GILTI TAX CHANGED LANDSCAPE OF TAXES ON FOREIGN COMPANIES
Last Update: December 2021
Of all the changes to the tax system brought on by the Trump Tax Reform, perhaps the most significant and lasting change for expat business owners was the introduction of the GILTI tax regime starting with the 2018 tax year.
The GILTI tax regime changed the landscape of taxes on foreign companies by requiring current taxation of a foreign company’s business income in the hands of its U.S. owners. This has had a major impact on U.S. persons owning foreign companies who can no longer enjoy deferral of U.S. tax on business income earned abroad via a foreign company.
In this blog, we break down the GILTI rules, including the most updated modifications to the rules, as well as the key exceptions to the GILTI regime. We also include practical examples to give you a concrete understanding of how the GILTI regime can affect your business operations abroad.
INTRODUCTION TO THE GILTI TAX
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. The GILTI regime compliments the well-established “Subpart F” rules of the Internal Revenue Code, which generally apply to “passive” income (such as interest, dividends, royalties) of a CFC.
Together, the Subpart F and GILTI regimes prevent deferral of U.S. tax of both active and passive income of a foreign company owned by U.S. persons.
As to why the GILTI regime expanded the scope of the CFC anti-deferral rules to include active business income – the answer lies in another key feature of the Trump Tax Reform, which was the introduction of the so-called “participation exemption” that allows the tax free distribution of income from a foreign corporation to its U.S. parent. Without the combined force of the Subpart F and GILTI rules, a U.S. parent / foreign subsidiary structure would allow U.S. owners to repatriate business income earned abroad, including income earned in low-tax jurisdictions, without paying any U.S. tax at all (at least until dividends were distributed to the U.S. owners, who could enjoy beneficial capital gains tax rates).
MECHANICS OF THE GILTI TAX
Under new Section 951A of the Internal Revenue Code, “global intangible low-taxed income” or “GILTI” is defined as a U.S. Shareholder’s pro rata share of a controlled foreign corporation’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).
A “controlled foreign corporation” (“CFC”) is a non-U.S. corporation that is owned more than 50 percent by >10% U.S. shareholders. You can read our page on foreign companies for a full definition of “controlled foreign corporation” for U.S. tax purposes.
“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.
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.
A U.S. expat living in France sets up a limited company in Paris that provides consulting services to clients in France. The company generates €100,000 in profit per year, which is subject to French corporate tax at the rate of 28%. The company doesn’t have depreciable fixed assets.
Since the U.S. owner owns 100% of the non-US company (treated as a “corporation” for U.S. tax purposes), the company should be treated as a CFC for U.S. tax purposes. Since the company has no QBAI, €72,000 of the company’s business income (profits less foreign taxes) would be subject to GILTI tax, or current tax in the hands of the U.S. owner at ordinary income tax rates (currently the maximum rate is 37%).
EXCEPTIONS TO THE GILTI TAX
There are certain aspects of the GILTI tax that make it potentially less onerous than at first blush. Two key exceptions to the GILTI tax are as follows:
- 962 Election for Individual Owners
In brief, U.S. corporations that own 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 (this would require a foreign tax rate of at least 13.125%, so that 80% of such tax would offset the 10.5% GILTI tax).
Individual U.S. shareholders can take utilize corporate-level foreign 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.
- High-Tax Exception
In July of this year, the U.S. Department of Treasury and IRS issued final regulations that exempt active income from the the GILTI tax if the foreign effective tax rate on such income exceeds 90% of the top U.S. corporate tax rate (currently 18.9% based on the current 21% corporate tax rate).
The regulations provide detailed rules for determining a CFC’s foreign effective tax rate, using a system of “tested units,” which are defined to include the CFC, its branches and certain other pass-through entities. Under a combination rule, tested units that are resident of, or have a taxable presence in, the same country are combined for purposes of determining the effective rate of foreign tax.
The GILTI high-tax exception must be elected on the tax return of the “controlling domestic shareholder” of the CFC, generally the U.S. Shareholder(s) owning more than 50% of the CFC’s stock (or, where there are no such shareholders, all of the U.S. Shareholders of the CFC). A GILTI high-tax election may be made on or after July 23, 2020 (the effective date of the regulations). In addition, taxpayers may choose to apply the election on an amended return to taxable years that begin with the 2018 tax year.
The election may be revoked on an amended return, but requires that all U.S. Shareholders of the CFC file amended tax returns reflecting the effect of the revocation for the relevant taxable year and for any other taxable year in which the U.S. tax liability of the U.S. Shareholder would be increased by reason of the revocation.
A U.S. expat living in the United Kingdom sets up a limited company in London that provides consulting services to clients in the UK. The company generates £100,000 in profit per year, which is subject to UK corporate tax at the rate of 19%. Since the 19% corporate tax rate is higher than 90% of the U.S. corporate tax rate of 21% (which is 18.9%), the high-tax exception would apply and the limited company's income would not be subject to GILTI taxation.
If, in theory, the high-tax exception did not apply (for example, the UK corporate tax rate would be reduced in a future year), then the U.S. expat could file a 962 election, and the tax paid in the UK at the corporate level could be used to offset the GILTI tax owed by virtue of the election, which could mean that no U.S. tax would be currently owed. U.S. tax would be imposed at the individual level when a distribution is made from the UK company to the U.S. expat owner (taxation at the individual level would depend on the individual tax profile of the U.S. owner).
TAKEAWAY FOR US EXPATS
Given the potentially adverse consequences that can result from the GILTI tax rules, it is crucial that a U.S. owner of a business abroad consider the GILTI tax implications of their business structure. It also important to understand if any other CFC regimes are at play.
At Expat Tax Professionals, our international tax experts have helped a number of expats with businesses overseas navigate the CFC tax regimes, including the Subpart F and GILTI rules. Our consulting practice is dedicated to the tax issues facing business owners. We always stay on top of the latest legislative changes to make sure your business operates in the most tax-efficient manner available.
Contact us to hear more about how we can help your business abroad.