As companies are currently preparing for second quarter releases, estimated tax payments and cash tax planning, we are feverishly modeling the impact of Global Intangible Low-Taxed Income (GILTI), revealing several glitches and uncertainties. Among these uncertainties, one nuanced issue generating substantial frustration for companies involves code Section 78. The issue relates to a potential limit on a taxpayer’s ability to use foreign tax credits against GILTI, which may result in significantly raised exposures. Many conservative attest firms have previously concluded that taxpayers are limited.
In short, our position is in favour of using foreign tax credits. This could reduce the exposure for companies by affecting earnings releases, estimated tax payment obligations and future planning.
Purpose of the Section 78 Gross-Up
The deemed paid foreign tax credit provided by Section 960 (and previously by now repealed Section 902) creates a fiction whereby a US parent company is treated as if it directly paid its allocable portion of income taxes paid by its 10 percent or more foreign subsidiaries, for which the parent may receive a foreign tax credit. When a US parent company is deemed to have paid the taxes of its foreign subsidiary(ies), Section 78 requires the US parent to gross-up the income inclusion from its foreign subsidiaries by the amount of the deemed paid taxes. In this way, the parent reports the same amount of income and foreign taxes as it would have reported if it earned the income directly, rather than through a foreign subsidiary.
Historically, this concept applied when a foreign subsidiary distributed a dividend to its US parent, or when it had subpart F income includible by its US parent. For example, if a foreign subsidiary distributed $75 of its income on which it paid $25 in taxes as a dividend to its U.S parent, the US parent is treated as if it received a $100 dividend and directly paid the $25 in foreign tax itself.
As US companies continue to model the effects of GILTI and foreign tax credit usage on their existing structures, they should be aware of the potential tax impact should the Section 78 Gross-Up on GILTI be allocated to the general limitation basket. Discussion regarding whether a technical correction or regulatory guidance will be issued to clarify this issue remains prevalent. Even absent such a legislative or regulatory fix, we believe the existing statutory language can and should be interpreted to put the Section 78 Gross-Up on GILTI in the GILTI basket. Reach out to us for the explanation of our verdict on this issue (i.e. for further detail of our alternative interpretation of the relevant statutory language) and to discuss its impact on your fact pattern.