§1.951A-2: Calculating Tested Income and Tested Loss

Treasury Regulation §1.951A-2 provides the rules for calculating a Controlled Foreign Corporation’s (CFC) “tested income” or “tested loss.” This calculation is an input for determining a U.S. shareholder’s income inclusion under the Global Intangible Low-Taxed Income (GILTI) regime. The GILTI rules, found in Internal Revenue Code Section 951A, require U.S. shareholders to include a portion of their CFCs’ foreign earnings in their U.S. taxable income annually.

The regulation establishes a process that begins with a CFC’s gross income, subtracts certain excluded items to arrive at “gross tested income,” and then subtracts allocable deductions to yield the final tested income or loss figure. This amount from each CFC is then used by the U.S. shareholder to compute their aggregate GILTI inclusion.

Determining Gross Tested Income

The calculation starts with a CFC’s gross income for the taxable year, determined under the principles of Internal Revenue Code Section 61 as if it were a domestic corporation. From this amount, the regulations require several categories of income to be excluded to determine “gross tested income.” These exclusions prevent double taxation on income already subject to U.S. tax or governed by other anti-deferral regimes.

The specific items excluded from gross income to arrive at gross tested income are:

• Income effectively connected with the conduct of a U.S. trade or business (ECI).
• Subpart F income, which is already subject to a separate U.S. anti-deferral regime.
• Income excluded from foreign base company income due to the high-tax exception under Internal Revenue Code Section 954.
• Dividends received from a related person, which prevents the same earnings from being taxed multiple times as they move within a corporate group.
• Foreign oil and gas extraction income (FOGEI), as defined in Section 907, which is governed by a separate set of tax rules.

Allocating Deductions to Gross Tested Income

After determining gross tested income, the next step is to subtract properly allocable deductions. This is done using the allocation and apportionment principles of Treasury Regulation §1.861-8. These rules are used to separate deductions related to tested income from those related to other income, such as Subpart F income or ECI.

The process involves allocating deductions to the class of gross income to which they are directly related. For example, the cost of goods sold for inventory that generates gross tested income would be directly allocated to that income. Depreciation for equipment used exclusively in a business line that produces tested income would also be directly allocated to that category.

Expenses that are not directly related to a specific income item, such as general and administrative overhead or interest expense, must be apportioned. These deductions are apportioned between the CFC’s gross tested income and its other gross income on a basis that reasonably reflects the factual relationship of the expense to the income. The method of apportionment must be reasonable and consistently applied.

Calculating Final Tested Income and Tested Loss

Subtracting the total allocated and apportioned deductions from the gross tested income figure yields the final amount for the year. If the result is positive, it is the CFC’s “tested income.” This figure represents profitable operations whose earnings fall within the scope of the GILTI regime.

If subtracting the deductions from gross tested income results in a negative number, it is defined as a “tested loss.” A tested loss indicates that the CFC’s allowable deductions were greater than its gross tested income for the year. This loss amount is also a component of the broader GILTI calculation.

At the U.S. shareholder level, the tested income from all CFCs is aggregated and then reduced by any aggregate tested losses from other CFCs. This netting process determines the shareholder’s “net CFC tested income,” which is the base amount for the final GILTI inclusion on the shareholder’s U.S. tax return.

The GILTI High-Tax Exclusion

The regulations also provide an elective GILTI high-tax exclusion. This election allows a CFC to exclude items of income from its tested income calculation if that income was subject to a high rate of foreign tax. The election is made by the controlling domestic shareholders of a CFC and, once made, applies to all CFCs controlled by those shareholders.

The threshold for the exclusion is met if an item of income is subject to a foreign effective tax rate that is greater than 90 percent of the maximum U.S. corporate tax rate. With the U.S. corporate rate at 21 percent, this means the foreign effective rate must exceed 18.9 percent.

To apply this test, a taxpayer must separate a CFC’s income into different “testing units.” A testing unit can be the CFC itself, an interest in a pass-through entity held by the CFC, or a branch of the CFC. The gross income, deductions, and foreign taxes must be determined for each separate testing unit.

If a particular testing unit’s net income meets the high-tax threshold, that net income is excluded from the CFC’s tested income. This is an all-or-nothing test for each unit; if the effective rate is 18.9 percent or lower, the unit’s income remains in the tested income base.