The recently enacted tax reform legislation significantly expanded the application of Subpart F, including by adding a new inclusion rule for non-routine CFC income, termed “global intangible low-taxed income” (GILTI). The GILTI rules apply higher tax rates to GILTI attributed to individuals and trusts who own CFC stock (either directly or through LLCs or S corporations) than to C corporation shareholders. This article describes the difference and suggests steps individuals and trusts may take to defer or reduce the effect of the GILTI rules on individuals and trusts.
Effective for the first tax year of a controlled foreign corporation (CFC) beginning after December 31, 2017, any US person who is a US shareholder of a CFC and directly or indirectly owns stock in the CFC on the last day of the CFC’s tax year (or the last day on which the foreign corporation is a CFC) is subject to US federal income tax on the owner’s share of the CFCs’ Global Intangible Low Taxed Income (GILTI) under new Section 951A of the Internal Revenue Code. GILTI is defined to include most business income of a CFC, reduced by 10 percent of the adjusted tax basis of the CFC’s depreciable tangible personal property (generally, plant and equipment, but not real property). The new GILTI rule, which is intended to subject all of a CFC’s above-routine income to a minimum tax, results in a significantly higher tax cost to US shareholders that are not C corporations (non-C corporation US shareholders) than to US shareholders that are C corporations (C corporation US shareholders).
In short, C corporation US shareholders are entitled to reduce their GILTI by 50 percent, are subject to a US federal corporate tax rate of only 21 percent, and are entitled to claim a credit for up to 80 percent of the foreign taxes paid or accrued by the CFC on the GILTI. As a result, the GILTI rules generally impose a US corporate minimum tax of 10.5 percent (50% x 21%) and to the extent foreign tax credits are available to reduce the US corporate tax, may result in no additional US federal income tax being due.
In the case of non-C corporation US shareholders, however, the effective rate imposed on GILTI is much higher. The reason for this is that non-C corporation shareholders are not entitled to deduct 50 percent of their GILTI, are subject to a US federal income tax rate of up to 37 percent and cannot generally claim a credit for the foreign taxes paid or accrued by the CFC on GILTI. As a result, non-C corporation US shareholders will generally be subject to US federal tax on GILTI at a 37 percent rate plus any foreign taxes imposed on the CFC’s GILTI. Steps may be taken to allow non-C corporation US shareholders to claim a credit for the foreign taxes imposed on their share of a CFC’s GILTI and to defer paying full US tax on the GILTI.
It is unclear whether or to what extent GILTI will be subject to state or local income tax or to the 3.8 percent tax on net investment income. This article addresses only the regular US federal income tax aspects of GILTI. Tax planning should take into account the potential application of the state and local and net investment income tax regimes as well as the taxpayer’s particular facts and overall tax position.
Prior to the GILTI rules, the active business income of a CFC owned by a non-C corporation US shareholder generally qualified for deferral from US tax and, when distributed, may have qualified for a reduced qualified dividend rate of 20 percent, resulting in an overall effective US regular federal income tax rate of 20 percent on such income on a fully repatriated basis. As a result of the GILTI rules, however, active business income of a CFC is generally subject to full US individual regular federal income tax at a 37 percent rate so GILTI not only eliminates deferral but also increases the effective tax imposed on the GILTI attributable to non-C corporation US shareholders of CFCs.
There are certain steps that may be taken to reduce the overall tax burden on non-C corporation US shareholders as a result of the GILTI rules. These steps may allow a non-C corporation US shareholder to obtain partial deferral of US regular federal income tax on the shareholder’s GILTI and may allow for crediting of foreign taxes (although the total tax computed on a fully repatriated basis will generally be equal to at least 37 percent).
Because of the significantly adverse impact of the GILTI rules to non-C corporation US shareholders, it is important that investment funds, family offices, US closely held companies, domestic trusts, domestic estates, and US citizens or resident alien individuals with investments in foreign corporations assess the US federal income tax impact of the GILTI provisions on their foreign investments and consider whether it may be beneficial to take advantage of one of the planning ideas discussed below.
Public Law 115-97 (the Act) ushers in a new era of US international taxation. In particular, the Act adds new Section 951A of the Code, pursuant to which US shareholders of CFCs are subject to US federal income tax on GILTI, a new category of income that is treated in the same manner as Subpart F income for purposes of applying numerous provisions of the Code (although it is not actually Subpart F income). Despite its name, GILTI is neither limited to income that is derived from intangible property nor is it limited to low-taxed income generated abroad. In general, the GILTI rules are intended to tax a CFC’s income that is not otherwise subject to US tax as Subpart F income or effectively connected income (ECI) to the extent that income exceeds a notional return on the CFC’s tangible depreciable property (10 percent of the adjusted tax basis of such property).
The GILTI rules do not apply to a CFC whose only income is passive investment income as that income would generally already be taxed under the Subpart F rules.
