Treasury Regulation Section 1.952-2 sets the fundamental ground rules for determining taxable income of foreign corporations for purposes of Subpart F and global intangible low-taxed income (GILTI). As discussed in more detail in Part 1, Treas. Reg. Section 1.952-2 generally requires that a controlled foreign corporation’s (CFC’s) taxable income be determined by treating the CFC as a domestic corporation. The concept of treating a foreign corporation as a domestic corporation is a deceptively simple approach but fraught with pitfalls for unwary U.S. multinationals.
WHEN IS A FOREIGN CORPORATION TREATED AS A DOMESTIC CORPORATION AND WHEN IS IT NOT
How expansively should this mandate to treat a foreign corporation as a domestic corporation be interpreted? There are obvious tax code sections that would produce counterintuitive results if a foreign corporation is treated as a domestic corporation. Some of these sections are “turned off” by the regulation as discussed in Part 1, but many other general tax code sections remain applicable to determining a domestic corporation’s taxable income, at least ostensibly. Treas. Reg. Section 1.952-2(c)(1), discussed in Part 1, provides a list of provisions that are not applicable.
Take tax code Section 250 as an example. Section 250, created by the TCJA, provides a deduction to corporate taxpayers for half of their GILTI and 37.5% of their foreign-derived intangible income (FDII). Domestic corporations that sell, lease, or license products to any non-U.S. person for use outside the U.S., or that provide services to any person or with respect to any property located outside of the U.S., may be eligible for a special deduction with respect to the thereby-derived income (i.e., foreign-derived deduction-eligible income). (Section 250(b)(4).) The deduction is meant to limit the role tax consequences play when a domestic corporation chooses the location of its intangible income attributable to foreign markets.
Section 250 looks to achieve this policy objective by counterbalancing the different effective tax rates applicable to income earned by a CFC under GILTI as compared to the same income being earned directly by a domestic corporation. (See example in H.R. Rep. No. 115-466 (2017) (Conf. Rep.) at 498.) Nothing in the legislative history would indicate that Congress intended for the rule to apply to CFCs. In fact, the conference report accompanying TCJA provides an illustration of effective tax rates on foreign derived intangible income and GILTI indicating that it was not intended to apply at the CFC level. Yet, a literal interpretation of Treas. Reg. Section 1.952-2 would seem to imply that Section 250 is applicable when computing taxable income. Nevertheless, obviously, this would result in an outcome that can be safely assumed to be contrary to the Congressional intent of Section 250.
In the preamble to the final GILTI regulations (T.D. 9866), the IRS stated that there is a “…concern that §1.952-2 could be interpreted so expansively as to entitle a CFC to a deduction expressly limited to domestic corporations, such as a deduction under section 250,” and provided that a future guidance project would address this issue. The preamble further stated that “[t]his guidance is expected to clarify that, in general, any provision that is expressly limited in its application to domestic corporations, such as section 250, does not apply to CFCs by reason of §1.952-2.”
Excluding any provision that is expressly limited in its application to domestic corporations, thus prevented from applying to CFCs despite Treas. Reg. Section 1.952-2, is an obvious solution to this problem. However, complicating the matter further, there are such expressly domestic-only provisions that arguably should be applied to foreign corporations by virtue of Treas. Reg. Section 1.952-2 treating a foreign corporation as a domestic corporation. Section 245A is the best example of such a provision, as it generally provides a domestic corporation a 100% dividends received deduction (DRD) for the foreign-source portion of a dividend received from a specified 10%-owned foreign corporation. Section 245A(a) specifically provides that “[i]n the case of any dividend received from a specified 10-percent owned foreign corporation by a domestic corporation which is a U.S. shareholder with respect to such foreign corporation, there shall be allowed as a deduction an amount equal to the foreign-source portion of such dividend.” (Emphasis added.)
The intent of the Section 245A provision is to allow certain types of foreign income to be exempt from U.S. federal income tax. Preventing this provision from applying to tiers of CFCs could disrupt the intent of the provision. For example, if a U.S. multinational receives directly from a foreign corporation a dividend of qualifying earnings, it may be eligible for the 100% DRD, and thus exempt from U.S. federal income taxation on such earnings. However, if that same foreign corporation were owned by a CFC in a tiered structure, and the distribution moved up-tier from CFC to CFC before going to the U.S., the distribution may be Subpart F to the upper-tier CFC. Section 954(c)(6), often referred to as the “look-through rule,” provides generally that dividends, interest, rents, and royalties received or accrued by a CFC from a related CFC are not treated as FPHCI to the extent attributable to or properly allocable to income of the related CFC that is neither Subpart F income nor income treated as effectively connected income. Thus, the look-through rule may prevent Subpart F treatment in the scenario discussed. However, the provision expires in 2026. Further, the look-through rule does not apply to dividends received by CFCs from foreign corporations that are not themselves CFCs. This would result in ordinary income that would be ineligible for Section 245A.
