IRS Issues Taxpayer-Friendly Regulation For Individual Owners of Foreign Companies
As we’ve discussed in previous blogs, Trump’s recent tax reform focuses heavily on the operation of overseas businesses by U.S. persons. The reform installs several new regimes, which are broadly aimed at encouraging U.S. persons to repatriate funds that have been held overseas via a foreign company structure.
One such regime is the so-called Global Intangible Low-Tax Income or “GILTI” regime under new Section 951A of the Code. In brief, the GILTI tax is an annual and immediate ordinary tax in the hands of a controlled foreign corporation (CFC) owner on the CFC’s “active” (used here loosely) business income beginning in 2018.
In regulations proposed just this week, Treasury and the IRS have significantly eased the pain of the GILTI tax for individuals, by adding a provision which allows individuals to utilize the new 50% deduction against GILTI when making a so-called “962 election.”
To understand the full impact of this provision, we begin with a summary of the GILTI rules.
Introduction to the Tax on GILTI
Under new Section 951A of the Code, GILTI is defined as a U.S. 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 U.S. shareholder). “Net CFC tested income” is defined, in brief, as all of a CFC’s gross income (other than income effectively connected with a U.S. trade or business, Subpart F income, income excluded from Subpart F by virtue of the so-called “high tax” exception, and dividends from related persons) less certain deductions such as interest expense and taxes.
A CFC’s “net deemed tangible income return” is measured by multiplying the adjusted tax basis of the CFC’s “qualified business asset investment” (“QBAI”) by a deemed return of 10 percent. A CFC’s QBAI for a tax year is the average of its aggregate adjusted bases (for US federal income tax purposes, as measured as of the close of each quarter of the tax year) in “specified tangible property” used by the CFC in a trade or business and for which a deduction is allowable under Section 167 of the Code.
Easing the Pain of GILTI
There are certain aspects of the GILTI tax that make it potentially less onerous than at first blush. A default application of these rules, however, easily favors corporate shareholders over individual shareholders of CFCs.
In brief, C corporations that are U.S. Shareholders of a CFC can (1) reduce their GILTI by 50 percent under new Section 250 of the Code, and (2) claim a credit of 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 U.S. 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 U.S. federal income tax being due.
In the case of individual shareholders (or more technically, non-C corporation shareholders), however, the effective rate imposed on GILTI is potentially much higher. The reason for this is that individuals are not entitled to deduct 50 percent of their GILTI, and cannot generally claim a credit for the foreign taxes paid or accrued by the CFC on GILTI (or arguably for foreign taxes paid or accrued on the distribution of GILTI to the individual shareholder). The latter rule falls in line with the general tax principle that individuals cannot claim tax credits for foreign taxes paid or accrued by their foreign subsidiaries (so-called “indirect” tax credits). As a result, individuals can be subject to U.S. federal tax on GILTI at a 37 percent rate plus any foreign taxes imposed on the CFC’s GILTI (plus arguably foreign taxes imposed upon a distribution to the shareholder).
The 962 Election
As mentioned above, individual shareholders are by default not allowed to utilize indirect foreign tax credits – that is, unless they make a so-called “962 election” in order to claim such credits.
The 962 election is designed to ensure an individual taxpayer is not subject to a higher rate of tax on the earnings of a directly-owned foreign corporation than if he or she owns it through a U.S. corporation. Individuals who make a section 962 election are taxed as if there was a fictional domestic corporation interposed between them and the foreign corporation.
As a result, when the foreign corporation makes a distribution to the U.S. shareholder who has made a section 962 election, the individual is subject to tax on the amount of the distribution that exceeds the amount of tax previously paid as a result of the section 962 election (whereas without a 962 election, the previously taxed income would not again be subject to U.S. tax upon distribution). The tax rate on such distribution can generally be reduced to a maximum of 20% (plus 3.8% Obamacare tax) if the foreign corporation is located in a country that has an income tax treaty with the United States.
New IRS Proposed Regulation
Prior to publication of the new proposed regulations, a 962 election would allow an individual CFC shareholder to “unlock” indirect foreign tax credits (subject to the 80 percent limitation), but it was generally thought that the election would not “unlock” the 50 percent deduction under new Section 250 of the Code. This would have significantly and adversely limited the impact of the 962 election.
The proposed regulations have a provision that now definitively states that a 962 election can be used for GILTI purposes to “unlock” the 50 percent deduction as well. (See proposed regulation 1.962-1(b)(1)(i)(B)(3).)
This new rule will potentially reduce significantly or in some cases eliminate the GILTI tax for expats residing in and owning a CFC in a country that has a treaty with the United States, which has a corporate tax rate of 13.125% or higher. We caution, however, that each taxpayer’s case should be analyzed individually to understand the GILTI implications of his or her foreign company ownership.
We also note that it remains to be seen whether this provision of the regulations will be included in the final version of the regulations. The Treasury and IRS certainly won’t be hearing any complaints from taxpayers prior to finalization.
By Joshua Ashman, CPA & Nathan Mintz, Esq.