IRC Section 951 generally requires a U.S. shareholder that owns more than 10% of a CFC to include in its gross income its pro rata share of the CFC’s earnings and profits from certain discouraged activities or from investments in certain U.S. property (Subpart F income). The Tax Cuts and Jobs Act of 2017 added Section 951A aimed at base erosions of GILTI. Section 951A adopts pro rata inclusion mechanisms similar to Subpart F.
Aggregate versus entity theory for partnerships for purposes of Subpart F and GILTI
Under U.S. tax law, a partnership is treated as either an entity separate from its partners (in which case the aggregate tax impact is determined at the partnership level and then allocated to the partners) or as an aggregate of its partners (meaning partners take into account pro rata shares of the components of an affected tax item rather than a distributive share of the item), depending on the operative code section being applied. For purposes of IRC Section 958, a domestic partnership generally has been treated as an entity separate from its partners when determining who is a U.S shareholder of a foreign corporation and, thus, whether the foreign corporation qualifies as a CFC. Similarly, the entity theory was applied under Section 951 for purposes of determining who had an inclusion under Subpart F. Accordingly, under current law (without taking into account the proposed regulations) partners include their distributive share of a domestic partnership’s Subpart F inclusion. Similarly, partnerships currently are treated as an entity separate from their partners for purposes of determining Subpart F inclusions under IRC Section 951.
On the same date that the proposed regulations under IRC Section 958 were published, the IRS published final regulations with respect to Section 951A that treat ownership of foreign corporations through domestic partnerships the same as ownership of foreign corporations through foreign partnerships and adopt an aggregate theory for GILTI inclusions. These final GILTI regulations did not address the treatment of other inclusions under Subpart F.
Independent high-tax exception not adopted for GILTI
Section 954(b)(4) provides a high-tax exception to Subpart F for a CFC’s earnings that are subject to local tax at a rate that is equal to or greater than 90% of the highest corporate rate (currently 18.9%). The GILTI regime excludes inclusions under Subpart F, or items of CFC income that would be included under Subpart F but for the high-tax exception, from tested income used to determine the GILTI inclusion. Section 951A does not have an independent high-tax exception for items of CFC income that would not otherwise qualify under Subpart F. The final GILTI regulations did not adopt a comprehensive high-tax exception for GILTI despite widespread calls to do so.
GILTI aggregate theory treatment for domestic partnerships applied to all of Subpart F
The proposed regulations treat domestic partnerships for purposes of the inclusions under Subpart F the same as they are treated for purposes of the GILTI inclusion under the final IRC Section 951A regulations. Consequently, the proposed regulations provide that a domestic partnership that owns a foreign corporation is treated as an entity for purposes of determining whether the partnership and its partners are U.S. shareholders, whether the partnership is a controlling domestic shareholder, and whether the foreign corporation is a CFC. However, the domestic partnership is treated as an aggregate of its partners for purposes of determining whether, and to what extent, its partners have inclusions under IRC Sections 951 and 951A and for purposes of any other provision that applies by reference. To illustrate, a domestic partnership that owns 100% of a foreign corporation qualifies the foreign corporation as a CFC, but partners that own less than 10% of the partnership are not subject to taxation under GILTI or Subpart F. The preamble to the proposed regulations notes that the same principles apply to S corporations and S-corporation shareholders under IRC Section 1373(a). The proposed IRC Section 958 regulations do not change the treatment of foreign corporations held through foreign partnerships.
GILTI high-tax exception
Although the final GILTI regulations did not adopt a parallel high-tax exception for GILTI, the proposed regulations expand the high-tax exception applicable to Subpart F income under Section 954(b)(4) to include tested income under GILTI. As a result, once finalized, the regulations under IRC Section 954(b)(4) will provide an elective exception from the taxable base for GILTI for items of CFC income taxed at a rate greater than 18.9%.