interest and stewardship) would be allocated or apportioned to GILTI or reduce the GILTI FTC limitation. Expenses that otherwise would have been allocated or apportioned to the GILTI category of income would apparently, for FTC limitation purposes, have to be reallocated or reapportioned among the remaining categories of income, including the US-source income as the residual category.
The change would apply to tax years beginning after December 31, 2021.
Treatment of separate limitation losses
The HW&M Proposal would modify the separate limitation loss (SLL) provisions to reflect the CbC FTC Limitation. It would also provide an ordering rule such that SLLs would only reduce GILTI for any tax year to the extent that the aggregate amount of losses exceeds the aggregate amount of separate limitation income. For this purpose, separate limitation income would exclude GILTI. Thus, for example, a taxpayer with an SLL in the passive category would offset separate limitation income in the GILTI only to the extent that the SLL exceeded separate limitation income in the general category.
The change would apply to tax years beginning after December 31, 2021.
Source and character of items resulting from covered asset dispositions
Consistent with the Biden Administration's Green Book proposal, the HW&M Proposal would extend the principles of IRC Section 338(h)(16) to any "covered asset disposition" (i.e., transactions treated as an asset disposition for US tax purposes, but as a stock disposition (or disregarded) for foreign tax purposes). Therefore, solely for purposes of the FTC limitation provisions, the source and character of any item resulting from a covered asset disposition would be determined as if the seller had sold or exchanged stock (determined without regard to IRC Section 1248). For example, a sale of a disregarded entity by a CFC that generates tested income would result in passive category income for purposes of the FTC limitation, preventing what would often be a favorable increase to a taxpayer's GILTI FTC limitation.
The change would apply to tax years beginning after December 31, 2021.
Changes to rules for claiming FTCs
The HW&M Proposal would codify the period for electing under Treas. Reg. Section 1.901-1(d) either credits or deductions for foreign income taxes to (1) reflect IRS guidance and case law, and (2) align the proposed change to the five-year FTC carryforward period. Accordingly, IRC Section 901(a) would be revised to explicitly require taxpayers to elect to claim an FTC for foreign income taxes before the expiration of the limitation period under IRC Section 6511(d)(3), which would be shortened from the current 10 years to 5 years, in line with the new 5-year FTC carryforward period. The choice to claim a deduction in lieu of an FTC would need to be made at any time before the expiration of the general three-year limitation period under IRC Section 6511(a) (or later period if extended by agreement under IRC Section 6511(c)). A corresponding modification would be made to IRC Section 905(c) to treat the change from claiming a credit or deduction as a foreign tax redetermination that would allow the IRS to assess and collect any US tax deficiencies that result from the change in election even if the 3-year assessment period has passed. As mentioned by the JCT Report, these changes to IRC Section 905(c) are intended to parallel proposed changes to the IRC Section 905(c) regulations issued by Treasury in December 2020.
The HW&M Proposal would also limit the application of IRC Section 6511(d)(3) to claims for credit or refund of an overpayment of US tax attributable to a "change in the liability for" any foreign income taxes paid or accrued for which an FTC is allowed. This change would apparently limit the ability of a taxpayer to claim a refund to only those instances in which a change in foreign tax liability occurs. As such, a change from deduction to credit, or vice-versa, would have to be made within the general 3-year limitation period under IRC Section 6511(d)(3) to obtain a refund.
The changes to IRC Sections 901(a), 905(c) and 6511(d)(3) regarding claims for credit or refund of an overpayment of US tax attributable to a "change in the liability" for any foreign income tax that is claimed as an FTC would take effect 60 days after the enactment of the HW&M Proposal.
The change to shorten the extended limitation period under IRC Section 6511(d)(3) to 5 years would apply to taxes paid or accrued in tax years beginning after December 31, 2021.
TCJA-related changes to IRC Section 78
A corporate US shareholder that is deemed to pay a CFC's foreign income taxes under IRC Section 960 must generally treat the taxes deemed paid as a dividend under IRC Section 78 (the IRC Section 78 gross-up amount). If deemed paid taxes on subpart F income and tested income were not grossed-up under IRC Section 78, the result would be the allowance of both a deduction (at the CFC level) and credit (at the US shareholder level) for those foreign income taxes.
The HW&M Proposal would retroactively correct IRC Section 78 to eliminate the current gross-up for foreign income taxes deemed paid by a corporate US shareholder under IRC Section 960(b). IRC Section 960(b) treats a corporate US shareholder as paying any foreign income taxes (e.g., foreign withholding taxes) that are imposed on previously taxed E&P (PTEP) and received by an upper-tier CFC from a lower-tier CFC when the PTEP is ultimately received by the US shareholder. The HW&M Proposal to amend IRC Section 78 to remove the gross-up for IRC Section 960(b) deemed paid taxes would eliminate what otherwise is a second inclusion of an amount of CFC earnings (equal to the IRC Section 960(b) deemed paid taxes) that was already included in income as a subpart F inclusion or GILTI. This change would apply to tax years of foreign corporations beginning after December 31, 2017, and limit the IRC Section 78 gross-up to IRC Section 960(a) and (d) deemed paid taxes.
The HW&M Proposal would also enact an off-Code provision to retroactively provide that the IRC Section 78 gross-up for taxes deemed paid under IRC Section 960 of the Code in effect on the last day before the enactment of the Tax Cuts and Jobs Act (TCJA) would not be treated as a dividend for purposes of applying IRC Section 245A. The apparent purpose of this proposal would be to prevent an IRC Section 245A dividends received deduction from offsetting the IRC Section 78 gross-up on IRC Section 960 foreign income taxes deemed paid by a fiscal-year taxpayer on any subpart F inclusion (including an IRC Section 965 transition amount) in its transition year.
Dual capacity taxpayers
The HW&M Proposal would amend IRC Section 901 by incorporating and modifying the rules applicable to dual capacity taxpayers, which are currently in Treas. Reg. Sections 1.901-2(a) and 1.901-2A. Consistent with those regulations, the HW&M Proposal would define a "dual capacity taxpayer" as a person that is subject to a foreign country's levy and also receives (or will receive) a specific economic benefit from that country.
The HW&M Proposal would not treat the levy as a tax if the foreign jurisdiction has no generally applicable income tax. Further, it would limit the amount of any levy that would qualify as a tax to the amount of the generally applicable income tax that the dual capacity taxpayer would have paid to the foreign government if it were a non-dual capacity taxpayer.
The change would apply to tax years of foreign corporations beginning after December 31, 2021
Repeal of election for 1-month deferral under IRC Section 898(c)
IRC Section 898 generally requires a CFC to use the tax year of its majority US shareholder. IRC Section 898(c)(2), however, permits a CFC, in lieu of conforming with its majority US-shareholder year, to elect a tax year beginning one month earlier than the majority US shareholder's year. This provision allows taxpayers additional time to obtain information needed to determine the items of a foreign corporation that are relevant for US tax reporting purposes.
