May 28, 2021 marked the release of the Department of Treasury’s Fiscal Year 2022 budget as well as a detailed explanation (known as the Green Book) of the Biden Administration’s proposed American Jobs Plan and American Families Plan. Merely a few years after the Tax Cuts and Jobs Act (TCJA), the proposals to the Internal Revenue Code (IRC) originally unveiled in March 2021 seemingly gave the international sections of the tax code another significant facelift. The Green Book provides further details into these overhauls. We have prepared a summary of the most impactful and/or relevant pieces below as a more digestible version of the 100+ page document.
The following items relate to tax years beginning after December 31, 2021.
How the Corporate Tax Rate will be Affected by the American Jobs and American Families Acts
Starting with the most far-reaching provision, the latest proposal includes an increase to the corporate income tax (CIT) rate from 21% to 28%. This is not an item specific to multinational corporations, but it is too important to not mention (and will be relevant in the GILTI discussion later). While 28% was the rate discussed in the original proposal, there was some conversation that a compromise would be reached of potentially 25%. That has not happened, at least as it relates to the Administration’s initial proposal.
Note that for fiscal year taxpayers, the CIT rate will be a blended rate for their first fiscal year pursuant to Section 15.
Global Intangible Low-Taxed Income (GILTI)
There are a multitude of proposed changes to the current GILTI regime that are intended to bring the U.S. in line with the OECD and BEPS frameworks that are attempting to bring forth a ‘global minimum tax.’ Below, we review a few of the most relevant portions in further detail.
GILTI – Section 250 Deduction
Under the current rules, corporate tax filers who are not subject to the taxable income limitation in Section 250(a)(2) are allowed a deduction of 50% of their GILTI. The deduction creates an effective tax rate (“ETR”) on the GILTI inclusion of 10.5%. For example:
- $1,000 GILTI – ($1,000 x 50%) = $500 inclusion
- $500 x 21% tax rate = $105 tax liability
- $105 / $1,000 = 10.5% ETR
Under the proposed rules, the Section 250 deduction on GILTI will be reduced to 25%. Coupled with the rise in the CIT rate to 28%, the new ETR on GILTI will be 21%. Using the same example, the calculation would work as follows:
- $1,000 GILTI – ($1,000 x 25%) = $750 inclusion
- $750 x 28% tax rate = $210 tax liability
- $210 / $1,000 = 21% ETR
It is also important to note that the proposal does not include a change to the 20% haircut on creditable foreign taxes in the GILTI basket. If you recall, under the current rules, the breakeven global effective tax rate (“ETR”) on GILTI is 13.125% if a foreign tax credit is claimed. Therefore, with the GILTI ETR doubling from 10.5% to 21%, the global ETR breakeven point will also double to 26.25%. Here is another example to help illustrate this (please note that expense apportionment is again ignored). Under the current rules:
- $1,000 GILTI + $151 Foreign Tax/Section 78 Gross-up = $1,151 Total GILTI
- $1,151 – ($1,151 x 50%) = $576 inclusion
- $576 x 21% tax rate = $121 tax liability
- $121 – ($151 x 80%) = $0 residual U.S. tax
- $0 + $151 = $151 worldwide tax liability
- $151 / $1,151 = 13.125% global ETR
Under the proposed rules, the example would look like this:
- $1,000 GILTI + $355 Foreign Tax/Section 78 Gross-up = $1,355 Total GILTI
- $1,355 – ($1,355 x 25%) = $1,016 inclusion
- $1,016 x 28% tax rate = $285 tax liability
- $285 – ($355 x 80%) = $0 residual U.S. tax
- $0 + $355 = $355 worldwide tax liability
- $355 / $1,355 = 26.25% global ETR
GILTI – Qualified Business Asset Investment (QBAI)
Taxpayers currently receive a reduction of their GILTI for an amount equal to 10% of their QBAI. QBAI generally refers to depreciable property like building and machinery. Under the proposed rules, the QBAI reduction would be repealed, thus effectively making a CFC’s tested income equal to its GILTI.
