More Anti-simplification: How Pti and Gilti Override the Section 245a Exemption and the U.s. Territorial Tax System
| Publication year | 2020 |
More Anti-Simplification: How PTI and GILTI Override the Section 245A Exemption and the U.S. Territorial Tax System
Christine A. Davis
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In December of 2017, the United States (U.S.) enacted tax reform commonly known as the "Tax Cuts and Jobs Act" (TCJA),2 which was initially thought to "establish[] a territorial tax system for multinational companies."3 Over time, however, tax professionals began to understand that the TCJA layered a territorial tax system that exempted foreign earnings from the U.S. income tax (exemption tax system) on top of a residence-based worldwide tax system that used a foreign tax credit (FTC) to protect against juridical double taxation (worldwide tax system).4 Furthermore, the U.S. exemption tax system
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is severely limited by the worldwide tax system.5 This Article continues an analysis developed in a companion paper, Is the Tax Cuts and Jobs Act GILTI of Anti-Simplification?, which demonstrates that previously taxed income (PTI) is the keystone used to determine whether dividends are taxed as part of the worldwide or exemption tax system.6
Historically, PTI was used to prevent a United States shareholder from paying taxes twice on certain earnings of its foreign corporations. Without a method to track income taxed by the United States, a U.S. shareholder would potentially pay taxes twice on the same earnings—once as an inclusion required by Subpart F (Subpart F) and again as a payment of dividends. Section 959 tracked previously taxed earnings and profits to ensure that earnings taxed as a Subpart F inclusion were excluded from gross income when actually distributed to the U.S. shareholder.7 Prior to the 2017 tax reform, § 959 implemented the policy goals of "avoiding double taxation and allowing United States persons to receive the full benefit of their PTI at the earliest possible time."8 However, when the TCJA effected an exemption for the foreign source portion of dividends distributed to corporate U.S. shareholders,9 the actual distribution of earnings was no longer a taxable event. This precipitated the question: Does the United States still need the concept of PTI after the TCJA?
This Article examines the operation of previously taxed income rules after enactment of the TCJA and whether PTI is still a necessary part of the U.S. international tax system. This paper is organized as follows: Part II summarizes the statutory law related to previously taxed income before and after the TCJA. Part III presents a hypothetical multinational corporation and demonstrates how the PTI rules affect the determination of U.S. corporate income tax. Part IV considers whether tax policy historically supporting PTI is still valid. Part V demonstrates how the post-TCJA laws function to override the U.S. exemption tax system and effectively create a pure worldwide tax system without deferral for multinational corporations with a large amount of PTI. Part VI concludes.
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A. Statutory Law Related to PTI Before the TCJA.
The concept of previously taxed income, also referred to as "previously taxed earnings and profits" (PTEP), was included in and was an integral part of the original 1962 enactment of Subpart F.10 Prior to January 1, 2018, a U.S. shareholder generally paid U.S. income tax on its foreign corporation's foreign source earnings only upon a realization event, such as when it received a dividend or sold stock for a gain.11 As a result, a U.S. multinational corporation (MNE) could defer paying U.S. income taxes on its foreign subsidiary's earnings so long as the entity did not distribute its profits as dividends.12 Because of the time value of money, this ability to defer paying income taxes conferred a significant economic benefit, which was often subject to abuse.13 Subpart F curtailed this abuse for certain income.