The HW&M Proposal would repeal the 1-month deferral election for CFC tax years beginning after November 30, 2021. A transition rule would provide that a taxpayer's first tax year beginning after November 30, 2021 would end at the same time as the first "required" year ending after that date. Therefore, CFCs with a tax year ending November 30, 2021, under a 1-month deferral election will automatically have a short tax year ending December 31, 2021.
Implications of proposed changes to FTCs
In many instances, the HW&M Proposal would significantly increase US shareholders' residual liability on their foreign-taxed earnings. A CbC FTC limitation greatly limits taxpayers' ability to blend high- and low-tax income, leaving US shareholders with higher residual US tax liability on foreign earnings in lower-taxed countries. Moreover, requiring the application of the FTC limitation and GILTI on a country-by-country basis would likely result in a substantial compliance effort and increased complexity for taxpayers.
The HW&M Proposal leaves many critical questions to future guidance from Treasury and the IRS, including transition rules for FTC carryforwards and rules on the attribution of income and foreign taxes to taxable units. Until that guidance is issued, taxpayers would face considerable uncertainty. On the other hand, the HW&M Proposal would also amend the FTC regime in several beneficial ways, including by reducing the IRC Section 960(d) haircut to 5% and retroactively eliminating IRC 960(b) credits from the IRC Section 78 gross-up.
Proposed changes for GILTI and subpart F income
Country-by-country application of GILTI
The HW&M Proposal would apply GILTI on a country-by-country basis to require a US shareholder to include in gross income under IRC Section 951A separate per-country GILTI amounts based on the tested income, tested loss, QBAI and interest expense allocable to gross tested income of "CFC taxable units" that are residents of the same country. Applying GILTI on a per-country basis conforms with the changes the HW&M Proposal would make to apply the FTC limitation on a per-country basis, as discussed previously. A CFC taxable unit would be defined by reference to the definition of a taxable unit under the CbC FTC Limitation rules (as discussed previously).
Unlike the Green Book proposal, the HW&M Proposal would not eliminate the net deemed tangible income return (NDTIR) on QBAI (currently 10% of QBAI, reduced by certain amounts of interest expense allocable to gross tested income). Rather, the HW&M Proposal would reduce the NDTIR percentage from 10% to 5%.4
The HW&M Proposal would also include in gross tested income foreign oil and gas extraction income (FOGEI) and take into account any deductions properly allocable to gross FOGEI in determining the overall net tested income of a CFC taxable unit that may be subject to GILTI.
Under the existing GILTI regime, a US shareholder's "net CFC tested income" is the excess of its aggregate pro rata share of net tested income of each CFC over its aggregate pro rata share of net tested loss of each CFC. If a US shareholder's aggregate pro rata share of net tested loss exceeded its aggregate pro rata share of net tested income, the US shareholder would not be subject to a GILTI amount. The excess of the aggregate loss over aggregate income could not, however, be taken into account in determining the US shareholder's GILTI amount in the subsequent year.
For example, under the current GILTI rules, USP owns 100% of the stock of CFC1, which has net tested income of $100x, and CFC2, which has a net tested loss of <$160x> in the current year. As USP has a net CFC tested loss of <$60x> for the tax year, it is not subject to a GILTI amount for the year. USP cannot, however, take into account the net CFC tested loss of <$60x> in determining its net CFC tested income (and resulting GILTI amount) in the subsequent year.
The HW&M Proposal would favorably allow for the carryover of a net CFC tested loss to be taken into account by a US shareholder in the subsequent year in determining the US shareholder's net CFC tested income (or loss) for that subsequent year.5 Using the prior example, assume CFC1 and CFC2 are CFC taxable units that are residents of Country A. Assume in the next year (Year 2) that CFC1 and CFC2 each derive $100x of net tested income. Setting aside the Country A net CFC tested loss of <$60x> from the prior year (Year 1), USP would have Country A net CFC tested income of $200x in Year 2 (and resulting Country A GILTI amount of $200x if no Country A QBAI existed). The HW&M Proposal would allow USP to carry over its Country A net CFC tested loss of <$60x> from Year 1 and take it into account in determining its Country A net CFC tested income for Year 2, which would be $140x ($200x - $60x) (and resulting Country A GILTI amount of $140x in the absence of any Country A QBAI).
The HW&M Proposal would treat any net CFC tested loss carryover (e.g., the Country A net CFC tested loss of <$60x> that USP has going into Year 2) as pre-change loss subject to IRC Section 382.
The following example provides a basic illustration of how the per-country GILTI regime would apply under the HW&M Proposal.
USP owns 100% of the stock of CFC1 (a Country A resident) and CFC2 (a Country B resident). CFC1, in turn, owns all the interests of FDRE (a Country C resident), an entity organized in Country C that is disregarded for US tax purposes but treated as a Country C resident under the tax laws of Country C . CFC1, CFC2 and FDRE are each considered CFC taxable units that are residents of separate countries.
CFC1 has $100x of net tested income and $20x of QBAI for the current year. CFC2 has <$40x> of net tested loss with no QBAI for the current year. FDRE has $30x of net tested income and no QBAI. Under the existing GILTI rules (taking into account an NDTIR rate of 5% as proposed by the HW&M Proposal), USP would have a GILTI amount of $89x ($130x - $40x — $1x (5% x $20x) = $90x - $1x).
Under the per-country GILTI regime, USP would have a Country A GILTI amount of $99x ($100x - $1x (5% x $20x)) and a Country C GILTI amount of $30x. The <$40x> of tested loss from CFC2 would not reduce any of the net tested income of CFC1 and FDRE for purposes of determining USP's GILTI amounts. Under the HW&M Proposal, however, the <$40x> of net tested loss of CFC2 would constitute a Country B net CFC tested loss of <$40x>, which would carry over and be taken into account in determining USP's Country B net CFC tested income (or loss) in the next year.
The changes to implement a per-country GILTI regime would apply to a foreign corporation's tax years beginning after December 31, 2021.
Limitation on foreign base company sales income and foreign base company services income
The HW&M Proposal would significantly limit the scope of the provisions on foreign base company sales income (FBCSI) and foreign base company services income (FBCSvI). Under current law, FBCSI and FBCSvI arise by reason of certain related-party transactions, including transactions with related CFCs, and certain transactions through manufacturing and sales branches. Under the HW&M Proposal, FBCSI and FBCSvI would be limited to situations in which the relevant transaction involves a related person that is a taxable unit (within the meaning of IRC Section 904(e)) and a tax resident of the United States. Thus, for example, a US corporation, but not its DRE resident in a foreign country, may be party to a transaction giving rise to FBCSI or FBCSvI. As a result of these changes, a significant portion of income that would have previously qualified as FBCSI or FBCSvI would be treated as tested income. The HW&M Proposal directs Treasury to issue guidance addressing serial transactions involving at least one (domestic) related person.
This provision would apply to foreign corporations' tax years beginning after December 31, 2021, and to US shareholders' tax years in which or with which the tax years of foreign corporations end.
