When it comes to the new GILTI tax, individual shareholders can have dual personalities
- A new tax imposed on certain earnings of controlled foreign corporations (CFCs) hits individual shareholders harder than corporations
- An individual shareholder can elect to be treated as a corporation with respect to these earnings in any given year, mitigating or eliminating the impact of the new tax
A recent U.S. tax imposed on certain foreign income threatens to hit individuals (including trusts or estates) who own controlled foreign corporations (CFCs)1 harder than their corporate counterparts, who benefit from certain deductions, credits, and lower rates unavailable to individuals. But there’s a way out: An individual shareholder can choose to be treated as a corporation with respect to the new tax in any given year. The shareholder can make a so-called “Section 962 Election” when the return is filed, several months after the taxable year is over, and can freely change his or her election from one year to the next. This permits the taxpayer to use hindsight each year to determine whether it is favorable to make the election.
In many cases, because of certain corporate deductions, entitlement to foreign tax credits, and lower corporate tax rates, electing to be taxed in the same manner as a corporation will be much more favorable for individual shareholders who own foreign corporations directly or through partnerships. Given that an individual taxpayer can change his or her election from year to year, a comprehensive evaluation of the individual shareholder’s particular circumstances should be made at the end of each taxable year.
Global intangible low-taxed income (GILTI) is a new category of CFC income added by Congress in 20172 as part of an effort to stop U.S. taxpayers from migrating intangible property, and the income it produces, to offshore tax havens. Generally, the tax is designed to reach a CFC’s earnings from intangible, highly mobile assets, such as patents, trademarks, and copyrights, by taxing the CFC’s U.S. shareholders on earnings that exceed a 10-percent return on the tax basis of the CFC’s depreciable tangible property. Because of the formulaic nature of the tax, it can reach income that is decidedly not generated from intangible property. The new regime taxes the U.S. shareholders on their pro rata portion of the CFC’s GILTI even if there is no actual distribution of earnings to shareholders.
The GILTI tax will have the most impact on individual U.S. taxpayers who hold CFC shares either directly or through an entity taxed as a flow-through by the U.S. because such individuals will be required to take into income their pro rata share of the CFC’s GILTI at the full individual ordinary rate (up to 37%), regardless of whether the CFC distributes cash to those shareholders. Further, GILTI inclusions do not have the status of “qualified dividends” and cannot benefit from the 20% capital gains rates sometimes available to actual dividends.
Corporate U.S. shareholders also take into account their pro rata share of the CFC’s GILTI, but three key tax attributes mitigate its effects on corporate shareholders:
- Lower Corporate Tax Rate: Corporations are taxed at a maximum 21% federal rate, compared to an individual’s top rate of 37%.
- GILTI Deduction3: Corporate shareholders are generally entitled to deduct one-half of the GILTI they would otherwise have to include as taxable income, further cutting the federal tax rate on GILTI from 21% to 10.5%, while individuals receive no such deduction.
- Foreign Tax Credits: Corporate shareholders of a CFC may credit up to 80% of the foreign taxes paid by the CFC on its items of GILTI,4 which can reduce even further their effective U.S. tax rate on GILTI, while individuals do not get the benefit of any such “indirect” foreign tax credits.
The combination of these three factors means corporate shareholders are taxed on GILTI at significantly lower rates than their individual counterparts.
Enter the Section 962 Election
Internal Revenue Code Section 962 allows non-corporate U.S. shareholders of a CFC to elect to be taxed as a corporation on amounts currently included as income under the GILTI and subpart F regimes. Essentially, the election interposes an imaginary domestic corporation between individual shareholders and a CFC. If a taxpayer makes the Section 962 Election, the tax benefits that apply to corporate shareholders of CFCs would apply to the individual shareholder’s GILTI and subpart F inclusions, giving the shareholder the benefit of the GILTI deduction, foreign tax credits, and the lower corporate tax rate on the initial GILTI inclusion.
When amounts are actually distributed by the CFC to the U.S. shareholder, the individual tax rate is imposed on such distribution, but assuming that the CFC qualifies for benefits under a U.S. tax treaty, it is expected that the distribution would qualify for the 20% capital gains rate.5 But this additional “individual” tax is not imposed until an actual distribution is made. As a result, the tax might be deferred indefinitely as long as there is no need to distribute the earnings of the corporation.
A Section 962 Election might eliminate the GILTI tax on the initial inclusion if the effective foreign tax rate on the GILTI income is at least 13.125%. In such cases, the CFC can re-invest its earnings locally, without making distributions to its individual shareholders to pay taxes. The chart below compares the tax treatment of an individual shareholder who has made a Section 962 Election against the tax treatment of one who has not made the election, assuming GILTI inclusions of $100 and a foreign tax rate of 10%.
GILTI Taxation of Individual: Comparison With and Without Section 962 Election
|Taxation in Year GILTI Earned by CFC|
|Deduction under §250||$50||N/A|
|Less Foreign Taxes Paid||-||$10|
|Taxable Income Inclusion in Current Year||$50||$90|
|Tax in Current Year||$10.50||$33.50|
|Less: 80% Foreign Tax Credit||($8)||N/A|
|Total Inclusion-Year Tax||$2.50||$33.50|
|Taxation in Year of Distribution to U.S. Shareholder|
|TOTAL TAX IMPOSED ON INCLUSION & DISTRIBUTION||$20.50||$33.50|
The chart illustrates that it may be advantageous for an individual U.S. shareholder of a CFC to make the Section 962 Election, even after taking into account the additional tax upon the actual distribution of the CFC’s earnings. But whether the election is advantageous depends on the facts of each situation. For example, when the shareholder sells his or her CFC interest, a Section 962 Election might increase the shareholder’s tax burden under some sale structures. However, because the Section 962 Election is made after the tax year closes with the benefit of hindsight, a taxpayer can avoid making the election in years when it provides no advantage.
Accordingly, an evaluation of the merits of a Section 962 Election should be made on a yearly basis for each U.S. individual, trust, or estate that holds stock in a CFC.