This article deals with one of the many unanswered questions of the 2017 tax legislation—the potential impact of a basis adjustment on sale of a lower-tier controlled foreign corporation’s (CFC’s) stock for an upper-tier CFC’s global intangible low-taxed income (GILTI) and Subpart F calculations. The question, a classic exercise in statutory interpretation, revolves around a seemingly incommensurable overlap between the existing rules and the newly enacted statutory language. The implications are far reaching—from fundamentally altering the tax structuring of multinational enterprises to providing a vital precedent to statutory and regulatory interpretation.
In short, the question is how a basis adjustment for the sale of stock from a lower-tier CFC to an upper-tier CFC would affect Subpart F and GILTI tested income calculations. Assuming both basis bumps1 occur, the top CFC—as the directly benefiting shareholder at the time of the earnings—would get the bump from the lower-tier’s Subpart F on the sale so as to ensure there was no Subpart F duplication.
The New York State Bar Association (NYSBA) Tax Section specifically addressed this issue in its October 11, 2018 Report on Previously Taxed Earnings.2 The report pointed to a conflict in the interpretation of the section 961(c) basis adjustment. “The GILTI regime expressly requires that an enumerated set of other provisions, including Section 961, treats a GILTI inclusion in the same way as a Subpart F inclusion.”3 Yet this GILTI requirement potentially clashes with section 961(c) itself because it is explicitly stated to apply “only for the purposes of determining the amount included under section 951.”4 There is no statutory direction under section 961(c) for purposes of determining GILTI tested income.
I. Nuts and Bolts
Sections 959 and 961 work together to ensure that double taxation of a CFC’s earnings may be avoided.5 Section 959(a) provides that if the earnings and profits (E&P) of a CFC have already been taxed to a U.S. shareholder under section 951(a), then the E&P will not be taxed again when distributed to that shareholder.6 The section achieves this result by excluding previously taxed income (PTI) from the gross income of an upper-tier CFC for purposes of calculating the Subpart F income of the US shareholder. The statutory provision and regulations provide tracing rules7 that treat a cash distribution recipient as receiving income that was previously taxed to the US shareholder before receiving income that is still taxable to that shareholder.8 Professor Eric Laity notes that these “divide the payor’s earnings and profits into six categories and require the recipient and its United States shareholder to deem the dividend paid out of the six categories in succession.”9 The categories consist of (1) current E&P taxed under sections 951(a)(1)(B) and 956 (investments in U.S. property), (2) accumulated E&P taxed under those sections, (3) current E&P attributable to Subpart F income plus “an amount of the payor’s other current earnings and profits equal to the amount of ordinary income realized under Code section 1248(a) or (f) by a predecessor-in-interest to the United States shareholder,”10 (4) accumulated E&P attributable to Subpart F income or Subpart F income that the payor withdrew from qualified shipping operations and less-developed country operations plus “an amount of the payor’s other accumulated earnings and profits equal to the amount, if any, by which the ordinary income realized under Code section 1248(a) or (f) by a predecessor-in-interest to the United States shareholder exceeded the payor’s current earnings and profits for purposes of the third category,”11 (5) remaining current E&P, if any, and (6) remaining accumulated E&P.12 Under the tracing rules, a dividend is allocated among the categories in the order provided, using the E&P in each category before moving to the next category.13 As Laity notes, “[w]ithin a category consisting of accumulated earnings and profits (which are the second, fourth, and sixth categories above), the dividend is allocated among the accumulated earnings and profits in the reverse order in which the payor accumulated those earnings and profits.”14
II. Legislative History
Congress added section 961(c) to circumvent double inclusions that may arise.15 The Preamble to the proposed PTI regulations confirms the IRS’s interpretation of section 959 as giving effect to the gross income exclusion “at the earliest possible point.”16
III. New York State Bar Association Alternative Theories
In general, section 961 treats the GILTI inclusion in the same way that it would treat a Subpart F inclusion through section 951A(f)(1)(A).17 The basis that results under section 961(c) applied to determining only amounts included in gross income under section 951, so this could lead to items of income being taxed twice.18 The Service has requested comments on this issue, as well as the potential for inappropriate reduction of gain in CFC stock held by corporate U.S. shareholders that receive a dividend-received deduction.19
