United States: To Check Or Not To Check? The TCJA's Impact On Entity Classification Decisions

I. Introduction

Since the introduction of the entity classification regulations over two decades ago (the so-called "Check-the-Box Regulations"), ¹ the U.S. rules governing the classification of business entities—as corporations, partnerships, or disre¬garded entities—have been simple and flexible, generally requiring nothing more than the filing of a two-page form with a few boxes to check (hence the common names "Check-the-Box Regulations" and "Check-the-Box Election"). Over the past two decades, the consequences of such elections have become well-understood. Such elections could be used to simplify intercompany trans¬actions (essentially by making them "disappear" for tax purposes), to mitigate the adverse consequences of the subpart F regime, to combine (or separate) the tax attributes of various entities, and to control the characterization of various corporate transactions (e.g., turning a Code Sec. 351 transaction into a reorga¬nization under Code Sec. 368(a)(1)(D)). And with the 2006 introduction of the CFC look-through rules of Code Sec. 954(c)(6), much of the benefit of the Check-the-Box Regulations was neutered.

And then came tax reform. The enactment of the legislation commonly known as the Tax Cuts and Jobs Act (the "TCJA") ² introduced a veritable alphabet soup of new tax regimes, in particular in the international arena. The interaction of those new tax regimes with the long-standing Check-the-Box Regulations can in turn lead to some unexpected results—presenting both traps for the unwary and opportunities for the alert. This article explores the intersection of the Check-the-Box Regulations with two of the TCJA's new regimes—the new tax on Global Intangible Low-Taxed Income ("GILTI") and the new interest lim¬itations under Code Sec. 163(j), in particular as they apply to controlled foreign corporations ("CFCs"). As will be shown from the discussion below, in particu¬lar through a variety of examples, the Check-the-Box Regulations, through their ability to separate or combine the income and tax attributes of multiple foreign entities, can have a significant impact on the tax profile of U.S. corporations that hold foreign subsidiaries. The calculation of GILTI income under Code Sec. 951A, the availability of foreign tax credits under Code Sec. 960(d), the allocation of expenses and result¬ing foreign tax credit limitations under Code Secs. 861 et seq. and 904, and the availability of interest deductions under Code Sec. 163(j) can all be altered—for better or worse, and sometimes in counterintuitive ways— through Check-the-Box Elections. Each of the sections below will demonstrate the impact that a Check-the-Box Election can have on these new features of post-TCJA tax law, thereby illustrating, at the very least, the factors that must now be considered when deciding whether to check or not to check.

II. GILTI and the Problem of Disappearing QBAI

As noted above, Code Sec. 951A, enacted as part of the TCJA, introduced a new regime for the taxation of for¬eign earnings pursuant to which U.S. shareholders of CFCs are required to include in income on a current basis the GILTI with respect to those CFCs. ³ GILTI for a U.S. shareholder is the excess (if any) of such share¬holder's "net CFC tested income" for such taxable year over such shareholder's "net deemed tangible income return" ("DTIR") for such taxable year. ⁴ Net CFC tested income for this purpose is measured formulaically as including all of the "tested income" and "tested losses" of the shareholder's CFCs, other than certain specified categories of income and losses. ⁵ A shareholder's DTIR, in turn, is generally equal to (i) a 10% return on all of the CFCs' qualified business asset investment ("QBAI"), which is generally the CFC's basis in depreciable tan¬gible property that is used in the production of tested income, minus (ii) the net amount of interest expense taken into account in determining the net CFC tested income above. ⁶

Thus, in a simple case, assume a domestic corpora¬tion ("USP") wholly-owns a CFC ("CFC1"), and CFC1 earns $100 of gross tested income, has $20 of deduc¬tions allocable to that gross tested income, and has $100 of depreciable tangible property (Example 1a). USP's GILTI inclusion will equal $70–$100 of gross income, minus $20 of allocable deductions, minus DTIR of $10 (10% of the $100 of basis in depreciable tangible property).

The GILTI regime—unlike the subpart F regime— does, however, allow the effective netting of income (or, more precisely, tested income) against losses (or, more precisely, tested losses) across CFCs for purposes of com-puting a U.S. shareholder's GILTI inclusion. ⁷

So, for example, assume the same facts as in Example 1a, except that CFC1 owns another CFC ("CFC2") that has $50 of tested losses (Example 1b). In that case, USP's GILTI inclusion would be reduced to $20–$100 of gross tested income minus (i) $20 of allocable deductions, (ii) $10 of DTIR, and (iii) $50 of tested losses. In that sce¬nario, the GILTI regime effectively permits the netting of income and losses across CFCs in a manner that mir¬rors the combination of those items that would occur if the two entities were to be combined via an election to treat CFC2 as a disregarded entity.