Determining a US shareholder's pro rata share
The HW&M Proposal would significantly change the determination of a US shareholder's pro rata share of subpart F and tested income. According to the JCT report, the HW&M Proposal targets perceived "loopholes" under current law, whereby dividends paid to either (1) non-US persons or (2) persons eligible for the IRC Section 245A DRD can reduce a US shareholder's pro rata share of subpart F and tested income.
By way of background, a US shareholder of a CFC must include in its gross income its pro rata share of subpart F income and include in its GILTI computation its pro rata share of tested income from that CFC.
Under current law, a US shareholder's pro rata share of subpart F and tested income is the amount that would be distributed to the US shareholder on the last day of the CFC's year on which it is a CFC (the Last Relevant Day), limited to the CFC-Status Portion. The CFC-Status Portion of current-year subpart F and tested income is determined based on the portion of the year that the CFC is a CFC. For example, if a US shareholder acquires a foreign corporation nine months into the foreign corporation's year and the corporation was not a CFC before the acquisition, then the US shareholder's pro rata share of subpart F and tested income is only 25% of the corporation's subpart F and tested income under this rule.
A US shareholder's pro rata share is then reduced by all or a portion of certain distributions made to other persons on CFC stock that is held by the US shareholder on the Last Relevant Day (the Dividend-to-Another-Person Reduction). This Dividend-to Another-Person Reduction is limited to the corporation's subpart F and tested income for the year multiplied by the fraction of the year that the US shareholder did not own the stock on which the distributions were made. For example, assume a US shareholder acquired all the shares in a foreign corporation nine months into the foreign corporation's year. The foreign corporation paid a distribution to its former shareholders of $80 before the acquisition and had $100 of subpart F and tested income during the year. In this case, the US shareholder's pro rata share would be reduced by $75 (which is the lesser of the $80 distribution or the product of $100 of subpart F income multiplied by nine-twelfths).
The HW&M Proposal would (1) limit the Dividend-to-Another-Person Reduction and (2) treat certain US shareholders that own shares during the year, but not on the Last Relevant Day, as having a pro rata share. Specifically, the Dividend-to-Another-Person Reduction would apply only to the extent that the other person is a United States person and the CFC was a CFC at the time of the distribution. If a CFC paid "nontaxed current dividends" on shares that a US shareholder owned (within the meaning of IRC Section 958(a)), and the US shareholder disposed of the CFC shares (directly or indirectly) before the Last Relevant Day, the HW&M Proposal would treat the US shareholder as having a pro rata share with respect to those CFC shares based upon the ratio (expressed as a percentage) of the nontaxed current dividends paid on those shares during the year divided by the CFC's earnings for the year.
Under the HW&M Proposal, a nontaxed current dividend is the portion of any amount received with respect to stock that is treated as a dividend (including gain treated as a dividend by reason of IRC Section 1248) out of current-year earnings and profits and (1) would give rise to a deduction under IRC Section 245A(a) or (2) is paid to a CFC and would be excluded from subpart F income under IRC Sections 954(b)(4) (high-tax exception), 954(c)(3) (same country exception) or 954(c)(6) (related-CFC look-through rule).
To the extent that a US shareholder has a pro rata share attributable to nontaxed current dividends paid by the CFC, the pro rata share of any US shareholder holding shares of the CFC on the Last Relevant Day would be reduced.
The HW&M Proposal would apply retroactively to distributions made after December 31, 2017.
Reinstatement of IRC Section 958(b)(4) and proposed IRC Section 951B
Foreign corporations are generally treated as CFCs if more than 50% of their stock, by vote or value, is owned by US shareholders. US shareholders are US persons that own 10% or more (by vote or value) of the stock of a foreign corporation. Ownership may be direct, indirect or (for certain purposes of the IRC) "constructive." Constructive ownership means, for example, that when a person owns all the shares of Corporation A and all the shares of Corporation B, Corporation B is treated as constructively owning all the shares of Corporation A (and vice versa). That is, constructive ownership means (among other things) that a wholly owned subsidiary is treated as owning shares owned by its sole shareholder.
Before the TCJA's enactment in 2017, shares owned by a foreign person were not treated as owned by a US subsidiary of that foreign person (i.e., there was no "downward attribution" from a foreign person to a US person). The TCJA repealed this provision, IRC Section 958(b)(4), in 2017. As a result, many foreign corporate subsidiaries of a foreign-parented multinational group were treated as owned by domestic corporations and, correspondingly, were treated as CFCs because (for example) a foreign parent would own shares in a foreign corporation and a US corporation, and the shares of the foreign corporation would be treated as constructively owned by the US corporation.
The HW&M Proposal would (1) reinstate IRC Section 958(b)(4), and (2) add a new provision, IRC Section 951B, which would treat certain foreign corporations as "foreign controlled foreign corporations" (FCFCs). With the first change, certain foreign corporations that were treated as CFCs by reason of the IRC Section 958(b)(4) repeal in 2017 would no longer be treated as CFCs. The new provision, however, would require (among other things) "foreign controlled United States shareholders" (FC US shareholders)of FCFCs to include in gross income their pro rata shares of subpart F income, tested income and IRC Section 965 inclusions. That is, IRC Section 951B would replicate some consequences of IRC Section 958(b)(4) repeal, but not all of them.
The HW&M Proposal defines FC US shareholders of a foreign corporation as US persons that are treated as owning more than 50% of that foreign corporation after applying the downward attribution principles under IRC Section 958(b) (i.e., constructive ownership without applying IRC Section 958(b)(4)). In addition, the proposal defines a FCFC as a foreign corporation that is more than 50% owned by FC US shareholders (again, taking into account downward attribution).
The HW&M Proposal to re-enact IRC Section 958(b)(4) and to enact IRC Section 951B would be retroactive to "the last taxable year of foreign corporations beginning before January 1, 2018 … ."
Perhaps to reduce the impact to taxpayers negatively affected by the retroactivity of this proposal (and the impact of other proposals), the HW&M Proposal would also generally allow foreign corporations and all their US shareholders to make a new election under IRC Section 957 to treat the foreign corporation as a CFC. The foreign corporation would not, however, be treated as a CFC for purposes of the definition of FCFC or for any other purpose if the Treasury determines that such treatment would be inconsistent with the purposes of subchapter N (generally, the international provisions of the IRC). While the extent to which the Treasury may determine that CFC treatment is inconsistent with the purposes of subchapter N is not clear, Treasury regulations (both final and proposed) issued since the repeal of IRC Section 958(b)(4) have indicated that treating foreign corporations as CFCs for purposes of IRC Sections 954(c)(6), 267(a)(3), 304(b)(5)(B) and 904(d)(3), among others, was inconsistent with US tax policy.
Expansion of IRC Section 961(c)
IRC Section 961(a) increases a US shareholder's basis in its CFC stock, or in the property by reason of which it is deemed to own that stock (such as a partnership interest). The basis increase equals the US shareholder's subpart F income or GILTI with respect to that stock. The basis increase prevents a US shareholder from being taxed on gain in the stock or other property that is attributable to E&P that has already been included in income as subpart F income or GILTI (i.e., PTEP). Under IRC Section 961(b)(1), the adjusted basis of the stock or other property decreases when a US shareholder receives a PTEP distribution. To the extent that a PTEP distribution to a US shareholder exceeds the US shareholder's basis in the stock, the US shareholder recognizes gain under IRC Section 961(b)(2).
