The GILTI High-Tax Exclusion and the Tested Unit Standard: New Administrative Burdens Await for Taxpayers

The New “Tested Unit” Standard

The Proposed Regulations applied a QBU-by-QBU approach to identify the relevant items of income that may be eligible for the GILTI high-tax exclusion, which aimed to minimize the “blending” of income subject to different foreign tax rates and more accurately identify income subject to a high rate of foreign tax. For this purpose, a “QBU” is any separate and clearly identifiable unit of a trade or business of a taxpayer that maintains separate books and records, and whether certain activities constitute a “trade or business” is generally based on a facts and circumstances analysis.

The Final Regulations replace this QBU-by-QBU approach with a new “tested unit” standard, which applies to the extent an entity, or the activities of an entity, are actually subject to foreign tax, either as a tax resident of a permanent establishment under foreign law. According to the Preamble of the Final Regulations, the tested unit standard is “a more targeted measure than the QBU standard and will be more easily applied to the GILTI high-tax exclusion than the QBU standard.”

In so adopting the tested unit standard, Treasury and the IRS cited comments to the Proposed Regulations asserting that reliance on a facts and circumstances test under the QBU-by-QBU approach may have created uncertainty and inconsistency, and that taxpayers may have engaged in affirmative tax planning to avoid the QBU rule by bifurcating operations of a single large QBU into smaller components. In addition, the Preamble indicates that, while the QBU standard was a proxy for an entity or operations being subject to foreign tax, the tested unit standard more closely tracks whether an entity or activities are actually subject to foreign tax.

The Final Regulations provide that the following categories qualify as tested units: (1) a CFC; (2) a partnership or disregarded entity held directly or indirectly by a CFC, provided that the pass-through entity is either a tax resident of a foreign country or is treated as a corporation for purposes of the CFC’s tax law; and (3) a branch that gives rise to a taxable presence in the country in which the branch is located or under its owner’s tax law (which provides an exclusion for income attributable to the branch).

Grouping of tested units is generally permitted—and, in fact, is mandatory—only where a CFC has multiple tested units that are tax residents in the same foreign country; however, grouping is not permitted for nontaxed branches. This tested unit concept is similar to, but not the same as, a number of other concepts used for separately tracking sub-units involving foreign operations—”separate units” for dual consolidated loss purposes, QBUs and foreign branches, for example.

Separate “Books and Records” for Each Tested Unit

For purposes of computing the GILTI high-tax exclusion, the Final Regulations require taxpayers to maintain a “separate set of books and records” for determining income attributable to a tested unit, a standard defined by cross-reference to the standards required for a QBU.

Notwithstanding this cross-reference to books and records of a QBU, taxpayers will likely be forced to maintain two sets of books and records for each QBU—one for section 987 purposes (maintained in local currency) and one for GILTI high-tax exclusion purposes (maintained in USD)—due to the inherent complexities associated with reconciliation of section 987 transactions with transactions among and between tested units.

The IRS and Treasury apparently believe that maintaining books and records for tested units may not be unduly burdensome because taxpayers are already required in many cases to keep similar records to file foreign tax returns. Moreover, taxpayers currently can avoid any such new US filing burdens by simply refraining from electing the GILTI high-tax exclusion. However, the Final Regulations, together with new proposed regulations on the Subpart F income high-tax exception under section 954(b)(4) (REG-127732-19), issued on the same date as the Final Regulations, as well as proposed foreign tax credit regulations issued in December 2019 (REG-105495-19) indicate that the government intends to extend tested unit concepts more broadly in future guidance.

In fact, the proposed Subpart F high-tax regulations, which would conform the Subpart F high-tax exception to the GILTI high-tax exclusion (rather than the reverse, as commentators requested), would both adopt the tested unit regime and further modify it. These proposed regulations would replace the “separate set of books and records” standard with an even newer standard that would require taxpayers instead to track items of gross income attributable to the “applicable financial statement” of a tested unit. Unlike the “books and records” standard, the “applicable financial statement” standard would be based on separate entity (or separate branch) financial statements that are independently maintained.