But a slight variation in the facts reveals a critical man¬ner in which the GILTI regime does not truly net results across CFCs. Assume now the same facts as Example 1b except that CFC2 also owns depreciable tangible property with a basis of $100 that is held for the pro¬duction of tested income (Example 1c). The preamble to the proposed regulations under Code Sec. 951A (the "Proposed GILTI Regulations") states that, "[c]onsistent with the statute and the conference report ... the pro¬posed regulations clarify that a tested loss CFC does not have specified tangible property." ⁸ As a result of that rule, CFC2's investment in tangible property is simply irrele¬vant for purposes of calculating USP's GILTI inclusion. Since CFC2 is a tested loss CFC, the Proposed GILTI Regulations treat it as if it "does not have [any] specified tangible property," and USP's "intangible return" from its foreign subsidiaries is unaltered by its tangible prop¬erty investment. USP's GILTI inclusion in Example 1c thus remains $20—just as in Example 1b. Isolating the tangible property in a separate CFC with a tested loss effectively made the QBAI disappear for GILTI purposes.

In this instance, though, a simple Check-the-Box Election can make that QBAI reappear. If the facts remain the same as those in Example 1c, but USP elects to treat CFC2 as a disregarded subsidiary ("DRE2") of CFC1 (Example 1d), then for U.S. federal income tax purposes there is simply a single, profitable entity that has $100 of gross tested income, $70 of allocable deduc¬tions (the $20 of deductions from CFC1 and the $50 of deductible expenses of DRE2), and $20 of DTIR (10% of the $200 of total tangible property held by both CFC1 and DRE2)—yielding a GILTI inclusion of $10. Essentially, by checking the box on CFC2, USP received credit for the tangible property investment in CFC2 and thereby reduced its GILTI inclusion by $10 (or 10% of the additional tangible property investment in CFC2).

The initial—and perhaps most straightforward manner—in which the TCJA has complicated the Check-the-Box Election calculus is thus through the treatment of QBAI held by tested loss CFCs. While the GILTI regime in many respects purports to be an "aggregate" CFC regime (unlike the subpart F regime) that allows for the combination of attributes across CFCs, the treat¬ment of tangible property held by tested loss CFCs cre¬ates an incentive for taxpayers in certain circumstances to achieve a more fulsome "synthetic" netting across CFCs via entity classification elections to mitigate the problem of "disappearing QBAI."

III. Code Sec. 960(d) and the Inclusion Percentage Haircut

A similar, but somewhat more subtle, issue arises with respect to tested loss CFCs and their impact on the foreign tax credits that can be claimed with respect to GILTI inclusions under Code Sec. 960(d). New Code Sec. 960(d), which was introduced in the TCJA as part of the general GILTI regime, provides domestic cor¬porate shareholders of CFCs with a foreign tax credit equal to 80% (the so-called "GILTI FTC haircut") of the "tested foreign income taxes" paid by the CFC mul¬tiplied by the U.S. shareholder's "inclusion percentage." ⁹ Tested foreign income taxes are generally foreign income taxes paid by a CFC that are properly attributable to the CFC's tested income, ¹⁰ and a U.S. shareholder's inclu¬sion percentage is defined as the shareholder's GILTI inclusion divided by "the aggregate amount described in section 951A(c)(1)(A) with respect to such corpora¬tion." ¹¹ Following through the cross-references, Code Sec. 951A(c)(1)(A) refers to a U.S. shareholder's pro rata share of the tested income of each CFC with respect to which it is a U.S. shareholder. The immediately fol¬lowing subparagraph—951A(c)(1)(B)—in turn allows a U.S. shareholder to calculate its GILTI inclusion by taking into account its pro rata share of the tested losses of the CFCs with respect to which it is a U.S. shareholder. The cross-reference in Code Sec. 960(d) to Code Sec. 951A(c)(1)(A)—to the exclusion of Code Sec. 951A(c) (1)(B)—causes the inclusion percentage to be equal to a U.S. shareholder's GILTI inclusion divided by the tested income of its tested income CFCs without regard to the losses of its tested loss CFCs. The result of this is that while tested loss CFCs reduce a U.S. shareholder's GILTI inclusion, those losses reduce the U.S. shareholder's "inclusion percentage," thereby effectively reducing the foreign tax credits available with respect to that GILTI inclusion under Code Sec. 960(d).

