As we’ve discussed in previous blogs, Trump’s 2017 tax reform made major changes to the taxation of overseas businesses owned by U.S. persons. The reform installed 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 narrowed the scope of the GILTI tax, by adding a provision which excludes income of a CFC that is subject to “high tax” in the foreign company’s country of incorporation, whether such income is active or passive in nature. As discussed below, the proposed regulation defines “high tax” to mean tax at a rate of 90% of the U.S. corporate income tax rate of 21%, or 18.9%. This would mean that U.S. shareholders of CFCS in countries with an effective corporate tax rate that is higher than 18.9% would generally not be subject to the GILTI tax.
To understand the full impact of this proposed 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 less certain deductions such as interest expense and taxes, but it does not include income effectively connected with a U.S. trade or business, Subpart F income, and dividends from related persons. As we will focus on further below, it also does not include income excluded from Subpart F by virtue of the so-called “high tax” exception.
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.
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.
Individual U.S. shareholders can take utilize corporate-level taxes, subject to the above two rules, by filing a so-called “962 election,” an election which 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 PROPOSED REGULATION
As explained above, one of the exceptions to GILTI is Subpart F income that is exempted from current inclusion under the high-tax exception. In the first iteration of the GILTI rules, the IRS stipulated that the exception only applied only to Subpart F income. This would mean that the active business income of a CFC would remain generally subject to the GILTI tax.
In a total reversal of its original position, the IRS has now issued proposed regulations providing for an election to exclude from gross tested income, gross income subject to foreign income tax at an effective rate that is greater than 90% of the rate that would apply if the income were subject to the U.S. maximum rate of tax (i.e., 21%). The resulting 18.9% rate is below the corporate tax rate in many countries, including the UK, Australia, and dozens of others.
The CFC’s controlling domestic shareholders would be responsible for making the election by attaching a statement to an amended or filed return for the inclusion year. It would be binding on all U.S. shareholders of the CFC. Under the regulations, the election would be revocable, but once revoked, a new election generally could not be made for any CFC inclusion year that begins within five years after the close of the CFC inclusion year for which the election was revoked.
THE EFFECTIVE DATE OF THE NEW REGULATION
We believe that the high-tax exception to the GILTI tax will mean a significant reduction in the tax reporting and compliance costs for many foreign business owners.
The one drawback of the proposed regulation, however, is its applicability date. The proposed regulation, if finalized, would apply to tax years of foreign corporations beginning on or after the date of publication of the final regulations, and to tax years of a U.S. person in which or with which such tax years of foreign corporations end. In most cases, this would probably mean that the expansion of the high-tax exception would apply starting with the 2020 tax year.
We note that it remains to be seen whether this provision of the regulations will be included in the final version of the regulations, but the Treasury and IRS certainly won’t be hearing any complaints from taxpayers prior to finalization.