Adjustments to Reflect Disregarded Payments

The Final Regulations also require taxpayers to make adjustments for disregarded payments between tested units to associate the income with the tested unit in which it is subject to tax. Specifically, if a tested unit makes a disregarded payment to another tested unit, taxpayers must reduce the payor tested unit’s gross income to the extent of such payment, and must increase the payee tested unit’s gross income by the same amount.

This principle—that taxpayers must “regard” disregarded transactions for purposes of computing the GILTI high-tax exclusion—is consistent with other recent guidance issued by Treasury and the IRS requiring taxpayers to take disregarded payments into account for certain US tax purposes, which itself may be indicative of a larger trend. For example, a similar approach was taken in final regulations promulgated under section 904 for purposes of determining foreign branch category income, and proposed foreign tax credit regulations would apply to the same types of disregarded payments between CFCs and their branches and other units (which conceivably could be determined under a tested unit regime if these proposed regulations are finalized). Similarly, taxpayers are required to “regard” disregarded entities for purposes of determining a related party for purposes of the anti-hybrid rules under section 267A.

Expansion of Administrative Burdens

Applying the tested unit concept to determine whether to elect the GILTI high-tax exclusion will be a complex process. Taxpayers must now examine each CFC, identify tested units within each CFC (including the CFC itself), account for disregarded transactions, and group tested units in the same country. Because the GILTI high-tax exclusion must be made “all or nothing” (i.e., for the entire group or none of the group), taxpayers must examine their worldwide structure and engage in the detailed accounting necessary to determine whether each tested unit is highly taxed on an annual basis. For taxpayers with more complex ownership structures, or with CFCs with multiple unrelated owners, there may be further complications in determining which CFCs are in the same CFC group for purposes of the all-or-nothing application of the GILTI high-tax exclusion.

With this new requirement to track tested units (under both the books and records standard and the applicable financial statement standard), and also to make adjustments to reflect disregarded payments, taxpayers must grapple with an ever-expanding list of units of account (and the associated administrative burdens) with respect to tracking and reporting income earned abroad, including those obligations arising from the Tax Cuts and Jobs Act (TCJA). This could include:

• Tested income and qualified business asset investment (QBAI) for GILTI purposes
• Foreign branch tracking for basketing purposes
• Extraordinary reduction accounts under section 245A
• Hybrid deduction accounts under section 245A(e)
• Specified payments under section 267A
• Adjusted taxable income for purposes of section 163(j)

Taxpayers should also consider the administrative burdens in existence prior to the TCJA, including:

• Measuring current and accumulated E&P for each CFC
• Maintaining separate books and records for section 987 QBUs
• Tracking attributes of foreign branches for purposes of certain Subpart F rules
• Tracking and reporting of splitter arrangements under section 909
• Tracking “separate units” for dual consolidated loss purposes

In addition, the proposed regulations on the Subpart F income high-tax exception would further increase taxpayers’ reporting obligations by requiring that US shareholders maintain specific contemporaneous documentation to substantiate their Subpart F income high-tax exception computations and to report such information on Form 5471. Such additional information reporting appears to be part of a trend of increased international information reporting (e.g., Forms 8992 and 8993 for GILTI and the section 250 deduction, respectively; additional reporting on Form 8949 (to report the section 961(d) loss disallowance attributable to the section 245A DRD)).

The Road Ahead

The adoption of the tested unit standard in the Final Regulations may impact how taxpayers approach information collection and retention. That taxpayers must track information on a more granular level, and must even make adjustments for disregarded payments, may push taxpayers to revisit their internal recordkeeping systems on a holistic level in order to properly identify tested units for purposes of computing the GILTI high-tax exclusion. Making these detailed calculations on a worldwide basis, annually, will be no small task. And as with anything TCJA-related, broad generalizations and assumptions about the impact of the rules may prove incorrect, and modeling is king.