As with the discussion above regarding the problem of disappearing QBAI, the inclusion percentage formula under Code Sec. 960(d), and its resulting impact on the Code Sec. 960(d) foreign tax credit formula, reveals a second way in which the GILTI regime is not a true "netting" regime. As illustrated in more detail below, the presence of a separate CFC with a tested loss results in the inclusion of fewer foreign tax credits under Code Sec. 960(d) than would be included if such loss had been incurred within another CFC with offsetting income. This disparity, in turn, requires domestic corporate share¬holders of CFCs to consider entity classification elections as a means to achieve more comprehensive netting than the GILTI regime does by itself.

Continuing with the example from above in which USP wholly-owns CFC1, which in turn owns CFC2, assume now that CFC1 has $100 of net tested income (before taking into account foreign taxes) and pays $10 of foreign income tax, while CFC2 has a $20 tested loss and pays no foreign income tax; for the sake of simplic¬ity assume neither CFC owns any QBAI (Example 2a). USP's GILTI inclusion would equal $70—CFC1's $100 of pre-tax tested income, minus $10 of CFC1's foreign tax, minus $20 of tested losses from CFC2. ¹²

But we then need to determine how many of those foreign taxes are available to USP as a deemed paid for¬eign tax credit under Code Sec. 960(d). To do so we need to compute USP's inclusion percentage, which equals its GILTI inclusion ($70 per the above) divided by the tested income of its tested income CFCs. Since CFC2 has a tested loss, it is ignored for these purposes. Instead we only compute the tested income of CFC1, which is $90–$100 of pre-tax tested income minus $10 of foreign tax. So USP's inclusion percentage is 70/90 (approxi¬mately 78%), and its Code Sec. 960(d) credits would equal the $10 of taxes, multiplied by 70/90, and further multiplied by 80%—resulting in $6.22 of foreign tax credits. A further twist in the calculation—the Code Sec. 78 gross-up is calculated in the same manner, only with¬out the 80% GILTI FTC haircut, yielding a Code Sec. 78 gross-up of $7.78 ($10 multiplied by 70/90). USP's additional U.S. taxable income is thus $77.78 (the $70 of GILTI plus the $7.78 Code Sec. 78 gross-up). And USP can claim $6.22 of foreign tax credits. Assuming no limitation on USP's Code Sec. 250 deduction with respect to its GILTI inclusion, ¹³ and no limitation on its use of those foreign tax credits under Code Sec. 904 (more on that below), USP's taxable income would equal $38.89 (50% of its $77.78 income inclusion), and it would owe U.S. tax of $8.17 (21% of $38.89) on a pre-credit basis, or $1.95 of U.S. tax after utilizing the for¬eign tax credits ($8.17 minus $6.22). In essence, while USP was allowed to use the losses of CFC2 to offset the GILTI arising from CFC1, the use of those tested losses "cost" USP some of the foreign tax credits associated with CFC1 via the reduced inclusion percentage and its resulting reduction in the Code Sec. 960(d) foreign tax credit calculation.

Consider, instead, what happens if USP elects to treat CFC2 as a disregarded entity. Assume all the same facts as Example 2a, except that CFC2 now becomes DRE2—a disregarded subsidiary of CFC1 (Example 2b). USP has the same $70 GILTI inclusion—$100 of CFC1's pre-tax tested income, minus $10 of CFC1's foreign taxes, and minus $20 of DRE2's losses. But now the denominator of USP's inclusion percentage fraction is also equal to the same $70 since those expenses of DRE2 net against the income of CFC1 within a single tested income CFC, rather than arising in a separate tested loss CFC as above. USP can thus claim $8 of foreign tax credits with respect to CFC1, and its taxable income inclusion arising from GILTI plus its Code Sec. 78 gross-up equals $80. Assuming the same Code Sec. 250 deduction and foreign tax credit utilization profile as above, USP would have net taxable income of $40 (50% of the $80 income inclusion), U.S. tax of $8.40 on a pre-credit basis (21% of $40), and only $0.40 ($8.40 minus $8) of U.S. tax on an after-credit basis, as compared to $1.95 of U.S. tax without the election. Essentially, by checking the box on CFC2, USP was able to fully utilize both the losses of CFC2 and the foreign tax credits of CFC1. As with the problem of "disappearing QBAI," the entity classi¬fication election allowed for a more efficient netting of tax items across CFCs than would otherwise be available "naturally" under the GILTI regime.