Under current law, IRC Section 961(c) generally authorizes regulations under which adjustments similar to "the adjustments" provided under IRC Section 961(a) and (b) are made to the basis of stock in a CFC that is owned by another CFC (and certain other CFCs in the chain). IRC Section 961(c) provides that this adjustment is for a limited purpose: determining the subpart F income included in a US shareholder's gross income. It is unclear under current law whether adjustments to basis under IRC Section 961(c) may also reduce a US shareholder's GILTI.
The HW&M Proposal includes two changes impacting these rules. First, IRC Section 951A(f) would be retroactively amended to treat references to IRC Section 951 (the operative rule for including subpart F income) in IRC Section 961 (among other provisions) as referring to IRC Section 951A (the operative rule for GILTI) in all cases. Second, the HW&M Proposal would prospectively provide that the IRC Section 961(c) adjustments to basis apply for all purposes of the Code. Taken together, these changes provide that IRC Section 961(c) basis would reduce a US shareholder's GILTI, retroactive to the time that GILTI became effective. The prospective rule would also require gain to be recognized when a lower-tier CFC distributes PTEP in excess of basis. The JCT report states that the latter change "clarifies" current law.
This provision would apply to foreign corporations' tax years beginning after December 31, 2021, and to US shareholders' tax years in which or with which the foreign corporations' tax years end.
Implications of proposed changes to GILTI and subpart F income
The significant limitation of FBCSI and FBCSvI would be beneficial to taxpayers that currently recognize such income — taxable at a 21% US rate, which would increase to 26.5% — without adequate foreign tax credits to offset the resulting liability. However, taxpayers that have (or would have) restructured their operations to convert tested income into FBCSI or FBCSvI to utilize foreign tax credits efficiently may find the rules less beneficial.
The expansion of IRC Section 961(c) represents a mixed blessing for taxpayers. On the one hand, the clarification that basis described in IRC Section 961(c) may reduce a US shareholder's GILTI is generally welcome. On the other hand, the requirement to recognize gain on lower-tier PTEP distributions that exceed basis potentially would subject many taxpayers to multiple layers of US income tax on the same earnings. Further, the reference in the JCT report to that change as a "clarification" is at odds with most practitioners' understanding of current law.
Proposed changes to IRC Section 250 and FDII
The HW&M Proposal would retain, but modify, the deduction for foreign-derived intangible income (FDII) and largely retain the existing framework of IRC Section 250, with several noteworthy modifications. This contrasts with President Biden's Green Book, which would repeal FDII in its entirety, and the Senate Finance Committee Chair's more recent proposal, which would collapse the IRC Section 250 deduction into a single rate for both FDII and GILTI and replace, or eliminate, some components of the current FDII formula.
The HW&M Proposal would reduce the percentages a domestic corporation uses to compute its IRC Section 250 deduction in a tax year, which would yield a lower deduction for taxpayers. Also, a corporation would determine its deduction eligible income (DEI) — a key driver of the FDII component of the deduction — by excluding certain additional categories of gross income from DEI. Lastly, the HW&M Proposal would repeal the taxable income limitation under IRC Section 250(a)(2) and allow the IRC Section 250 deduction to be taken into account in computing a corporation's net operating loss (NOL), as well as the rate at which NOLs are utilized in carryover years.
In general, the changes would be effective for tax years beginning after December 31, 2021, though the additional exclusions from DEI would be effective retroactively to the introduction of IRC Section 250 in 2018.
Reduction in IRC Section 250 deduction percentages
Current IRC Section 250(a)(1) allows a domestic corporation a deduction generally equal to 37.5% of its FDII, plus 50% of the sum of its GILTI amount and the corresponding IRC Section 78 gross-up. For tax years beginning after December 31, 2025, however, current IRC Section 250(a)(3) reduces those percentages to 21.875% and 37.5%, respectively.
Under the HW&M Proposal, those reduced percentages would apply earlier, specifically for tax years beginning after December 31, 2021. Together with the proposed increase in the headline corporate rate to 26.5%, the reduced percentages would result in effective tax rates of 20.7% for FDII and 16.5625% for GILTI.
Although this proposal would generally apply to tax years beginning after December 31, 2021, blended percentages would apply for taxpayers with a tax year that straddles December 31, 2021 (e.g., corporations with a fiscal tax year).
Elimination of taxable income limitation and inclusion of IRC Section 250 deduction in NOL
Current IRC Section 250(a)(2) reduces a domestic corporation's FDII and GILTI amounts for purposes of calculating the corporation's IRC Section 250 deduction to the extent that the sum of those two amounts exceeds the corporation's taxable income (computed without regard to IRC Section 250).
The HW&M Proposal would eliminate the taxable income limitation in current IRC Section 250(a)(2). Further, the HW&M Proposal would amend IRC Section 172 to take into account the IRC Section 250 deduction in computing a domestic corporate taxpayer's NOL. As a result, the IRC Section 250 deduction could cause, or increase, an NOL in a loss year and increase the amount of an NOL carryover available for utilization in a carryover year.
Additional exclusions from DEI
IRC Section 250(b)(3) excludes certain amounts of gross income from DEI. The HW&M Proposal would expand the scope of these exclusions. These new DEI exclusions would apply retroactively to tax years beginning after December 31, 2017.
Specifically, the proposal would exclude from gross DEI any income of a kind that would be foreign personal holding company income (FPHCI), as defined in IRC Section 954(c). The HW&M Proposal would also exclude gross income derived under IRC Section 1293 (relating to income that is subject to current taxation under a qualified electing fund (QEF) election) and certain disqualified extraterritorial income (under now repealed IRC Section 942).
The exceptions for FPHCI and income subject to IRC Section 1293 previously appeared in the JCT explanation of the TCJA.6 Virtually identical draft statutory text also appeared in former House Ways and Means Chairman Brady's Discussion Draft released in January 2019 that proposed various technical changes to the TCJA.
Finally, with the proposed elimination of the foreign branch income category in current IRC Section 904(d), the HW&M Proposal would update the definition of foreign branch income in the exclusions from DEI to incorporate, by reference, the definition of a branch in the HW&M provision that would adopt a country-by-country foreign tax credit limitation. This proposal would apply to tax years beginning after December 31, 2021.
Implications of proposed changes to IRC Section 250 and FDII
The proposals to repeal the IRC Section 250(a)(2) taxable income limitation and amend IRC Section 172 would likely be welcome changes for taxpayers. Together, they would preserve a taxpayer's full IRC Section 250 deduction, whether in the form of a current year deduction or a NOL carryover, or both, by enabling the IRC Section 250 deduction to generate and/or increase a taxpayer's NOL.
