The U.S. federal tax reform legislation in the Tax Cuts and Jobs Act of 2017 brought substantial changes to the U.S. international tax provisions. As a result, certain U.S. shareholders of controlled foreign corporations (CFCs) are currently required to report and pay U.S. federal tax on a CFC’s undistributed earnings from global intangible low-taxed income (GILTI). The GILTI rules under section 951A of the Internal Revenue Code apply to different types of U.S. shareholders, including U.S. corporations and U.S. individuals that own CFCs. GILTI is an additional Subpart F anti-deferral provision designed to discourage U.S. taxpayers from leaving unrepatriated earnings offshore. While the GILTI rules impose a global minimum tax on U.S. shareholders with respect to CFC earnings, there is now some relief available.
On July 20, 2020, the IRS finalized the GILTI high foreign tax exception election regulations. The final regulations (T.D. 9902) were published in the Federal Register on July 23, 2020. At the same time, the IRS also issued proposed regulations (REG-127732-19) on the Subpart F income high foreign tax exception. The proposed regulations effectively align and conform the Subpart F income high foreign tax exception with the new rules for the GILTI exception. Subpart F income includes certain types of CFC income that result in taxable inclusions of undistributed CFC earnings to U.S. shareholders.
The GILTI high foreign tax exception allows a complete exclusion of GILTI tested income from the federal taxable income of a U.S. shareholder that owns a CFC. To be eligible for the exclusion, the CFC’s earnings must be subject to an effective foreign corporate income tax rate that is greater than 90% of the current U.S. federal corporate income tax rate. The current U.S. federal corporate income tax rate is 21%. To be high taxed, the effective foreign corporate income tax rate (ETR) must be greater than 18.9% (i.e., 90% x 21%). The ETR is calculated by dividing the foreign corporate income tax expense associated with GILTI tentative tested income by the GILTI tentative tested income plus a gross-up by the foreign corporate income tax expense. Therefore, the numerator in the calculation is the foreign corporate income tax expense associated with the GILTI tentative tested income. The denominator in the calculation is the GILTI tentative tested income plus the associated foreign corporate income tax expense. GILTI tentative tested income is basically all of the CFC’s net income that is not reduced by certain exclusions, including Subpart F income and income that is effectively connected with a U.S. trade or business (ECI). In calculating GILTI tentative tested income, it is necessary to allocate and apportion certain expenses such as interest expense to the GILTI.
For U.S. C corporation shareholders, a benefit of the GILTI high tax exception is that the excluded CFC earnings are non-previously taxed earnings and profits (in the I.R.C. section 959(c)(3) category) that can qualify for the I.R.C. section 245A 100% dividends received deduction (DRD) when repatriated. At first impression, this appears to be a great advantage. The U.S. C corporation shareholder is not required to pay U.S. tax on the undistributed GILTI earnings. The earnings are also not subject to U.S. tax when repatriated in the form of a dividend distribution. The question is whether there is a cost to this benefit, and the answer is that there could be. When a U.S. C corporation shareholder is electing the GILTI high tax exception, it is important to consider and model the overall U.S. tax consequences including the impact with respect to other CFCs. It may be great that GILTI could be excluded with respect to one CFC with high taxed earnings. However, a disadvantage is that there is a loss of foreign tax credits in the GILTI foreign tax credit limitation basket with respect to foreign corporate income tax paid at the high foreign tax rate. Depending on the U.S. C corporation shareholder’s tax profile, it could possibly benefit from utilizing the foreign tax paid at the high foreign tax rate to offset U.S. tax on GILTI from more than one CFC. In some circumstances, there could be more incremental U.S. federal tax due resulting from the loss of foreign tax credits in the GILTI basket when GILTI earnings are excluded with the high tax exception. Again, modeling is critical to determine whether the GILTI high tax exclusion is more tax-efficient from the U.S. tax perspective.