In particular with respect to the impact of the inclu¬sion percentage on the Code Sec. 960(d) calculation, given the annual nature of both tested losses and Code Sec. 960(d) foreign tax credits—neither can be carried forward—the loss of credits due to tested loss CFCs can be particularly harsh. For example, in Example 2a, absent the Check-the-Box Election, USP was able to fully utilize the tested loss of CFC2 at the price of losing foreign tax credits from CFC1. But what if in the subsequent year CFC2 earns positive taxable income? For local country purposes, CFC2 may be able to carry forward its pri¬or-year operating loss and thereby reduce its local coun¬try tax burden. But the tested income of CFC2 would be fully includible under the GILTI regime in that second year. And the adverse impact of the Code Sec. 960(d)(2) inclusion percentage formula from the prior year would not be reversed. In essence, across the two years, USP would have included all of the income of both CFCs under the GILTI regime without any true benefit from an economic loss, and yet USP would have permanently lost a portion of the foreign tax credits associated with the CFC1 income. If instead, CFC2 is treated as a dis¬regarded entity throughout that period, USP can fully utilize all of the attributes of the two entities without suffering any loss of foreign tax credits.

IV. 904 Limitations—Inclusion Percentage and the GILTI Basket Limitation

At this stage a reader might be wondering—why the pon¬derous question in the article's title? Isn't the answer obvi¬ous? If the absence of a Check-the-Box Election results in a potential increase in GILTI through the loss of QBAI and reduced foreign tax credits through the Code Sec. 960(d) inclusion percentage calculation, then why not always check the box? The beginning of the answer lies in the even more complex foreign tax credit limitation rules of Code Sec. 904, and the expense allocation rules that feed into the Code Sec. 904 limitation calculation.

While a complete review of the foreign tax credit limi¬tation and expense allocation rules under Code Secs. 904 and 861, et seq. —including the 312 pages of proposed new rules that were released in late 2018¹⁴—is beyond the scope of this article, a brief overview is necessary for the following discussion.

Under Code Sec. 901, a U.S. taxpayer can claim a credit in respect of certain foreign taxes paid with respect to its income. However, to prevent the foreign tax credit from effectively allowing taxpayers to reduce U.S. tax on U.S. source income, Code Sec. 904 limits the available foreign tax credits to those that bear the same propor¬tion to total taxes as the taxpayer's foreign source income bears to its total taxable income. ¹⁵ In essence, Code Sec. 904 generally limits the available foreign tax credits to those that equal the U.S. tax rate multiplied by the tax-payer's foreign source income. Code Sec. 904(d), in turn, applies that same limitation to each separate category (so-called "basket") of foreign source income identified in that subsection. Critically for purposes of this article, the TCJA created a new separate foreign tax credit lim¬itation for income includible under Code Sec. 951A— i.e., GILTI inclusions (the so-called "GILTI basket").¹⁶ Thus, to determine the portion of the Code Sec. 960(d) credits that a taxpayer can actually use, it must calcu¬late its Code Sec. 904 foreign tax credit limitation in the GILTI basket.

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Footnote

1 T.D. 8697, 61 FR 66,584 (Dec. 18, 1996).

2 The TCJA is actually entitled "An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018," P.L. 115-97.

3 Code Sec. 951A(a).

4 Code Sec. 951A(b)(1).

5 Code Sec. 951A(c).

6 Code Sec. 951A(b)(2). The precise rules for measuring the various components of GILTI— gross tested income, allocable deduction, DTIR, QBAI, and interest expense—are beyond the scope of this article.

7 Code Sec. 951A(c)(1).

8 Guidance Related to Code Sec. 951A (Global Intangible Low-Taxed Income), REG-104390- 18, 83 FR 51,072 (Oct. 10, 2018), Preamble at 8. See also Proposed Reg. §1.951A-3(b) ("A tested loss CFC has no qualified business asset investment.").

9 Code Sec. 960(d)(1).

10 Code Sec. 960(d)(3).

11 Code Sec. 960(d)(2).

12 As an aside, it is worth noting that while the GILTI inclusion is based upon a measure of taxable income—as opposed to earnings and profits as under the subpart F regime—foreign taxes are effectively deducted from that mea¬sure of taxable income, with the addback of those taxes accomplished through the mech¬anism of the Code Sec. 78 gross-up. See Code Secs. 78 and 951A(c)(2)(A)(ii).

13 Code Sec. 250(a)(1)(B) provides domestic cor¬poration with a 50% deduction in respect of their GILTI inclusion and associated Code Sec. 78 gross-up, subject to certain limitations.

14 Guidance Related to the Foreign Tax Credit, Including Guidance Implementing Changes Made by the Tax Cuts and Jobs Act, REG- 105600-18, 83 FR 63,200 (Dec. 7, 2018).

15 Code Sec. 904(a).

16 Code Sec. 904(d)(1)(A).

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