The varying impact of the changes put forth by P.L. 115-97 (the “Act” or the act formerly known as the Tax Cuts and Jobs Act), requires proactive year-end planning with a vigilant eye on continuing Treasury guidance on various aspects of the Act. One effect of the Act that should be addressed by practitioners and investors prior to year-end is the impact of Section 951A or the "global intangible low-taxed income" (“GILTI”) tax. For individuals and owners of flow through entities, in particular, ownership of shares in a foreign corporation may produce unwelcome results under the GILTI tax regime.
The GILTI Tax
While in general, the Act has the salutary effect of shifting the U.S. corporate taxation of foreign earnings to a "quasi-territorial" system, this is only a benefit for certain corporate taxpayers. For example, under Section 245A, a U.S. corporation is allowed a dividends received deduction for dividends received from an active foreign corporation. Therefore, a corporate U.S. shareholder of a foreign corporation would pay zero U.S. tax on such foreign source dividends. However, this benefit only extends to corporate taxpayers, as the Act treats flow through taxpayers that own controlled foreign corporations (“CFCs”) considerably differently than corporate shareholders.
Under the regular anti-deferral regimes prior to the Act, U.S. shareholders (whether corporations or individuals) that owned 10% or more of the voting stock in a foreign corporation classified as a CFC generally were taxed on the CFC's earnings only upon receipt of a dividend. The primary exception to this rule was passive income or related party income that comprised the complex reporting rules known as the Subpart F regime. This regime required the inclusion in current income of certain types of income earned by a CFC, regardless of whether a distribution is received. A U.S. shareholder could, with proper structuring, plan around this regime and achieve tax deferral on income earned from a CFC.
However, under the Act, a new anti-deferral tax regime has been implemented—the GILTI tax. Under the rules of the new GILTI tax, any U.S. person who is a U.S. shareholder of a CFC will be will be required to include its GILTI, currently as taxable income (in addition to any Subpart F income), its share of a CFC’s undistributed GILTI, possibly including the CFC’s undistributed active business income. As in the case of Subpart F income, this inclusion would occur regardless of whether any amount is distributed to the U.S. shareholder.
The GILTI tax is effective for tax years starting after 31 December 2017 and applies to all U.S. shareholders, both corporate and non-corporate, (e.g., individuals, trusts, partnerships or S corporations). The Act also expanded the definitions describing the meaning of a CFC and a U.S. shareholder for CFC purposes. Consequently, more U.S. persons are now subject to the GILTI tax. Note that while the Act refers to “global intangible low-taxed income,” its reach goes well beyond intangible income and indeed could cause taxation on active business income that would have been excluded under the Subpart F regime. GILTI therefore potentially encompasses all income of a CFC that is not otherwise subject to tax as Subpart F income or income effectively connected to a CFC’s business including service and sales income.
Once the amount of GILTI has been determined, a corporate U.S. shareholder may claim a deduction under Section 250, subject to certain limitations, equivalent to 50% of its GILTI (reduced to 37.5% for tax years starting after 2025). Prior to the consideration of U.S. foreign tax credits, this results in a 10.5% minimum tax on a corporate U.S. shareholder's GILTI.
There is an exclusion from the application of the GILTI tax for high-taxed foreign income, but this high-taxed foreign income exclusion only applies to foreign base company income (i.e., income of a CFC that could already give rise to a Subpart F inclusion). Thus, income that is highly taxed but is not Subpart F income (and is not excluded from Subpart F by the high-tax exception) would be included in GILTI. Corporate shareholders, however, can claim a foreign tax credit for 80% of the foreign taxes associated with GILTI. Therefore, after applying the foreign tax credit, if the tested income is subject to an effective foreign income tax rate above 13.125% for tax years before 2026, and 16.406% thereafter, the corporate shareholder would have no GILTI tax (10.5%/80%= 13.125%). Flow through taxpayers, by contrast, do not benefit from foreign tax credits on GILTI, thereby, increasing the impact of GILTI on flow through taxpayers.
While the amount of a U.S. shareholder's GILTI is calculated the same for corporate and flow through taxpayers, only corporate taxpayers are entitled to the GILTI deduction and related indirect foreign tax credits. A flow through or individual taxpayer is subject to the entire GILTI tax. Further, because the GILTI tax arises from foreign sourced business operations, flow through taxpayers cannot benefit from the Section 199A deduction for this income. Therefore, under most circumstances, individual or flow through U.S. taxpayers will pay a current tax on GILTI at a rate up to 37% (the highest individual tax rate) plus a potential additional 3.8% Medicare Tax.
For both corporate and flow through taxpayers, GILTI is required to be included in gross income on the last day of the U.S. shareholder’s tax year. Therefore, GILTI planning must be in place by the last day of the U.S. shareholder’s tax year.
The Proposed Regulations
In late September 2018, the U.S. Dept. of Treasury (the “Treasury”) and Internal Revenue Service (“IRS”) issued proposed regulations (“Proposed Regs.”) for implementing the GILTI regime. Practitioners were hopeful the Proposed Regs. would add clarity, and possibly, relief for individual and flow through taxpayers affected by the GILTI tax. Unfortunately, such relief was not forthcoming.
The Proposed Regs. deal with Section 951A in three categories or phases. First, the proposed regulations offer guidance on items that are determined at the CFC level (i.e., “tested income” and “tested loss,” “qualified business asset investment” (“QBAI”), and items that reduce “net deemed tangible income return (“net DTIR”)). See §§1.951A-2 through 1.951A-4. Second, they detail the rules for determining a U.S. shareholder’s pro rata share of the CFC-level items. See §1.951A-1(d). Finally, the proposed regulations discuss the obligatory aggregation rules that lead to the determination of a shareholder’s GILTI inclusion amount. See §1.951A-1(c).
