Good News/Bad News on GILTI Exclusion for Highly Taxed Income

I noted in my February 23, 2018 posting that the taxation of GILTI under Code §951A does not apply to foreign base company income and insurance income that is excluded from Subpart F by reason of being highly taxed by a foreign country. The way the statute was drafted, income that was NOT foreign base company income or insurance income, but otherwise would be GILTI and subject to pass-through tax, could NOT use the high tax kickout to avoid tax. I noted that this appeared to me to be a statutory glitch and was inconsistent with the policy of allowing a high tax kickout and the overall purpose of the GILTI provisions.

Others have brought this issue to the attention of Treasury in regard to comments to the GILTI proposed regulations. The bad news is that while Treasury did take those comments under consideration, in enacting final regulations it declined to extend the high tax kickout to income other than foreign base company income and insurance income under Subpart F. See Treasury Decision 9866 (6/19/2019).

The good news is that Treasury also released a proposed regulation that allows a CFC to make an election to have gross income items qualify for exclusion from GILTI if such income is subject to foreign income taxes at an effective rate that is greater than 90% of the §11 maximum tax rate. Prop. Treas. Regs.§1.951A-2(c)(6). While not entirely clear from the language of the proposed regulation (at least to me), the Preamble to the proposed regulation confirms this intent:

For the foregoing reasons, the proposed regulations provide that an election may be made for a CFC to exclude under section 954(b)(4), and thus to exclude from gross tested income, gross income subject to foreign income tax at an effective rate that is greater than 90 percent of the rate that would apply if the income were subject to the maximum rate of tax specified in section 11 (18.9 percent based on the current rate of 21 percent). See proposed §1.951A-2(c)(6)(i). . .If an election is made with respect to a CFC, the election applies to exclude from gross tested income all the CFC's items of income for the taxable year that meet the effective rate test in proposed § 1.951A-2(c)(6)(iii). Preamble to Prop Regs., Fed. Reg. Vol. 84, No. 120 at p. 29114 [REG-101828-19]. 

Back to some bad news. The proposed regulations “are proposed to apply to taxable years of foreign corporations beginning on or after the date that final regulations are published in the Federal Register, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.” Preamble to Prop Regs. If there is any doubt as to not being able to use the proposed regulations before they are finalized, the Preamble to the final and temporary regulations provides: “until the regulations described in the separate notice of proposed rulemaking are effective, a taxpayer may not exclude any item of income from gross tested income under section 951A(c)(2)(A)(i)(III) unless the income would be FBCI or insurance income but for the application of section 954(b)(4) and § 1.954-1(d).

Due Process Limitations Apply to Limit State Tax of Trust Beneficiaries

States with income taxes have varying rules on when they assert authority to tax income of trusts, based on combinations of contacts with their state of settlors, trustees, beneficiaries, assets, and management activities. In one of the more aggressive assertions of authority to tax, several states assert that they can tax the income of a trust merely because a beneficiary resides in the state. In a challenge to North Carolina’s scheme, the U.S. Supreme Court ruled that the presence of in-state beneficiaries alone does not empower a state to tax undistributed trust income when the beneficiaries have no right to demand that income and are uncertain to receive it.

In the case, the settlor formed a trust for his children in his home state of New York. The trustee of the trust was a New York resident. Trust documents and records were kept in New York, and the asset custodians were in Massachusetts.The trust granted the trustee absolute discretion to distribute assets to the beneficiaries. One of the children moved to North Carolina, and North Carolina sought to tax all the income of a subtrust because that child was a North Carolina resident. The child had no right to, and did not receive, any distributions from the trust.

The Court based its decision on the requirements of the Due Process Clause of the U.S. Constitution, which limits states to imposing only taxes that bear fiscal relation to protection, opportunities and benefits given by the state. Some definite link, some minimum connection, is required so that the income attributed to the state for tax purposes be rationally related to values connected with the taxing state. Applied to beneficiaries, this results in taxation turning on the extent of the in-state beneficiary’s right to control, possess, enjoy, or receive trust assets.