When a "U.S. Shareholder" (USSH) directly or indirectly owns "Controlled Foreign Corporation" (CFC) stock on the last day of the CFC's taxable year, Subpart F requires that the USSH include specific types of the CFC's earnings in gross income without a realization event, thereby eliminating the benefit of deferral in these limited situations.14 A U.S. Shareholder is a U.S. person, which includes U.S. citizens, residents, and domestic corporations, that directly, indirectly, or constructively owns 10% or more of a foreign corporation's stock.15 A Controlled Foreign Corporation is a foreign corporation in which USSHs directly, indirectly, or constructively own more than 50% of its stock on any day during its taxable year when measured by the "total
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combined voting power of all classes of stock . . . entitled to vote," or the "total value of the stock."16 Prior to the TCJA, Subpart F applied to Subpart F income (Subpart F Income) and § 956 investments in U.S. property (U.S. Property Investments).17
In general, Subpart F Income was derived from earnings that could be easily manipulated to avoid taxes, or earnings from activities that the U.S. government discouraged.18 Subpart F Income included: (a) passive and investment income, such as dividends, interest, rents, royalties, annuities, and foreign currency gains (Foreign Personal Holding Company Income or FPHCI); (b) certain insurance income; (c) income from certain sales or service transactions involving related parties (foreign base company sales income and foreign base company services income respectively); and (d) certain income that the United States government discouraged, such as income associated with illegal bribes or kickbacks, countries on the U.S. international boycott list or countries with whom the U.S. did not have normal diplomatic relations.19 Notwithstanding the foregoing, Subpart F Income did not include any income "effectively connected with the conduct of a trade or business within the United States" (ECI with a USTB), and Subpart F Income could not exceed the CFC's current earnings and profits (E&P) for any taxable year.20 Subpart F Income was calculated at the level of the CFC and then divided pro rata among its USSHs.21
In addition, U.S. Property Investments were currently included in a USSH's gross income without a realization event.22 Although some exceptions applied, U.S. property generally included tangible property
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located in the U.S., the right to use intangible property in the U.S., as well as debt and stock instruments issued by U.S. corporations and other entities (collectively U.S. Property).23 A U.S. Property Investment occurred when a CFC utilized its E&P to obtain U.S. Property. Currently taxing U.S. Property Investments prevented the USSH from using its CFC's earnings as if it received a dividend without paying tax on the distribution.24 Thus, Subpart F required that a USSH include in its gross income a pro rata share (PRS) of the average adjusted basis of U.S. Property directly or indirectly held by its CFC at the close of each quarter of the taxable year, less any earnings previously taxed as a U.S. Property Investment, where the total inclusion was limited by undistributed E&P reduced by the earnings previously taxed as a U.S. Property Investment.25 Thus, whereas Subpart F Income was limited to current E&P, the U.S. Property inclusion was constrained by the aggregate of current and accumulated E&P reduced by distributions and income previously taxed as U.S. Property Investments.26
Thus, prior to the TCJA, a USSH included in its gross income, without a realization event, a pro rata share of its CFC's Subpart F Income and U.S. Property Investment.27 In each case, the USSH did not receive an actual distribution of income from the CFC. Instead, the USSH was taxed on a fictitious distribution of income (phantom income) from the CFC. Without a method to track earnings taxed by the United States, a U.S. shareholder would potentially pay taxes twice on the same earnings as a result of the following two taxable events:
Event 1: Subpart F Inclusion—USSH must pay tax on its CFC's earnings as a deemed distribution of phantom income.
Event 2: Actual Distribution to Shareholder—USSH pays tax on the same earnings when it receives a dividend from the CFC or when the CFC invests in U.S. Property.28
Prior to the TCJA, § 959 used PTI as a mechanism to ensure that earnings taxed during Event 1 were excluded from gross income during Event 2.29 Thus, when earnings were taxed as a Subpart F inclusion
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(Event 1), § 959 designated these earnings as PTI or PTEP. When these earnings were actually distributed to the USSH or invested in U.S. Property (Event 2), PTI was excluded from the USSH's gross income. This procedure functioned to prevent a second tax on the same earnings.30 Similarly, § 959 used the concept of PTI to insulate distributions from lower to higher level CFCs in a chain of ownership from multiple Subpart F inclusions.31
Section 959 effected two policy goals.32 First, § 959 tracked E&P that was taxed as a Subpart F inclusion and excluded those earnings from gross income when actually distributed to the USSH or invested in U.S. Property. This implemented the policy of preventing double taxation of the same earnings.33 Second, § 959 established an order of priority for a CFC's distributions, which utilized previously taxed earnings before untaxed earnings. This preference ensured that PTI was excluded from gross income at the earliest possible moment.34 This system of tracking and allocating PTI (PTI System) was implemented by assigning E&P into separate categories at the time of the Subpart F inclusion.
When included in a USSH's gross income, the CFC's E&P attributed to the Subpart F inclusion were designated as PTI. Consequently, three separate categories of E&P were used to track PTI: (1) earnings previously taxed...
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