Congress expressed its intent that the deduction be applied at the CFC level despite it being limited to “domestic corporations,” as the conference report provided that the Section 245A deduction should be available to a domestic corporation “[i]ncluding a controlled foreign corporation treated as a domestic corporation for purposes of computing the taxable income thereof.” H.R. Rep. No. 115-466 (2017) (Conf. Rep.) at 470. Referring to the regulation, the report further provided:
“See Treas. Reg. sec. 1.952-2(b)(1). Therefore, a CFC receiving a dividend from a 10-percent owned foreign corporation that constitutes subpart F income may be eligible for the DRD with respect to such income...”
Thus, the legislative history supports the broader read of Treas. Reg. Section 1.952-2 and its treatment of foreign corporations as domestic corporations even with respect to provisions that are expressly limited to domestic corporations. When drafting future guidance, the IRS will need to strike a balance, allowing provisions expressly applicable to domestic corporations where policy (and legislative history) mandates such treatment, but limiting the application in other areas that might produce absurd results.
Sections 250 and 245A are just two examples, but there are a number of other tax code sections that might produce unintended outcomes when treating a CFC as a domestic corporation for purposes of computing taxable income. This is an area that merits further attention from the IRS. Until such time, U.S. multinationals should tread carefully.
DOES THE MATERIAL EFFECT RULE APPLY FOR TAXABLE INCOME ADJUSTMENTS
Ambiguity also exists in other areas. One such area is the application of the “material effect rule” contained in the earnings and profits (E&P) regulations. The material effect rule provides that no adjustment shall be required when making U.S. Generally Accepted Accounting Principles (GAAP) and tax accounting adjustments in the E&P process unless material. (Treas. Reg. Section 1.964-1(a)(2).)
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. While a bright line threshold for materiality is not specifically defined in the E&P rules, another area in which an arguably analogous threshold may exist is the “de minimis rule” under Section 954(b)(3), which provides that if a CFC earns only a de minimis amount of gross foreign base company income and gross insurance income during a taxable year, no part of the CFC’s gross income for the year will constitute foreign base company income or insurance income. The de minims rule establishes a threshold at the lesser of 5% of gross income or $1 million.
As discussed in Part 1 in more detail, Treas. Reg. Section 1.952-2 require consistency between the principles governing the computation of E&P and taxable income. The regulations ostensibly extend this consistency between E&P and taxable income for foreign corporations beyond the specific tax and GAAP accounting principles, and also incorporate the material effect rule.
When addressing the adjustments required under U.S. GAAP accounting principles, the rule specifically notes:
"…the accounting principles to be employed are those described in paragraph (b) of §1.964-1. Thus, in applying accounting principles generally accepted in the U.S. for purposes of reflecting in the financial statements of a domestic corporation the operations of foreign affiliates, no adjustment need be made unless such adjustment will have a material effect, within the meaning of paragraph (a) of §1.964-1.” [Emphasis added.]
However, contrasting the above rule for U.S. GAAP adjustments with the rule for tax accounting adjustments, there is no mention of “material effect” in the latter. Instead, it provides:
“The tax accounting methods to be employed are those established or adopted by or on behalf of the foreign corporation under paragraph (c) of §1.964-1. Thus, such accounting methods must be consistent with the manner of treating inventories, depreciation, and elections [provided in, and used for purposes of, Reg. §1.964-1].”
Given the lack of specificity regarding materiality in the language discussing tax accounting methods, some have questioned whether the material effect rule should apply to both tax and U.S. GAAP adjustments, or whether it was intended to be limited to only U.S. GAAP adjustments. Although not without ambiguity, it would seem the use of “thus” in the language above is supportive of the view that the material effect rule in Treas. Reg. Section 1.964-1 should apply to both U.S. GAAP and tax adjustments by operation of the cross-reference to Treas. Reg. Sections 1.964-1(b) and 1.964-1(c). That is to say, the additional language in the U.S. GAAP rule highlighted above would clarify the cross-reference includes the material effect rule and is not additive to the general rule that is inherent in the cross-reference. This interpretation would also be in keeping with the spirit of the provision requiring consistency between the principles used for E&P and taxable income, similar to that required for domestic corporations.
As a result, the material effect rule provided for in the computation of the E&P would also apply to the computation of tested income or loss for GILTI purposes through Treas. Reg. Section 1.951A-2(c)(2), which refers to Treas. Reg. Section 1.952-2, which in turn arguably references the material effect rule in Treas. Reg. Section 1.964-1. In summary, the path to get from the requirement to make an adjustment for taxable income to the application of material effect rule limiting the need for certain adjustments is clearly subject to ambiguity, but the outcome where only adjustments with material effect are made for both computing taxable income as well as E&P is the only logical conclusion.
These are just a few examples of the ambiguities within the regulation. U.S. multinationals should carefully consider these rules when planning and analyzing the U.S. tax impact of their foreign subsidiaries to avoid the hazards they contain. The IRS could eliminate much of this ambiguity in a future regulation package. When doing so, it should balance simplification with policy, and not incorporate blanket limitations on provisions such as Section 245A.
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.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.