For U.S. individual shareholders of CFCs, it is necessary to consider whether the GILTI high tax exception or the I.R.C. section 962 election is more tax efficient. Unlike a U.S. C corporation shareholder, a U.S. individual shareholder cannot qualify for the I.R.C. section 245A DRD on a CFC’s dividend distribution following the GILTI high tax exception election. The I.R.C. section 962 election essentially provides an option for the U.S. individual shareholder to be taxed like a U.S. C corporation at the federal corporate tax rate on GILTI. The election allows the U.S. shareholder to claim a 50% reduction of the GILTI inclusion and a foreign tax credit for the foreign corporate income tax paid by the CFC. With the I.R.C. section 962 election, the U.S. shareholder is subject to U.S. federal individual income tax and the Net Investment Income Tax on the CFC’s distributions of the GILTI previously taxed earnings and profits (PTEP) less the U.S. tax paid on the inclusion. A major factor that impacts the analysis is whether the U.S. shareholder will be taxed on CFC distributions at the qualified dividend tax rate. This depends on whether the CFC is a qualified corporation in a treaty country and if the U.S. shareholder meets the applicable holding period requirement. In some circumstances based on the current U.S. federal corporate tax rate, the I.R.C. section 962 election could help a U.S. individual shareholder achieve a greater tax efficiency than the GILTI high tax exception.
The main cost associated with the GILTI high foreign tax exception is that GILTI foreign tax credits would not be utilized in the GILTI foreign tax credit limitation basket. There is also the loss of the excluded GILTI in the adjusted taxable income (ATI) calculation for the I.R.C. section 163(j) business interest expense limitation. The excluded GILTI is treated as exempt income in the I.R.C. section 245A subgroup for purposes of expenses that are disregarded in the foreign tax credit limitation calculation resulting in the denominator add-back under I.R.C. section 904(b)(4). These costs are contrasted with the benefits to U.S. shareholders of not reporting and paying tax on GILTI and the reduction of expenses that would otherwise be allocated and apportioned to GILTI in the foreign tax credit limitation basket.
The following are other important considerations of the GILTI high tax exception final regulations. The GILTI high foreign tax exception election must be made by the U.S. controlling shareholder(s) of a CFC group. The election applies with respect to all CFCs in a CFC group. The U.S. controlling shareholder(s) must provide a notification of the election to the non-controlling U.S. shareholders. The election is an annual election that is not binding for future years. The IRS will allow the U.S. controlling shareholder(s) to make the election on an amended U.S. federal tax return for a prior year if the amendment is filed within 24 months of the original unextended due date of the tax return. If the election is made with an amendment for a prior year, all affected U.S. shareholders must amend. The GILTI tentative tested income and ETR calculations are applied on a tested unit by tested unit basis within each CFC group. Tested units are the CFC, any foreign pass-through entity such as a foreign partnership or foreign disregarded entity owned by the CFC, and any foreign branch operated by the CFC. A combination rule aggregates a CFC and its other tested units into one tested unit if they are tax residents of the same country with an exception for non-taxed foreign branches.
The proposed regulations for the Subpart F income high foreign tax exception provide that a unified election applies to all GILTI and Subpart F income of all CFCs in a CFC group. The Subpart F income exception proposed rules apply a de minimis combination rule-based than the lesser of 1% of a CFC’s gross income or $250K USD after the same country combination rule for tested units. The Subpart F income high tax exception would apply before the Subpart F income full inclusion rule. This means that the CFC could have some residual net income that would not be Subpart F income and which could fall within the scope of GILTI.
Overall, modeling is critical to identify whether the GILTI high foreign tax exception is the most tax-efficient planning opportunity for a U.S. shareholder of a CFC. Going forward, the value of any current U.S. tax savings could decrease substantially with either the GILTI high tax exception or the I.R.C. section 962 election if the U.S. federal corporate or individual income tax rates increase. Planning to uncheck the box on any foreign pass-through entities to convert them to CFCs should be considered carefully in light of some present uncertainty regarding whether U.S. tax rates will change.
To learn more about GILTI planning opportunities available to U.S. taxpayers, download our free whitepaper, “Proving the U.S. Tax Efficiency of the GILTI High-Tax Exception.” Please contact Alison Dougherty at 301.222.8262 or ADougherty@aronsonllc.com for more information.