In contrast, the expansion of the categories of income that do not qualify as DEI could have significant negative implications for US companies, particularly given the retroactive effective date of this proposal. For example, the exclusion of FPHCI from DEI would include royalties and rents, and the excess of gains over losses from the sale or exchange of property that produces that type of income.
IRC Section 954(c) includes numerous exceptions to FPHCI treatment. Consider, for example, a royalty paid to a US person from a CFC that would satisfy the "look-through" rule in IRC Section 954(c)(6) (if the US recipient were treated as a CFC) because the royalty expense is not allocable against subpart F income or effectively connected income (ECI) of the CFC payor. Although not entirely clear, this would appear to mean that the income is not subject to the proposed DEI exclusion, such that the income remains DEI. Guidance from the House Ways and Means Committee would be helpful to explain the scope of the reference to the IRC Section 954(c) and the types of transactions to which this proposal is intended to apply.
Finally, the HW&M Proposal would retain the current offset of 10% of QBAI against DEI, whereas for purposes of computing GILTI, net tested income would be reduced by only 5% of a CFC's QBAI. These changes, along with a host of other significant modifications to the GILTI regime contained in the HW&M Proposal, may represent a gradual erosion of the complementary relationship between FDII and GILTI, which was described as a key objective of the IRC Section 250 deduction when enacted as part of the TCJA.
Proposed changes to BEAT
The HW&M Proposal would significantly modify IRC Section 59A. Of significance for US multinational groups is a provision that would except an amount from treatment as a "base erosion payment" if US income tax is imposed on the amount. The HW&M Proposal would also make certain modifications to BEAT to incorporate the concepts of the Stop Harmful Inversions and Ending Low-Tax Developments (SHIELD) proposal put forth by the Biden Administration.
More generally, the HW&M Proposal would retain the general framework of IRC Section 59A, including certain key exceptions, e.g. the exception to the services cost method (SCM). The gross receipts threshold that applies to determine whether a taxpayer is subject to BEAT would also be retained, though the base erosion percentage threshold would be eliminated prospectively for any tax year beginning after December 31, 2023. The proposal would also modify the treatment of cost of goods sold (COGS), and would treat certain payments to foreign related parties for which an amount must be capitalized under IRC Section 263A as base erosion payments.
The changes proposed by the HW&M Proposal would generally be effective for tax years beginning after December 31, 2021.
Exceptions for payments subject to US tax or a sufficient rate of foreign tax
The HW&M Proposal would add two new exceptions to the definition of a base erosion payment. First, proposed IRC Section 59A(i) would not treat an amount as a base erosion payment if US federal income tax is imposed with respect to that amount, determined under rules similar to the rules of IRC Section 163(j)(5) (as in effect before the TCJA's enactment date). According to the JCT Report, "payments that are subject to US income tax by either the payor or the payee are outside the scope of base erosion payments, without regard to whether the income related to such payments was eligible for a reduced rate of tax. Thus, outbound payments to a related party that are included in the computation of GILTI … , subject to withholding tax or taxable as effectively connected income to the recipient are not base erosion payments. Whether a payment is subject to Federal income tax is determined using principles similar [to] those in former [IRC Section] 163(j)(5)."
Second, proposed IRC Section 59A(i) would exclude from treatment as a base erosion payment any amount that the taxpayer establishes was subject to an effective rate of foreign income tax that is not less than the BEAT rate (i.e., currently 10%, 12.5% for tax years beginning after December 31, 2023, and 15% for tax years thereafter) for the tax year in which the amount is paid or accrued. This exception appears to incorporate elements of SHIELD. According to the JCT Report, the effective tax rate is computed in the same manner as under the provisions of IRC Section 904, and may be established on the basis of applicable financial statements (as defined in IRC Section 451(b)(3)), except as otherwise provided in regulations.
Elimination of the base erosion percentage test
Under current law, BEAT applies if certain thresholds are met, including a base erosion percentage test of 3% or more (2% or more for a taxpayer that is a member of an affiliated group with a domestic bank or registered securities dealer). The HW&M Proposal would eliminate the base erosion percentage test for tax years beginning after December 31, 2023. Thus, BEAT could apply for any tax year beginning on or after January 1, 2024, if the taxpayer satisfies the gross receipts test (i.e., has average annual gross receipts of at least $500 million for the prior three years).
Increased BEAT rates
Under current law, the ordinary BEAT rate is 10%, with a scheduled increase from 10% to 12.5% for tax years beginning after December 31, 2025. The HW&M Proposal would expedite this increase in the BEAT rate from 10% to 12.5% for tax years beginning after December 31, 2023, and before January 1, 2026, and then further increase the BEAT rate from 12.5% to 15% for tax years beginning after December 31, 2025.
The HW&M Proposal would also expand the scope of taxpayers subject to the higher BEAT rate that currently applies only to banks and registered securities dealers. Specifically, current law increases the BEAT rate by one percentage point for applicable taxpayers that are banks (as defined in IRC Section 581) or registered securities dealers. The HW&M Proposal would instead define "bank" by reference to IRC Section 585(a)(2), which includes not only banks as defined in IRC Section 581 but also corporations that would be a bank (under IRC Section 581) if they were domestic, rather than foreign, corporations. This change means that foreign banks with a US branch presence would now be subject to higher BEAT rates and a lower base erosion percentage threshold in the same manner as US banks, even if the branch operates on a stand-alone basis in the US (i.e., not in an affiliated group with a broker dealer or IRC Section 581 bank). The HW&M Proposal would also expand the application of higher BEAT rates and a lower base erosion percentage threshold to members of an affiliated group (as defined in IRC Section 1504(a)(1), determined without regard to IRC Section 1504(b)(3)), which includes the US branch of a foreign bank as defined under IRC Section 585(a)(2).
Calculation of BEAT liability
Under current law, an applicable taxpayer's "base erosion minimum tax amount" (BEMTA) equals the excess, if any, of the BEAT rate (e.g., 10%) multiplied by the taxpayer's "modified taxable income" (MTI) over the taxpayer's regular tax liability as reduced (but not below zero) by all income tax credits except for the research credit and a certain portion of other IRC Section 38 credits. The HW&M Proposal would modify the BEMTA definition such that an applicable taxpayer's regular tax liability would not be reduced by any credits (including foreign tax credits), potentially resulting in a larger offset against the BEAT rate as applied to modified taxable income.
The HW&M Proposal would also amend the definition of "net income tax" under IRC Section 38(c)(1) by including a reference to the tax imposed by IRC Section 59A. This change would mean that an applicable taxpayer's BEAT liability would be taken into account for purposes of the limitation on general business credits allowed under IRC Section 38(a). According to the JCT report, it is intended that taxpayers may apply general business credits under IRC Section 38 to offset the BEAT liability, though additional modifications may be necessary to achieve that result.
Adjustments to MTI
The HW&M Proposal would also modify the amount of the NOL deduction taken into account for purposes of computing MTI. Under current law, the NOL deduction for purposes of computing MTI is determined without regard to the base erosion percentage of any NOL. The base erosion percentage for any tax year is generally the aggregate amount of base erosion tax benefits for the year (the numerator) divided by the aggregate deductions for the year (including base erosion tax benefits) but excluding deductions allowed under IRC Sections 172, 245A or 250, and certain other deductions that are not base eroding payments.
