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Congress introduced the GILTI tax with the TCJA at the end of 2017. The tax applies to tax years beginning after December 31, 2017. GILTI is defined as the income of a “Controlled Foreign Corporation” (CFC) that exceeds the CFC’s “net deemed tangible income return.” The latter is defined as a 10% return on the tax basis of the tangible assets of the CFC that are used in the CFC’s business, adjusted for the CFC’s interest expense. Thus, the term GILTI is a misnomer because any CFC that earns a relatively high return on its business assets can have GILTI, even if intangible assets are not directly a factor in the production of its income. Note that the GILTI tax applies with respect to the annual income of a CFC regardless of any distributions of that income by the CFC.
The tax on GILTI is applied at the level of the “U.S. Shareholder” of a CFC. A U.S. Shareholder is one who owns 10% or more, by vote or value, of a CFC, and a CFC is a foreign corporation that is more than 50% owned by one or more U.S. Shareholders. For U.S. Shareholders that are C-Corporations, the GILTI tax is ameliorated by two factors: first — and until 2025 — 50% of the GILTI income is deductible before tax is imposed, so that a C-Corporation pays no more than 10.5% in federal income tax (half the federal corporate income tax rate of 21%). Second, if the GILTI of the CFC is subject to income tax in a foreign country, a “deemed paid” foreign tax credit is available to the extent of 80% of that foreign tax, not to exceed the GILTI tax itself. Thus, if GILTI is subject to a foreign income tax of 13.125% or more, the U.S. Shareholder’s GILTI tax is eliminated. Finally, any GILTI that is distributed to the C-Corporation at a later point is not taxed again in the U.S. because it is considered “previously taxed.”
On the other hand, individual taxpayers who are U.S. Shareholders, whether directly or through a pass-through entity such as a partnership or an S-Corporation, are ineligible for both the 50% GILTI deduction and the deemed paid foreign tax credit. This means that without tax planning, such individuals will pay federal income tax on GILTI at a rate up to 37% plus state income tax, if applicable, regardless of the amount of income tax paid by the CFC on its GILTI income. The individual now must fund a significant tax liability, although the CFC might not have distributed any profits to the individual. Although the individual can receive the income taxed as GILTI without further tax — because it was “previously taxed” — by that time the tax damage has been done. By way of example, an individual U.S. Shareholder of a CFC with GILTI income that is subject to a 25% foreign income tax would incur tax in excess of 55% after considering federal, state, and Net Investment Income taxation.
Proposed GILTI Regulations were issued by Treasury in September, but these did not address the adverse taxation of individuals under GILTI, and leave questions unanswered until the next set of Regulations is issued, which is probable to occur in 2019. As of the date of this article, two potential tax planning strategies for individuals are in circulation: the Section 962 election by individuals to be subject to tax at corporate rates, and the restructuring of CFC ownership under a C-Corporation.
The Section 962 election is a long-standing provision that allows individual U.S. Shareholders to elect to be taxed as a C-Corporation on “Subpart F income”, another form of “deemed dividend” income from a CFC. A taxpayer making this election is taxed at the corporate income tax rate on that foreign income and is eligible for the “deemed paid” indirect foreign tax credit on the foreign income. However, unlike a C-Corporation, when the foreign income is distributed to the individual making that election, the amount of that distribution that exceeds the tax paid by the individual at the time of making the election is taxed again to the individual at his individual income tax rates (plus the Net Investment Income tax, if applicable). Typically, the Section 962 election is not economically beneficial unless the foreign income is subject to a high rate of foreign tax (so that the deemed paid foreign tax credit eliminates most of the federal tax at the time of the election). In the context of GILTI, it is unclear as of today whether an individual making the election would be entitled to the 50% GILTI deduction that a C-Corporation receives, so that the economic consequences of a Section 962 election for GILTI income are uncertain.
The second potential solution consists of the interposition of a C-Corporation between the individual U.S. Shareholder and the CFC. The C-Corporation becomes the U.S. Shareholder that is subject to the GILTI tax and can avail itself of the 50% GILTI deduction, as well as the deemed paid foreign tax credit. If the CFC is subject to a foreign income tax at 13.125% or more, the C-Corporation pays no residual GILTI tax and can receive tax-free distributions of GILTI earnings from the CFC (potentially subject to local withholding tax and/or foreign exchange gain or loss recognition). If the C-Corporation can redeploy those earnings into business activities, the adverse GILTI tax provisions on individuals can be postponed. Of course, future dividends from the C-Corporation to the individual owner would be taxed, but the overall tax cost to the individual would be lower, particularly on a present value basis.
Because GILTI of a CFC, like Subpart F income, is deemed to arise on the last day of the year in which such corporation is a CFC, a typical calendar year individual who owns a calendar year CFC does not recognize Subpart F income or GILTI until December 31 of that year. This gives individual taxpayers a window in 2018 within which to consider the economics of a Section 962 election, or the interposition of a C-Corporation, with respect to GILTI income in their CFCs. Individual taxpayers with profitable CFCs should consult an international tax advisor to evaluate their best option.