The example in the NYSBA Report addresses whether an upper-tier CFC’s section 961(c) basis in a lower-tier CFC’s stock should be taken into consideration for computing the upper-tier CFC’s GILTI tested income—assuming that there is GILTI tested income—when the upper-tier CFC sells the lower-tier CFC stock to an unrelated party.20 If the upper-tier CFC must recognize the totality of the GILTI tested income, this would be a “Gain/Earnings Duplication” that inappropriately taxes the same economic income twice.21
Alternatively, the NYSBA Report contemplates that a basis adjustment under section 961(c) could apply for both Subpart F income and GILTI tested income. The upper-tier CFC would not have any GILTI tested income when the lower-tier CFC’s stock is disposed of, because the upper-tier CFC’s basis in the lower-tier CFC’s stock would be increased for GILTI purposes as well as Subpart F purposes. This would cause the realized gain from the disposition of the lower-tier CFC’s stock to be taken into account for Subpart F income—and thereby to be excluded from GILTI tested income.22
Another approach suggested is the exclusion of “items” of gross income used to determine Subpart F income from GILTI tested income—as opposed to the category of “amounts” of gross income. The NYSBA Report suggests that “items that give rise to Subpart F income, such as the disposition of stock, would be excluded from GILTI tested income even if the amount of gross income would be greater for GILTI purposes by reason of Section 961(c) applying positive basis adjustments for Subpart F purposes but not for GILTI purposes.”23 The theory behind this alternative is that because the statutory language provides that tested income does not include “gross income taken into account under Subpart F,”24 any items from a stock sale taken into account under Subpart F would not be considered in determining GILTI tested income. Following the language of the statute, the gain on the sale of the lower-tier CFC stock is taken into account under Subpart F rules, but no part of the stock sale is taken into account for determining GILTI tested income. This is because the language of section 961(c) provides, “if a United States shareholder is treated under section 958(a)(2) as owning stock in a controlled foreign corporation which is owned by another controlled foreign corporation, then adjustments similar to the adjustments provided by subsections (a) and (b) shall be made” to the basis of such stock and the basis of stock “in any other” CFC “by reason of which the United States shareholder is considered under” section 958(a)(2) “as owning the stock described in paragraph (1).”25 Under this approach, however, if the upper-tier CFC’s gain on the sale of lower-tier CFC stock were not used in determining Subpart F income, for whatever reason, that gain would be GILTI tested income, since “Congress did not identity stock gain as Exempt Income.”26 The NYSBA Report points to a counterargument that GILTI specifically excludes certain income that gives rise to Subpart F income—i.e., “income that would be Subpart F income but for the high-tax kickout, and dividends from related corporations,”27 but concludes that argument is not dispositive since those items are fully excluded while stock sale gains are included, at least in part. That leaves the question unresolved.
The final alternative suggested in the NYSBA Report is that section 961(c) applies only for Subpart F purposes and not for computing GILTI tested income.28 In this scenario, the upper-tier CFC would realize a gain upon the sale of the lower-tier CFC’s stock for GILTI tested income, but the portion of that gain recognized as Subpart F income is excluded from GILTI tested income while the remainder is treated as GILTI tested income.29
Likely because it considered it unreasonable, the NYSBA Report did not consider non-application of section 961(c) for both Subpart F and GILTI tested income purposes. The NYSBA Report concluded the discussion by urging that Treasury adopt regulations in line with the first approach suggested.30
IV. Can the Canons of Statutory Interpretation Help?
There may be a better and fairer approach. The NYSBA Report’s favored approach that a GILTI inclusion should be read within the context of section 961 as including a reference to GILTI income is not supported by any canon of interpretation. It is rather a persuasive use of principles akin to legal realism.31 Would it be better to take a formalist theory based on foundational canons of statutory interpretation, such as the one espoused by former Justice Antonin Scalia? He noted that “the extent to which one can elaborate general rules from a statutory or constitutional command depends considerably upon how clear and categorical one understands the command to be, which in turn depends considerably upon one’s method of textual exegesis.”32 Perhaps one helpful example would be the grammatical rule employing the last antecedent. This cannon indicates that a prepositional phrase modifies all the antecedents in a sentence.33
The problem with selection of an appropriate canon is, of course, that there is no definitive set of canons or clear contextual signals for choosing whether to apply a particular canon.