GILTI – Country-by-Country Foreign Tax Credit (FTC) Regime
As currently constructed, when calculating the FTC within the GILTI basket of income, taxpayers can aggregate attributes of their CFCs to essentially use creditable taxes from a high-tax foreign jurisdiction to offset the U.S. tax liability related to a GILTI inclusion from a CFC in a low-tax foreign jurisdiction. This is no different than the mechanics of the FTC calculation in any other basket of income (i.e., general, passive, foreign branch).
For all the tax historians out there, the tax code once manded (and was also proposed as part of Ronald Reagan’s 1985 budget proposal) a per-country approach to the FTC limitation computation. For most taxpayers, the country-by-country approach to the GILTI FTC computation under the proposed rules will seem new and potentially overly burdensome. However, the ‘income resourced by treaty’ bucket is currently done on a per-country basis, although the magnitude is far less impactful than GILTI as the treaty category is much less frequently used in practice.
Under this new approach, the FTC limitation calculation for GILTI will be done by individual jurisdiction instead of an aggregation. The effect, in theory and without the consideration of apportioned expenses, will consistently create a residual tax in the U.S. for operations in a low (or no) tax jurisdiction. Additionally, taxpayers will no longer be able to potentially use tested losses in one jurisdiction to offset tested income in another, which is another byproduct of the move away from the aggregate approach.
The repeal of the relatively new GILTI high-tax-exception rules would accompany this change.
An interesting note is that the country-by-country rule will also apply to the foreign branch basket, but no mention was made of the general or passive baskets. Effectively, Subpart F would not be governed in the same manner as GILTI. However, the proposed rules would also appeal the longer-standing Subpart F high-tax-exception.
Section 265 – Expenses Related to Tax-Exempt Income
Section 265 deals with the disallowance of deductions that are allocable to classes of income (other than interest) that are wholly exempt from tax. Currently, it does not apply to the 100% dividends received deduction (DRD) for foreign-sourced dividends under Section 245A or the amount of GILTI reduced by the 250 deduction (as previously discussed, currently 50% if not limited by taxable income). The reason being that those sections allow for deductions rather than wholly exempting income from taxation.
Under the proposed rules, this is slated to change. Section 265 would now apply to both foreign-sourced dividends that receive a DRD under 245A and the GILTI 250 deduction. As a result, Section 904(b)(4), which provides for removing expenses allocated and apportioned to exempt income from the foreign tax credit limitation, would be repealed.
The change to Section 265 could possibly be significant to taxpayers when combined with the higher corporate tax rate.
Repeal of Foreign-derived Intangible Income (FDII) Deduction
While the portion of Section 250 related to GILTI will be modified (see above), the portion related to FDII will be repealed. The indication is that FDII will be replaced with a revamped Research and Development (“R&D”) incentive, but no details are yet available aside from the revenue increase for the FDII repeal being offset exactly by expanded R&D credits.
The reason provided for the FDII repeal is that a new R&D program will reward current year innovation rather than rewarding profitable companies that are reaping the benefits of IP developed in years past.
Replacing the Base Erosion and Anti-Abuse Tax (BEAT) with SHIELD
The sections of the Green Book mentioned up until this point have been modifications, and in some cases significant modifications, to existing tax law. The newly proposed Stopping Harmful Inversions and Ending Low-Tax Developments (“SHIELD”) regime will be a relative overhaul to the corner of the tax code aimed at preventing the shifting of a company’s U.S. tax base to a foreign low-tax jurisdiction.
BEAT, for the most part, served as the successor to the corporate alternative minimum tax which was repealed under the TCJA. The BEAT regime imposed an additional tax on large corporations whose deductions taken for payments to foreign related parties breached a certain threshold.