Moreover, since Section 951A does not contain any specific rules on the treatment of domestic partnerships that own stock of CFCs, Proposed Reg. §1.951A-5 is meant to provide guidance to such domestic partnerships and their partners (including S corporations and their shareholders) on how to compute their GILTI inclusion amounts.
§1.951A-5 Domestic partnerships and their partners.
Proposed Reg. §1.951A-5 provides rules regarding the application of Section 951A to domestic partnerships that own (within the meaning of Section 958(a)) stock in one or more CFCs and to partners of such domestic partnerships, including U.S. persons (within the meaning of Section 957(c)). Furthermore, the section would require a domestic partnership to provide certain information to each partner necessary for determining the GILTI inclusion amount or distributive share of the partnership’s GILTI inclusion amount.
In considering the GILTI tax treatment of flow through shareholders, the IRS uses neither a pure aggregate nor a pure entity approach, but instead proposes distinguishing between non-U.S. and U.S. shareholder partners. In using a blended aggregate and entity approach, it treats a domestic partnership as an entity with respect to partners that are not U.S. shareholders of any CFC owned by the partnership, and treats the partnership as an aggregate for purposes of partners that are themselves U.S. shareholders with respect to CFCs owned by the partnership. In particular, paragraph (b) of Proposed Regs. §1.951A-5 provides rules for determining the GILTI inclusion amount of a domestic partnership and the distributive share of such amount of a partner that is not a U.S. shareholder; paragraph (c) provides the rules for determining the GILTI inclusion amount of a partner that is a U.S. shareholder.
Proposed Reg. §1.951A-5 also provides the definitions of CFC tested item, partnership CFC, U.S. shareholder partner, and U.S. shareholder partnership, and discusses provisions applicable to tiered domestic partnerships. Finally, paragraph (g) provides examples illustrating the rules of this proposed section.
§1.951A-6 Treatment of GILTI inclusion amount and adjustments to earnings and profits and basis related to tested loss CFCs.
Proposed Reg. §1.951A-6 focuses on rules relating to the treatment of GILTI inclusion amounts and adjustments to earnings and profits and basis to account for tested losses. Particularly, this Section provides rules for the treatment of amounts taken into account in determining the net CFC tested income when applying Sections 163(e)(3)(B)(i) and 267(a)(3)(B), and also provides rules that increase the earnings and profits of a tested loss CFC for purposes of Section 952(c)(1)(A).
Clearly, the Proposed Regs. did not provide any relief from the most onerous impact of the GILTI tax for flow through taxpayers owning CFCs. In addition, the Act introduced additional changes that will cause more U.S. taxpayers than ever before to be affected by the Internal Revenue Code’s anti-deferral provisions including the GILTI tax.
Additional Changes under the Act
As previously mentioned, prior to the Act, only U.S. persons owning 10% or more of the voting stock of the CFC were treated as US shareholders. For purposes of the GILTI tax, a U.S. shareholder is defined as a U.S. person who owns (directly or indirectly) 10% or more of the voting stock or equity in a foreign corporation. Therefore, more U.S. persons will be deemed U.S. shareholders for purposes of defining a foreign corporation as a CFC.
In addition, the Act repealed Internal Revenue Code Section 958(b), which generally prevented stock owned by a foreign shareholder from being attributed downward to a domestic subsidiary. As a result, the stock attribution rules under the Act now permit treating a U.S. person as constructively owning certain stock of a foreign corporation held by a foreign shareholder (often referred to as “Downward Attribution”). This requires a careful review of ownership structures to determine if a U.S. person is being treated as a U.S. shareholder of a CFC under the Downward Attribution rules.
The Act also eliminated the requirement that a U.S. shareholder must control a foreign corporation for an uninterrupted thirty (30) day period for the foreign corporation to be treated as a CFC. Under the new rules, a foreign corporation is a CFC even if it is only a CFC for a single day in a tax year.
Possible Planning Strategies
A non-corporate taxpayer may make the election under Section 962(a) to be taxed as a C corporation and, if such election is made effective prior to the date of inclusion of GILTI in gross income for such taxpayer (typically the last day of the taxable year), the taxpayer may generally obtain the benefits of the lower tax rate applicable to C corporations and associated foreign tax credits. However, making such an election generally gives rise to a dividend level tax that may or may not produce similar results depending on the impact of state taxes, etc.
A flow through U.S. shareholder could also opt to contribute its CFC stock to a domestic corporation. Assuming that the contribution of stock is effective prior to the date of inclusion of the CFC’s GILTI in gross income for shareholders of such stock, and that the foreign corporation pays at least 13.125% of foreign taxes, the domestic corporation should generally not be subject to any additional federal income tax, resulting in a complete deferral of U.S. tax. The flow through or individual U.S. shareholder could thus receive the dividends from the U.S. corporation at the qualified dividend tax rate of 20%, meaning the CFC’s income would only be subject to 20% of U.S. tax plus the local taxes paid.
Taxpayers should consult their tax advisors prior to year-end to determine if there is room to restructure their foreign corporate holdings to avoid the impact of the GILTI tax and/or other anti-deferral provisions of the Internal Revenue Code. Please note that for tax year 2018, any retroactive relief for year-end planning will be limited by the timing of the CFC’s inclusion of GILTI income.