[M]ost courts will continue to deal with trailing modifiers as they always have—by grabbing onto the last-antecedent canon or finding a reason not to. A court may, of course, decide not to apply the last-antecedent canon for contextual or nontextual reasons (such as legislative history). … [A] court facing an ambiguous trailing modifier can often choose from a dizzying mix of canons. Some point to one interpretation, some to another.34
Further, as Amy Griffin has noted,
Many “never binding” sources such as the Federalist Papers, legislative history, dictionaries, and canons of interpretation are all used in classic authoritative ways—for their status, not their substantive content. … [C]anons [of statutory interpretation] are often referred to simply as ‘rules of thumb’; their legal status is ambiguous. … [T]hey are not typically deemed binding in the same way as substantive law.35
These uncertainties suggest that the last antecedent rule is likely not conclusive, and perhaps argue against the NYSBA Report’s position. If it were appropriately applied, however, then perhaps GILTI inclusion should be read within the context of section 961 as including a reference to GILTI tested income.
There seem, therefore, to be four possible results: (1) the issue is resolved according to the NYSBA Report’s recommendation (or one of the alternative solutions suggested); (2) a further solution utilizing canons of statutory construction comes to the fore; (3) the existence of duplicative—yet not resoundingly double—taxation is permitted as following most closely the language of the provisions; or (4) section 961(c) is found to apply neither to Subpart F income nor to GILTI tested income. The NYSBA Report, and this author, do not consider item (3) an ideal solution from the view of foundational objection to double inclusions. Given the lack of persuasive authority, Treasury could well adopt any one of the three other results or something as yet undiscussed. Unfortunately, it is unlikely that an answer can be found in legislative or regulatory history. It does not seem that there is a clear or even persuasive answer in the preamble to formerly proposed regulations.
As indicated, the NYSBA Report pointed out there is a conflicting interpretation of two provisions: the section 961(c) basis adjustment and the amount included in GILTI tested income. The GILTI regime expressly requires that certain provisions—such as section 961—treat GILTI inclusions in the same way as Subpart F inclusions. This GILTI requirement clashes with section 961(c) itself because its rule is stated to apply “only for the purposes of determining the amount included under section 951.”36 The difficulty arises because Congress did not amend section 961(c) to clarify how it should apply for purposes of determining GILTI tested income. This an open-ended question with no definite answer prescribed in law. This article suggests the best path forward is a strict adherence to the canons of statutory interpretation rather than a legal realism approach. There has not been much scholarship on these kinds of questions. There are no dispositive regulations, preambles, comments, case law, pending case law, law review articles, proposed bills, think tank articles, or other authorities that resolve this issue. Moreover, there do not seem to exist peremptory norms or jus cogens that resolve this issue, such as through an application of Article 53 of the Vienna Convention on the Law of Treaties. Furthermore, given that GILTI is a fairly new creation in the positive law of tax law, it does not seem—or, at least, it is unknown to the author—that there exist other cases or courts that have dealt with an analogous issue from which guidance might be drawn, such as a case from the Court of Justice in the European Union or even from the European Court of Human Rights (which sometimes deals with tax issues based off the treaty freedoms enshrined in the foundational documents and treaties forming the European Union providing for the free movement of goods, capital, services, and labor—also known as the “four freedoms” or otherwise through the Treaty on the Functioning of the European Union) or in other jurisdictions. If time passes without an authoritative answer, taxpayers will likely agree with the NYSBA Report that, lacking statutory clarity, the best solution is to treat section 961(c) basis adjustments for lower-tier CFCs as applying for both Subpart F income and GILTI tested income of upper-tier CFCs. ■