GILTI Included in Gross Income on the Last Day of the CFC’s Tax Year
Like the Subpart F rules, the GILTI rules apply to require any US person who is a US shareholder of a CFC on any day during the tax year and who owns (directly or indirectly) stock on the last day of the CFC’s tax year to include in gross income its share of the CFC’s GILTI. For this purpose, a US shareholder is any US person (including US citizens and resident alien individuals, US trusts, US partnerships and US S corporations) who owns, directly, indirectly or constructively, at least 10 percent of the CFC stock (by vote or by value) at any time during the CFC’s tax year. A CFC is any foreign corporation more than 50 percent of the stock of which (by vote or value) is owned by US shareholders on any day during the taxable year.
Thus, only US shareholders who own (directly or indirectly) stock in the CFC on the last day of the CFC’s tax year (or on the last day that the CFC was a CFC in the tax year) are required to include in gross income their pro rata share of the CFC’s GILTI under Section 951A. For example, if US Shareholder A sells its interest in a CFC to US Shareholder B during the tax year, and the CFC remains a CFC, only US Shareholder B is required to include the CFC’s GILTI in the year of sale.
Like Subpart F income, GILTI is generally treated as previously taxed income (PTI) for purposes of Section 959, and thus is not again subject to US federal income tax when distributed (whether distributed to a non-C corporation US shareholder or a C corporation US shareholder). In addition, GILTI inclusions treated as PTI increase the basis in the CFC stock of the US shareholder who took the GILTI into account at the end of the year.
Computation of Tax on GILTI Amount
GILTI is defined as a US shareholder’s pro rata share of the CFC’s “net CFC tested income” over the shareholder’s “net deemed tangible income return” for the shareholder’s taxable year (which amounts are determined on an aggregate basis looking at all of the CFCs owned by a particular US shareholder). “Net CFC tested income” is essentially defined as all of a CFC’s gross income (other than ECI, Subpart F income, dividends from related persons and certain foreign oil and gas extraction income) less certain deductions such as interest expense and taxes. A CFC’s “net deemed tangible income return” is essentially measured by multiplying the adjusted tax basis of the CFC’s “qualified business asset investment” (QBAI) (i.e., depreciable tangible personal property used in a trade or business) by a deemed return of 10 percent.
The Act introduced certain GILTI relief provisions, which are only applicable to C corporation US shareholders of CFCs. Specifically, new Section 250 permits C corporation US shareholders of CFCs to deduct 50 percent of the GILTI amount calculated in Section 951A (reduced to 37.5 percent beginning in 2026). Section 250(a)(1) states that this deduction applies only “in the case of a domestic corporation” for any taxable year. The Senate report specifically provides that “the deduction for GILTI… is only available for domestic corporations. U.S. shareholders that are not domestic corporations are subject to full U.S. tax on their GILTI.” The Conference report further clarifies that the deduction for 50 percent of GILTI is not available to S corporations. Therefore, a non-C corporation US shareholder of a CFC is required to include in gross income 100 percent of any GILTI attributable to it from a CFC in which it owns stock at the end of the CFC’s tax year.
In addition, in the case of foreign tax credits, the Act amended Section 960 by adding subsection (d), which essentially provides that a domestic corporation is deemed to have paid a pro rata share of up to 80 percent of the foreign income taxes imposed on the CFC’s GILTI. The Section 960 deemed paid credit rules do not generally apply to non-C corporation US shareholders.
For purposes of illustrating these rules, assume that a CFC earns $200 of income (non-ECI, non-Subpart F income), has no QBAI and pays foreign tax at a rate of 10 percent on the income (i.e., pays $20 of foreign tax). Assume further that the CFC has two equal US shareholders, USCo, a US C corporation and Individual A, a US individual. USCo may claim a 50 percent deduction on the $100 ($90 GILTI + $10 foreign taxes) attributable to it and would thus have an initial US tax liability of $10.50 ($50 x 21%). USCo may also claim a foreign tax credit of $8 ($10 x 80%). Thus, USCo would pay only $2.50 of US federal income tax on its share of the CFC’s GILTI and the effective tax rate imposed on the C corporation US shareholder’s share of the GILTI including the foreign taxes would be 12.5 percent (2.5 percent US tax plus 10 percent foreign tax).
By contrast, Individual A would be required to include the full $90 ($100 – $10 foreign tax) of the CFC’s GILTI attributable to it in gross income and would be subject to US federal regular income tax at a 37 percent rate on such income (i.e., $90 x 37% = $33.30). Individual A would also not be entitled to a credit (absent the Section 962 election described below) for the $10 of foreign taxes imposed on its $90 of GILTI. As a result, the total effective tax rate imposed on Individual A’s share of the CFC’s GILTI would be 43.3 percent.
Below we describe three steps a non-C corporation US shareholder could take to reduce or defer taxes on GILTI: electing 962 treatment, owning CFCs through a C corporation, and structuring foreign operations in pass-through form. These steps reduce but do not eliminate the disparity between the GILTI taxation of C corporation US shareholders and non-C corporation US shareholders.