SHIELD, on the other hand, would look to disallow certain deductions. The mechanics of this system are worth a deeper look:
- U.S. corporations or U.S. branches of foreign corporations would be disallowed deductions made to ‘low-taxed members’ of the same ‘financial reporting group’
- ‘Low-taxed members’ are defined as having an ETR below a ‘designated minimum tax rate’
- That ‘designated minimum tax rate’ would be the rate agreed upon by the OECD under Pillar Two, with a recent suggested rate of 15%. Until that occurs, the rate will be the ETR on GILTI (21%)
- It is worth noting that taxes imposed by other jurisdictions as a result of the OECD Pillar Two or subpart F equivalents are expected to be considered in determining the minimum tax rate
- A ‘financial reporting group’ is defined as a group of entities that prepares consolidated financial statements under US GAAP, IFRS, or any other method approved by the Secretary of the Treasury
- ‘Low-taxed members’ are defined as having an ETR below a ‘designated minimum tax rate’
- Similar to BEAT, there will be a de minimis exception which excludes financial reporting groups with global revenue under $500M USD
- Unlike BEAT, COGS transactions will not be exempt
SHIELD will operate if there is a low tax entity in the group regardless of whether a payment is made by the U.S. directly to that entity through an indirect payment rule. The portion of the deduction disallowed in this instance will be determined on a pro rata basis based on the low tax entity’s income compared to the income of the entire group.
For example, assume the U.S. makes a payment to Related Party A, who has a 25% tax rate. In the group is also Related Party B, with a tax rate of 5%. A portion of the payment to Related Party A is disallowed even though the U.S. did not pay Related Party B directly. The amount of the disallowance is based on the amount of income Related Party B has in comparison to the entire group. If Related Party B has 10% of the entire group income, then 10% of the U.S. payment is non-deductible.
Because tax imposed by other countries on income earned in the low tax jurisdiction will be considered in determining the minimum tax rate, it is expected that SHIELD will have minimal impact to U.S. headquartered companies.
Excessive Interest Expense
The TCJA brought forth a revamped Section 163(j) to limit a taxpayer’s excess business interest expense. The Green Book proposes to layer a new interest expense rule on top of 163(j), not to repeal or modify the section itself.
An entity that is a member of a financial reporting group (as defined above in the SHIELD section) would see its interest expense deduction limited if, for U.S. tax purposes, it has net interest expense and its net interest expense for financial reporting purposes exceeds its proportionate share (based on earnings computed as a version of tax EBITDA) of the entire group’s net interest expense.
If the entity cannot substantiate its share of the group’s interest expense, or if it so elects, it can alternatively be subjected to the limitation by adding its interest income to 10% of its adjusted taxable income (as defined in Section 163(j)).
As stated above, this new rule would work in conjunction with Section 163(j). Both limitations would be calculated and the lower limitation would be utilized in computing a taxpayer’s ultimate interest expense deduction, if any.
Similar to SHIELD, the applicability of this change to U.S. headquartered groups may be limited. The proposal suggests that U.S. headquartered companies and all the related subsidiaries will be aggregated into one group, making the proportionate share calculation inapplicable.
Other International Provisions
The Green Book includes other international tax provisions, but they either do not provide the level of detail as the items we have already discussed or they may not be as far-reaching to U.S. multinationals. Examples include:
The rules governing corporate inversions are to be expanded to catch additional attempts by U.S.-headed enterprises to move their parent companies overseas.
Onshoring/Offshoring U.S. Businesses
The proposal includes further discussion into the plan to disincentivize companies to move U.S. jobs overseas and reward those who bring offshored jobs back home. The mechanics of the potential calculations have still not been expanded upon, but essentially a credit is to be available equal to 10% of eligible expense related to onshoring jobs and disallow deductions related to offshoring jobs.
338 Elections and Foreign Tax Credits
Under current rules, when the stock of a corporation is sold and a Section 338 election is made, the transaction is given asset sale treatment for U.S. tax purposes. Section 338(h)(16) exists to ignore this treatment for foreign tax credit purposes. The intent is to prevent the character of the gain to be shifted from capital to ordinary. Under the proposed rule change, Section 338(h)(16) would be additionally applied to the sale of foreign corporations treated as partnerships or disregarded entities for U.S. tax purposes and thus, for FTC purposes, treat the disposition as if it was a sale of stock.
As these proposals continue to evolve or reach enacted status, we will continue to provide updates so that you may plan for the potential impacts on your business. If you have any questions or wish to model the impacts of the discussed proposals to your company, please do not hesitate to reach out to your contact at Global Tax Management.