The Tax Cuts and Jobs Act made significant changes to the way U.S. multinationals’ foreign profits are taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. ed. GILTI, or “Global Intangible Low Tax Income,” was introduced as an outbound anti-base erosion provision. This new definition of income is meant to discourage companies from using intellectual property to shift profits out of the United States. However, GILTI in practice does not work the way in which many expected. Due to interactions with existing law, companies can face U.S. tax on GILTI even if their foreign effective tax rate is in excess of the advertised 13.125 percent. Ideally, this is something lawmakers should revisit. However, some argue that the Treasury Department should try to address this.
Structure and Purpose of GILTI
GILTI is a newly-defined category of foreign income added to corporate taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. each year. In effect, it is a tax on earnings that exceed a 10 percent return on a company’s invested foreign assets. GILTI is subject to a worldwide minimum tax of between 10.5 and 13.125 percent on an annual basis. GILTI is supposed to reduce the incentive to shift corporate profits out of the United States by using intellectual property (IP).
The primary purpose of GILTI is to reduce the incentive for U.S.-based multinational corporations to shift profits out of the United States into low- or zero-tax jurisdictions. This is done by placing a floor on the average foreign tax rate paid by U.S. multinationals of between 10.5 percent and 13.125 percent. The incentive to shift profits from one jurisdiction to another is the function of the difference between the countries’ statutory tax rates. That difference is the tax savings a company receives per dollar shifted. Companies subject to GILTI would compare a 21 percent domestic rate with a 10.5 to 13.125 percent rate rather than a zero rate.
The 10 percent qualified business asset investment (QBAI) exemptionQualified Business Asset Investment (QBAI) is a 10 percent tax exemption for U.S. multinationals based on the value of buildings, machinery, or equipment. The QBAI exemption is part of the Global Intangible Low-Tax Income (GILTI) tax base, a measure that discourages companies from shifting profits out of the U.S., and part of the calculation for Foreign Derived Intangible Income (FDII). in GILTI attempts to target the provision at assets that return above-normal returns, which is a proxy for the returns to intellectual property. This approach targets income that is more mobile. In addition, it exempts the returns to real investment, which should avoid distorting foreign investment decisions of U.S. multinational corporations. Under GILTI, the rate on foreign profits is now at or below most tax rates in the developed world. This limits the incentive for U.S. multinationals to move their headquarters out of the U.S.
Does GILTI Really Work as Intended?
In principle, GILTI is attempting to balance both base erosion and competitiveness concerns. However, it doesn’t seem like the law operates precisely as Congress intended.
One area which has garnered significant attention recently is GILTI’s treatment of companies with high-taxed foreign profits. For example, The Wall Street Journal highlighted a railroad transportation company that operates in the United States and Mexico. Although Mexico is a relatively high-tax country—it has a corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate of 30 percent—this company was still subject to tax liability on its GILTI. Given that GILTI is meant to only apply to companies with tax liabilities under 13.125, this is a surprise.
The reason this company ends up facing tax liability is that GILTI was constructed using previous law’s foreign tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. infrastructure. Under current law, foreign tax credits face a limitation. The limitation is that the credit is based on a formula, which cannot exceed your U.S. tax liability multiplied by the share of foreign profits divided by your worldwide profits. The purpose of this limitation is to prevent companies from using the foreign tax credit to offset domestic taxes.
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Rules that are part of the foreign tax credit limitation also require companies to allocate certain domestic expenses to foreign income. This requirement to allocate domestic interest expense against foreign income has the effect of altering the fraction that limits the foreign tax credit. For example, a company, before the interest expense allocation, may earn half of its profits outside of the United States. This means the foreign tax credit would be limited to half of the U.S. tax liability. However, expense allocation may shift expenses out of the U.S. and into a foreign jurisdiction. As a result, foreign profits may fall to, say, 25 percent of overall profits. The foreign tax credit would then be limited to one quarter of U.S. tax liability—a far smaller foreign tax credit.
Under GILTI, the reduced foreign tax credit means that companies are not getting full credit for the taxes they pay already to foreign jurisdictions. Companies with foreign effective tax rates in excess of 20 percent could end up with additional U.S. tax liability on foreign profits, even though it exceeds the minimum GILTI rate of 13.125 percent.
It does look as though lawmakers made a mistake in constructing GILTI. Expense allocation in the foreign tax credit was consistent with the previous worldwide tax systemA worldwide tax system for corporations, as opposed to a territorial tax system, includes foreign-earned income in the domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. . However, it makes less sense in the context of a territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. , which lawmakers clearly intended to move toward.
Ideally, lawmakers would work on legislation to revisit GILTI to make sure that it operates as originally intended: as a 10.5 to 13.125 percent minimum tax on foreign profits. However, there is little interest by lawmakers to do the heavy lifting in the short run. Alternatively, some companies argue that the Treasury Department could address this issue through further regulatory action. Treasury already released proposed rules that mitigated some of the effect of expense allocation in the foreign tax credit regarding GILTI. Other changes, such as looking at Subpart F’s high tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the IRS, preventing them from having to pay income tax. , may also be discussed.Share