The Tax Cuts and Jobs Act (TCJA) enacted various U.S. international tax provisions. The new law includes the U.S. federal tax on global intangible low-taxed income referred to as GILTI. The GILTI rule applies to U.S. shareholders of controlled foreign corporations (CFCs). Effective on January 1, 2018, a U.S. shareholder of a CFC is required to report and pay U.S. federal tax on their share of a CFC’s non-previously taxed and undistributed earnings on an annual basis. The GILTI reporting requirement applies if the U.S. shareholder owns at least 10% of the CFC’s vote or value while taking into account direct, indirect, and constructive ownership. However, the U.S. shareholder reports GILTI only to the extent of their direct and indirect ownership percentage of the CFC through other foreign entities even if less than 10%.
A U.S. individual shareholder generally may not claim a foreign tax credit for the CFC’s foreign corporate income taxes paid when reporting GILTI on the U.S. federal tax return. However, a U.S. individual shareholder may file an election to mitigate the impact of the U.S. federal tax on the GILTI. The IRC section 962 election allows a U.S. individual shareholder of a CFC to achieve the same level of parity with a U.S. corporation taxpayer. With the election, a U.S. individual is able to claim a foreign tax credit for the CFC’s foreign corporate tax to offset the U.S. federal tax on the GILTI. The election also allows a 50% deduction of the taxable GILTI under IRC section 250. Based on the election, the U.S. individual is subject to the U.S. tax on the GILTI at the 21% U.S. federal corporate tax rate instead of the U.S. federal individual tax rate. The combined benefits of the election with the 50% deduction, the lower U.S. corporate tax rate, and the foreign tax credit make the CFC ownership structure more tax efficient for a U.S. individual shareholder. The tradeoff is the IRC section 78 gross up requirement and the U.S. tax on the actual distribution of the earnings that were subject to the U.S. tax on the GILTI. The gross up increases the taxable GILTI amount by the creditable foreign tax. A distribution of the GILTI previously taxed earnings and profits (PTEP) is taxed to the U.S. shareholder as a dividend. However, the taxable amount of the dividend distribution is decreased by the U.S. tax paid on the GILTI based on the mechanics of the IRC section 962 election.
Before the U.S. federal corporate tax rate was decreased from 35% to 21%, the possible tax savings arbitrage with the IRC section 962 election generally was not as effective to decrease the U.S. tax on CFC Subpart F income or an IRC section 965 transition tax inclusion. With the lower U.S. federal corporate tax rate currently in effect, the election can make a significant difference resulting in more favorable tax savings to a U.S. individual shareholder of a CFC.
The mechanics of the IRC section 962 election in many U.S. individual tax return preparation software applications were somewhat of a technical challenge for the 2018 tax year. It was necessary to implement certain shortcuts and workarounds in the software to get the election to function properly in the 2018 U.S. federal individual tax returns. Aronson’s U.S. international tax services team mastered the 2018 tax year GILTI reporting for U.S. individual shareholders that make the IRC section 962 election. While it is hopeful that updated software will better address the mechanics of the election for the 2019 tax year, Aronson’s team is prepared to leverage its efficiencies for the upcoming tax season in the new year 2020.
For more information regarding how a U.S. individual shareholder of a CFC could save U.S. tax on GILTI and Subpart F income, please contact Alison Dougherty at 301.222.8262.