A key aspect was that the beneficiary could not count on necessarily receiving any specific amount of the income in the future. The Court noted that the assets of the trust could end up with others, and that the beneficiary had no power to assign her interest.

Some preliminary thoughts/observations:

     a. The use of a purely discretionary trust to avoid state income tax when a beneficiary resides in a state with an income tax is a valid planning mechanism, so long as no other ties and connections with the taxing state exist. It would appear that a spendthrift clause that prevents a beneficiary from assigning his or her beneficial interest is a necessary aspect of such planning. Of course, such planning has real world consequences, such as limited access to, and rights over, trust assets by the beneficiary.

     b. Would a power of appointment over trust assets in a discretionary trust by the in-state beneficiary give rise to taxing jurisdiction? This was not discussed in the case. If presently exercisable in the subject tax year, then probably yes. If not presently exercisable, maybe not.

     c. Would a right to receive all or a share of trust assets at a given future age give the requisite taxing nexus for an in-state beneficiary? This fact was present in the case. However, in the case there were facts that made this future right contingent which appear to have influenced the court, such as the ability for the trust to be re-written to exclude such a right under decanting provisions of law (which power was actually exercised after the tax years in issue) and that the trustee could exclude one beneficiary to the benefit of another.

     d. The Court noted that tests of nexus are different as to rights of settlors, trustees and beneficiaries. For example, prior precedent confirms that a resident trustee is enough nexus for state income tax, as well as residence of a settlor (at least where the settlor retains rights over the trust assets, such as a power of revocation). I believe there is at least one state that asserts continuing taxing jurisdiction over a trust with no contacts with the state other than the settlor was a resident of the trust at creation – perhaps a challenge to that nexus authority may be forthcoming based on the principles elucidated in this case.

     e. For practitioners in states without a state income tax on individuals, the case is still relevant, since in preparing or advising on a trust in your state you should still be planning for the circumstance of beneficiaries who reside in other states.

NORTH CAROLINA DEPT. OF REVENUE v. KIMBERLEY RICE KAESTNER 1992 FAMILY TRUST (U.S. Supreme Court 2019)

Limits on Effects of Order Determining Homestead on Title [Florida]

A recent appellate decision addresses the effect of an order determining homestead vis-à-vis title to the homestead. In the case, a decedent left her homestead by will to her three children. The will also provided a life estate in the property to two of the children. The probate court entered an order determining homestead, which determined that the homestead property was divided in equal shares to the children, but did not mention the life estate provided for in the will. The trial court determined the order determining homestead divested the life tenants from their life estate per the absence of any mention of the life estate (thus allowing partition of the property to proceed on petition of two of the children). Florida’s 5th DCA reversed the trial court, and held that the order determining homestead did not terminate the life estate provided for in the decedent’s will.[1] The appellate court noted that the homestead order did not create new rights, but only explained or clarified the rights that already existed by operation of law.

The appellate court rejected arguments that the children’s consents to the homestead order altered the parties’ individual interests in the estate. It also ruled that the order was not a title transaction within the meaning of Fla.Stats. §712.01(3) noting:

the Homestead Order in this case does not constitute a title transaction, as defined by section 712.01(3), Florida Statutes (2011), extinguishing the life estates in the property. ‘A title transaction within the meaning of this act is defined in section 712.01(3), Florida Statutes, and means any recorded instrument or court proceeding which affects title to any estate or interest in land and which describes the land affected with legal sufficiency.’ Cunningham v. Haley, 501 So. 2d 649, 652 (Fla. 5th DCA 1986). Although the probate and recording of a will constitutes a title transaction within the meaning of section 712.01(3), see Mayo v. Owens, 367 So. 2d 1054, 1057 (Fla. 1st DCA 1979); Kittrell v. Clark, 363 So. 2d 373 (Fla. 1st DCA 1978), Kenneth and Carla point to no authority holding or suggesting that an order determining homestead property constitutes the same.

Mullins v. Mullins, No. 5D18-1672, 2019 WL 2396753, at *4 (Fla. Dist. Ct. App. June 7, 2019)noting