Under the HW&M Proposal, the NOL deduction for purposes of computing MTI would be determined without regard to any deduction that is a base erosion tax benefit. Moreover, the HW&M Proposal would modify IRC Section 172, with respect to the MTI adjustment, to provide that the 80% limitation on an NOL deduction applies with respect to MTI (rather than taxable income). Thus, for purposes of calculating MTI, the general cap on the NOL deduction for any tax year would be 80% of MTI (rather than 80% of taxable income). Corresponding modifications would be provided for measuring the remaining amount of the NOL deduction available in subsequent carryforward years.
The HW&M Proposal would also modify the MTI according to other adjustments similar to the rules applicable to IRC Section 59. Specifically, new IRC Section 59A(c)(1)(D) would provide that rules similar to the rules of IRC Section 59(g) (Tax Benefit Rule) and IRC Section 59(h) (Coordination with Certain Limitations) would apply for purposes of determining the MTI of an applicable taxpayer.
COGS and payments with respect to inventory
The HW&M Proposal would add a new IRC Section 59A(d)(5), which would treat certain payments with respect to inventory as base erosion payments and, therefore, exclude them from COGS for purposes of determining MTI.
Subject to the exception discussed earlier for amounts that are subject to a US income tax or an effective rate of foreign income tax, the expanded base erosion payment definition would include (1) certain indirect costs that are paid or accrued by the taxpayer to a foreign related party and must be capitalized to inventory under IRC Section 263A (e.g., royalty costs incurred to secure the use of certain intellectual property/rights); and (2) the portion of the invoice price of inventory purchased from a foreign related party that exceeds the sum of (i) the property's direct costs (but see the look through rule discussed later), plus (ii) indirect costs that would be capitalizable under IRC Section 263A and are paid or accrued by the foreign person to a US person or a person that is unrelated to the taxpayer, or amounts otherwise subject to US tax.
For example, assume that a taxpayer (USP), who is an applicable taxpayer for purposes of IRC Section 59A, is owned by FX, a foreign related party organized in Country X. FX owns a patent and other manufacturing know-how that it licenses to USP to allow USP to produce inventory. USP pays FX $30 per year in royalties for the manufacturing know-how and capitalizes those royalty expenses to the inventory it produces. Assume USP sold all the inventory it produced during the current year, so all the costs capitalized to inventory during the year were recovered as COGS. Under IRC Section 59A(d)(5)(A), the $30 of royalties paid to FX would be a base erosion payment under the new definition unlessan exception applies (e.g., the exceptions for payments on which US tax is imposed and payments subject to sufficient foreign tax). COGS used in computing MTI would be reduced by the $30 (i.e., resulting in an increase to MTI of $30.)
Alternatively, assume the prior facts except that FX manufactures inventory and sells it to USP for resale to unrelated third parties. FX incurs $40 of direct costs (i.e., $30 of direct material and $10 of direct labor) and $60 of indirect costs described in IRC Section 263A(a)(2)(B)) to produce the inventory, for a total cost of $100. Assume all the direct and indirect costs incurred by FX to produce the inventory are paid or accrued (directly or indirectly) to a US person or a person that is not related to the USP or are otherwise subject to US income tax. FX sells the inventory to USP for $150 and USP has tax basis of $150 in the inventory purchased. Assume USP sold all the inventory it purchased from FX during the year, so all of the costs capitalized to inventory during the year were recovered as COGS.
Under the proposed definition of a base erosion payment in IRC Section 59A(d)(5)(B), the $40 of direct costs and $60 of indirect costs would not be base erosion payments because all of the direct costs and indirect costs capitalizable under IRC Section 263A were paid or accrued by FX to a US person or person not related to USP. However, the $50 difference between the $150 purchase price/tax basis in the inventory and the $100 of direct and indirect costs to FX would be a base erosion payment under the new definition unless an exception applies. COGS used in computing MTI would be reduced by the $50 (i.e., resulting in an increase to MTI of $50).
Instead of "looking through" to the actual indirect costs that are incurred by the foreign related party to determine the amount described in (2)(ii) and excluded from the definition of base erosion payments, taxpayers could use a safe harbor; the safe harbor would treat 20% of the amount paid or incurred by the taxpayer to the related party to purchase the inventory as indirect costs excludible from the definition of base erosion payments.
For example, assume the same facts as before but USP wants to use the safe harbor to determine the indirect costs that can be excluded from the definition of a base erosion payment (e.g., because FX does not identify or track the indirect costs that would be capitalized under IRC Section 263A and/or does not track which indirect costs were paid or accrued to a US person or a person unrelated to USP, etc.). The indirect costs excludible from the definition of a base erosion payment using the safe harbor would equal $30 (20% of the $150 paid by USP to FX for the inventory). Assuming no exception applies, only $70 of payment from USP to FX would be excluded from the definition of a base erosion payment (i.e., $40 of direct costs and $30 of indirect costs); $80 would be removed from COGS in computing MTI, resulting in an increase to MTI of $80.
As noted, amounts attributable to direct costs are generally not subject to BEAT under the HW&M Proposal. For direct costs paid or incurred by one foreign related party to another foreign related party in a tiered transaction, however, the direct costs would not be subject to BEAT only to the extent ultimately attributable to amounts paid or accrued (directly or indirectly) to a US person or an unrelated party.
For example, assume the same facts as before except that FX also owns FY, a foreign related party organized in Country Y. FX purchases $30 of direct materials from FY, a person related to USP, and uses them to manufacture inventory. FX's costs to produce the inventory include $30 of direct materials purchased from FY, $10 of direct labor incurred by FX employees and $60 of indirect costs that would be capitalizable under IRC Section 263A and were paid to a person unrelated to USP. The purchase of the direct material from FY requires USP to look at the tiered related-party transaction rules to determine the portion of the direct costs that are excluded from the definition of a base erosion payment. To the extent that the $30 of inventory purchased from FY, which is a direct cost to FX, was paid by FY to a US person or a person unrelated to USP, the entire $30 would still be excluded from the definition of a base erosion payment; USP would have a base erosion payment and increase to MTI of $50 (i.e., $150 purchase price less $40 of direct costs and $60 of indirect costs), assuming that no exceptions apply.
Alternatively, assume that FY incurs $10 of direct and indirect costs paid to a US person or person unrelated to USP to produce the inventory that FX buys for $30 and uses as direct material (i.e., $20 markup/profit at FY). Only $20 of the direct costs incurred by FX would be excluded from the definition of a base erosion payment ($10 of direct material cost from FY and $10 of direct labor cost). The $20 of direct material cost to FX from the markup charged by FY is not excluded from the definition of a base erosion payment because FY is related to USP. As such, if neither the US tax exception or foreign tax exceptions previously noted apply, $80 of the $150 paid from USP to FX would be excluded from the definition of a base erosion payment (i.e., $10 of direct material + $10 of direct labor + $60 of indirect costs paid to a US person or person unrelated to USP) and $70 would be a base erosion payment that decreases COGS used to compute MTI (i.e., increase in MTI of $70).