Electing Section 962 Treatment
Section 962, which was in the Code prior to the Act but was not widely used, provides a special rule which allows US individual shareholders to elect to be taxed on amounts included in their gross income under Section 951(a) at corporate rates and to get the benefit of Section 960 foreign tax credits with respect to such income. The GILTI rules expressly provide that GILTI is treated as included in Section 951(a) for purposes of Section 962, so this rule should apply to GILTI as well as to regular Subpart F income. However, the 50 percent deduction against GILTI which C Corporation US Shareholders enjoy is not made available by a section 962 election. The benefits to non-C corporation US shareholders of making a Section 962 election, therefore, are
(1) GILTI is subject to US tax at the 21 percent corporate rate rather than the higher 37 percent US individual tax rate and
(2) US tax on GILTI may be offset by foreign tax credits (subject to the generally applicable foreign tax credit limitation rules). A distribution of GILTI for which a 962 election was made will be subject to US tax upon distribution to the extent that the distribution exceeds the amount of US tax previously imposed on such income under the GILTI rules and such amount will not be treated as PTI.
In the example above, if Individual A made an election under Section 962, Individual A would be able to defer paying full US individual tax on its GILTI and would be entitled to a credit for 80 percent of the $10 of foreign tax paid on its GILTI. So, again, assuming that Individual A had $90 of GILTI and $10 of foreign tax, Individual A would be subject to US tax of $13 on its $100 inclusion ($100 x 21% = $21 – $8 foreign tax credit). Upon distribution of the GILTI, Individual A would owe US regular income tax on the portion of the distribution that exceeds the $13 of US regular income tax imposed on the distributed income (i.e., $90 – $13 = $77) and such amount would not be PTI. Assuming that the $77 taxable portion of the distribution is eligible for the 20 percent US rate on dividends, the US tax due on such amount would be $15.40 resulting in an overall rate of 38.40 percent (current US tax rate of 13%, deferred US tax of 15.4 percent plus foreign tax rate of 10 percent.) Thus the Section 962 election reduces the current US regular income tax from $33.30 to $13.00, and decreases the overall US regular income tax after all income is distributed from $33.30 to $28.40.
The Section 962 election may be made by US individual shareholders including US estates and trusts as well as US individual partners of partnerships. US individual shareholders of S corporations may also be able to make this election if the income is reported to them on a Schedule K-1. The election can be made annually, but once made for a particular year, it applies to all CFCs in which the non-C corporation US shareholder owns stock at the end of that year.
Owning CFCs through a C Corporation
As an alternative to a Section 962 election, a non-C corporation US shareholder may want to consider transferring its interest in its CFC to a US C corporation. A US C corporation holding company for CFCs would be particularly beneficial where the CFC has foreign tax credits that would essentially eliminate the US corporation’s US tax liability. In that case, while the CFC’s GILTI would be included in the gross income of the C corporation US shareholder, no additional US tax would be owed assuming the foreign taxes are sufficient to eliminate the US tax liability. The non-C corporation US shareholder would not be taxed on the GILTI until distributed by the holding company to the shareholder so the US taxation of the GILTI would essentially be deferred until distributed by the US C corporation to its shareholder. As there may be other adverse consequences to putting a C corporation above a CFC owned by a non-C corporation US shareholder, the consequences of this alternative should be carefully considered.
Owning Foreign Operations in Pass-Through Form
It may also make sense to have non-C corporation US shareholders set up new foreign operations through true foreign branches or through foreign entities that they elect to treat as pass-throughs for US federal income tax purposes under the check-the-box rules in order to avoid the application of the GILTI rules (and get the benefit of foreign tax credits) going forward. This option is more easily available for wholly owned CFCs but may be difficult to achieve in the case of CFCs in which there are both US non-C corporation shareholders and US C corporation shareholders (as the US C corporation shareholders may not agree to the check the box election).
If Individual A were in a position to own a new foreign business in pass-through form, Individual A’s share of the foreign income would be subject to US tax of 37 percent, but Individual A could reduce that amount by a foreign tax credit of 80 percent of the $10 of foreign tax paid. This reduces the $33.30 in US regular income tax determined above for ownership through a CFC to $29.00 if owned in pass-through form. All the tax would be due currently, however, so that this structure would be most likely advantageous if all income is to be repatriated currently.
The new GILTI regime applies harshly to non-C corporation US shareholders of CFCs. Measures are available to reduce or partially defer the tax, but careful consideration should be given to the taxpayer’s particular circumstances and overall tax position in determining what steps make sense.
The section 962 election may be a valuable tool in softening or deferring the double-tax blow of being a U.S. shareholder in a foreign business – but careful consideration should be used before making the election. Depending on the specific circumstances, using section 962 could result in an individual paying a greater effective rate of tax on their foreign earnings once they have been repatriated. The election is administratively simpler than forming an actual intermediary corporation, simply requiring a statement to be included with an individual tax filing, but does not offer the same level of benefit in mitigating the impact of GILTI. The right choice will vary depending on each taxpayer’s unique circumstances and needs, consulting your tax professional or advisor to discuss your specific situation.
Images are not from the National Law Review
for an example where section 962 makes it worse? https://www.thetaxadviser.com/issues/2018/oct/individual-taxpayers-sec-962-election.html