Implications of the proposed changes to BEAT
The HW&M Proposal would make several significant changes to BEAT, some of which could be favorable to taxpayers. For example, the change to IRC Section 59A(b)(1)(B) to refer simply to "regular tax liability" (unreduced by any credits) would be a favorable change for applicable taxpayers since it would potentially increase the amount that would offset the applicable percentage of modified taxable income. The addition of two new exceptions to the definition of "base erosion payment" may also permit certain payments to be excluded to the extent that either US income tax or a sufficient effective rate of foreign tax is imposed with respect to a particular payment. How beneficial these changes would be would depend on how certain key items are ultimately defined, and how the effective rate of foreign income tax is determined with respect to a particular amount paid to a foreign related party.
Other proposed changes could adversely affect applicable taxpayers subject to BEAT. For example, assuming no exception applies, the HW&M Proposal would treat certain direct and indirect costs that were incurred by a US taxpayer, capitalizable to inventory under IRC Section 263A and paid to a foreign related party as base erosion payments.
Further, the proposal would require US taxpayers to analyze the inventory invoice price to determine which portion of the purchase price that is related to direct and indirect costs incurred by the foreign related party, and which portion is related to profit or markup. The direct and indirect costs would have to be further analyzed to determine if the indirect costs would be capitalizable under IRC Section 263A and to demonstrate that the costs were paid or accrued by the foreign related party(ies) either to a US person or a person unrelated to USP, or otherwise subject to US income tax.
The proposed safe harbor that determines indirect costs excludible from the definition of a base erosion payment by taking 20% of the invoice price may be a welcome alternative for taxpayers that determine it is not administratively feasible or practical to analyze the direct and indirect costs incurred by foreign related parties at the level of detail that would be required under this proposal. To the extent that the invoice price of inventory purchased from a foreign related party includes a significant amount of costs or markups that would otherwise be base erosion payments (i.e., because they are not excludible direct or indirect costs under the new rules), this safe harbor could also be a good alternative. While the overall inventory-related modifications to the definition of a base erosion payment are generally not taxpayer favorable, many of these payments could still be excluded from the definition of a base erosion payment if either the exception for payments subject to sufficient foreign tax, or the exception for payments on which US tax is imposed, applies. Taxpayers should consider these exceptions in conjunction with their analysis of inventory-related payments.
Finally, the HW&M Proposal would remove the base erosion percentage test, which currently acts as a gating threshold (in addition to the $500M gross receipts test) to determine whether a taxpayer is an applicable taxpayer for BEAT purposes. Such a change has the potential to expand the scope of taxpayers subject to BEAT.
Proposed changes to IRC Section 163 interest deductibility
The HW&M Proposal would add new IRC Section 163(n), which would limit the interest deductibility of certain domestic corporations that are part of a multinational group that prepares consolidated financial statements, according to the domestic corporation's allocable share of the group's net interest expense. This new limitation would apply in conjunction with current IRC Section 163(j) so that interest deductions could not exceed whichever limitation is more restrictive. However, proposed IRC Section 163(o) would allow any disallowed interest expense under IRC Section 163(j) or proposed IRC Section 163(n) to be carried forward only up to five years, unlike current IRC Section 163(j), which allows for indefinite carryforward.
An earlier version of IRC Section 163(n) was proposed as part of legislative efforts that culminated in the TCJA. Consistent with that version, proposed IRC Section 163(n) would apply to any domestic corporation that is part of an IFR group, and not only foreign-parented multinationals. This contrasts with a similar rule, which was proposed earlier this year in the Green Book, that only applied to foreign-parented multinationals. Thus, proposed IRC Section 163(n) would apply to a large base of taxpayers.
The proposed amendments under IRC Section 163 would apply to tax years beginning after December 31, 2021.
Limitation on interest deductibility for certain domestic corporations that are members of an international financial reporting group
Under proposed IRC Section 163(n), a new limitation on interest deductibility would apply to any "specified domestic corporation" (SDC), if that SDC is a member of an "international financial reporting group" (IFR group). The proposal is similar to one proposed, but not enacted, under the TCJA, and is generally intended to limit interest expense deductions of a multinational group's US operations to its proportionate share of the group's overall interest expense.
Specifically, IRC Section 163(n) would limit a SDC's deduction for net interest expense to 110% of its net interest expense multiplied by the allowable percentage:
Net interest expense * 110% * Allowable percentage
The allowable percentage (which may not exceed 100%) would equal the SDC's allocable share of the IFR group's "reported net interest expense" on the group's applicable financial statements (i.e., for book purposes) over the SDC's reported net interest expense for book purposes:
Allowable percentage = SDC's allocable share of IFR group's net interest expense
The SDC's allocable share of the IFR group's reported net interest expense would equal the total group book net interest expense multiplied by the ratio of the SDC's EBITDA over the IFR group's EBITDA:
Allocable Share = IFR Group's Net Interest Expense * SDC's EBITDA
IRC Section 163(n) would not apply to any SDC that is a member of an IFR group with a zero or negative EBITDA. By contrast, if the SDC had a zero or negative EBITDA, the allowable percentage would be zero, meaning that interest expense would be deductible only up to interest income.
As noted, the limitation would only apply to an SDC, or a domestic corporation whose 3-year average net interest expense exceeds $12 million. For purposes of this threshold, an aggregation rule treats domestic corporations that are members of the same IFR group as a single corporation. The limitation would not apply to any small business exempt from IRC Section 163(j)(3) (e.g., taxpayers with average annual gross receipts of $25 million or less) or to any S corporation, real estate investment trust, or regulated investment company.
An IFR group means two or more entities, if the entities are included in the same applicable financial statement and (1) at least one entity is a foreign corporation engaged in a US trade or business or (2) at least one entity is a domestic corporation and another entity is a foreign corporation. Any foreign corporation engaged in a US trade or business would be treated as a domestic corporation with respect to any earnings, interest income and interest expense, or other amount, that is effectively connected with the conduct of a U.S. trade or business. The proposed legislation authorizes the Treasury to issue regulations permitting an SDC to elect to treat certain corporations as members of the group.
Consistent with certain proposed amendments to IRC Section 163(j)(4) (discussed later), IRC Section 163(n) would generally apply at the partner, rather than partnership, level. Neither the legislative text nor the supporting explanations address how the provision would apply to disregarded entities.
The proposed legislation would also authorize the Treasury to issue regulations or other guidance as necessary to carry out the purpose of proposed IRC Section 163(n), including guidance that (1) allows or requires the adjustment of amounts reported on an applicable financial statement, (2) allows or requires any corporation to be included or excluded as a member of any international financial reporting group, or (3) provides rules for the application of IRC Section 163(n) to domestic corporations (or foreign corporations treated as domestic corporations) that are partners in a partnership.
163(n) application of IRC Section 163(j) to partners in a partnership
Proposed IRC Section 163(j)(4) would be modified to apply at the partner, rather than partnership, level.
Limited carryforward of disallowed interest expense
Proposed IRC Section 163(o) would limit the period for carrying a disallowed interest deduction forward under proposed IRC Section 163(n) or IRC Section 163(j) (whichever imposes the lower limitation) to five years. This would depart from current law, which permits disallowed interest expense under IRC Section 163(j) to be carried forward indefinitely. For purposes of the five-year carryforward allowance, interest would be allowed as a deduction on a first-in, first-out basis.
Implications of proposed changes to IRC Section 163
The HW&M Proposal's version of IRC Section 163(n) does not explicitly members of a consolidated group as a single SDC. Similar to IRC Section 163(j), however, Treasury could choose to exercise its regulatory authority under IRC Section 1502 to clarify that new IRC Section 163(n) should apply on a consolidated group basis. The new rule could also be more impactful than current rules (e.g., IRC Section 163(j)); coupled with the proposed carryforward limitation of five years, the new rule could make the deduction for interest expense in the future less certain and less valuable (despite the prospective increase to the overall tax rate). In addition, the proposed legislative text leaves open several issues, including how new IRC Section 163(n) will interact with other provisions limiting interest expense, other than IRC Section 163(j).
Proposed changes to the IRC Sections 245A and 1059
IRC Section 245A currently allows a domestic corporation that is a "US shareholder" of a "specified 10%-owned foreign corporation" to take a 100% dividends-received deduction (the Section 245A DRD) for the foreign-source portion of any dividends received from that corporation, so long as certain requirements are met. A US shareholder, for this purpose, has the same meaning as for other purposes of the international rules — namely, a US person that owns 10% or more of the stock in the foreign corporation (by vote or value).
Under the HW&M Proposal, the Section 245A DRD would be allowed only for dividends received by domestic corporations from foreign corporations that are CFCs and for which the domestic corporation is a US shareholder (again, so long as certain conditions are met). Consequently, dividends received from a non-CFC foreign corporation, including a FCFC, would not be eligible for the Section 245A DRD unless the foreign corporation and all its US shareholders elected to treat the foreign corporation as a CFC. As a result of making the CFC election, however, the Section 245A DRD would only apply after each US shareholder includes its pro rata share of the foreign corporation's subpart F and tested income. This proposal would be effective for distributions made after enactment.
The HW&M Proposal would also grant Treasury and the IRS broad regulatory authority. The proposal appears to grant authority (retroactively) for Treasury and the IRS to issue the regulations that were already issued under Treas. Reg. Section 1.245A-5 (and subsequent sections), which target perceived abuses of the Section 245A DRD. This proposal would be effective retroactively to distributions made after December 31, 2017.
The HW&M Proposal also addresses perceived abuse of the Section 245A DRD by expanding IRC Section 1059. Under current law, shareholders of a corporation must reduce their basis in their shares in the corporation to the extent of the "nontaxed portion" of any "extraordinary dividend." Shareholders must recognize gain to the extent that the required basis reduction exceeds their basis in the shares. The nontaxed portion of a dividend is, effectively, equal to the amount of any DRD available in respect of such dividend under IRC Section 243, 245 or 245A. An extraordinary dividend includes certain dividends paid on shares held for less than two years and certain dividend-equivalent, non-pro rata redemptions.
The HW&M Proposal would expand IRC Section 1059 by treating any "disqualified CFC dividend" received by a domestic corporation as an extraordinary dividend without regard to the shareholder's holding period. A disqualified CFC dividend means any dividend paid by a CFC to a US shareholder of the CFC to the extent that the dividend is paid out of earnings and profits that were (i) earned by the CFC or (ii) attributable to gain on property that accrued, in each case, during a "disqualified period." A disqualified period means any period during which the foreign corporation was not a CFC or the stock on which the dividend was paid was not owned by a US shareholder.
As noted previously, the IRC Section 1059 basis reduction (and potential gain recognition) applies to the extent of the nontaxed portion of an extraordinary dividend. Therefore, under the HW&M Proposal, a US shareholder that receives a disqualified CFC dividend would be required to reduce its basis to the extent of any Section 245A DRD.
The IRC Section 1059 proposal would apply to distributions made after enactment.
Scope of exemption for portfolio interest
The HW&M Proposal would also modify IRC Section 871(h), which generally provides an exception from the withholding tax for "portfolio interest" received by a nonresident individual from sources within the United States (IRC Section 881(c) contains a similar exception for corporations). Current Section 871(h)(3) provides that the term "portfolio interest," for this purpose, does not include any interest received by a "10% shareholder." For obligation issued by a corporation, the term "10% shareholder" means any person that owns 10% or more of the total combined voting power of all classes of stock that are entitled to vote. The HW&M Proposal would modify the definition of the "10% shareholder" to also include any person that owns 10% or more of the total value of the corporation's stock. Therefore, for an obligation issued by a corporation, any person owning 10% or more of the total vote or value of the corporation's stock would not be eligible for the portfolio interest exemption under the HW&M Proposal.
IRC Section 881(c)(3) contains a similar exemption from the portfolio interest exception for corporations and defines the "10% shareholder" by reference to the definition in IRC Section 871(h)(3). Therefore, the proposed modification would equally apply to "portfolio interest" received by a foreign corporation.
This modification to the definition of the "10% shareholder" would apply to obligations issued after the date of the enactment of the HW&M Proposal.
Calculation of E&P for CFCs
For purposes of subpart F, current IRC Section 952(c)(3) generally requires a CFC's E&P of a CFC to be determined without regard to certain adjustments under IRC Section 312(n)(4), (5) and (6) (regarding LIFO inventory adjustments, installment sales and the completed contract method of accounting, respectively). The HW&M Proposal would move this rule to IRC Section 312(n), thereby making the rule generally applicable for purposes of computing a CFC's E&P.
1 All "Section" references are to the Internal Revenue Code (IRC) of 1986.
2 The TCJA also did not revise the cross-reference in IRC Section 904(d)(2)(H)(i) (after GILTI and foreign branch income categories were introduced by TCJA) to continue to treat a foreign income tax imposed on a base difference as general category taxes (as was the case before TCJA) such that in the absence of a technical correction a foreign income tax on a base difference currently is categorized to the foreign branch income category.
3 There would be no haircut under the HW&M Proposal for any income taxes paid or accrued to a US possession (e.g., Puerto Rico).
4 There would be no reduction to the NDTIR percentage under the HW&M Proposal for QBAI located in a US possession (e.g., Puerto Rico).
5 It appears the amount of a net CFC tested loss carried into the current year that is not absorbed in that year would be carried forward and included in the net CFC tested loss of the succeeding year.
6 Joint Committee on Taxation, General Explanation of Public Law No. 115-97 (JCS-1-18), December 2018, p. 379. The JCT report indicated that a "technical correction may be needed to reflect this intent." Id. at fns. 1733 and 1734.