An individual or trust US shareholder of a controlled foreign corporation (CFC) faces harsh treatment under the global intangible low-taxed income (GILTI) regime. These tax implications have forced these taxpayers to pursue planning to mitigate their US tax liability. Now that the US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) have finalized regulations permitting a US shareholder to elect the GILTI high-tax exclusion for its GILTI inclusion amount, noncorporate US shareholders should analyze the benefits and costs of using this additional planning tool.
The GILTI regime requires a US shareholder of a CFC to include a significant amount of the CFC’s income in its gross income on an annual basis. In so doing, a domestic C corporation shareholder can reduce its US tax liability associated with GILTI by claiming a deduction equal to 50% of its GILTI amount, and by also claiming a foreign tax credit equal to 80% of foreign taxes paid or accrued. As a result, a domestic C corporation shareholder generally has a US effective tax rate of 10.5% on its GILTI inclusion, which can be further reduced or even eliminated to the extent the US shareholder may claim a foreign tax credit to offset its US tax liability.
By contrast, a noncorporate US shareholder cannot claim the 50% deduction or a foreign tax credit with respect to its GILTI inclusion amount, and such amounts are subject to US federal income tax at 37% plus the 3.8% net investment income tax. Thus, absent any planning, the GILTI rules apply significantly higher US tax rates on GILTI attributed to noncorporate US shareholders than to domestic C corporation shareholders.
Noncorporate US shareholders have generally reduced the effect of GILTI by either making a section 962 election to be subject to corporate tax rates (thereby permitting a 50% deduction and a foreign tax credit), by contributing the shares of CFCs to a domestic C corporation, by engaging in check-the-box planning to treat each CFC as a transparent entity for US federal income tax purposes or as described in more detail below, by making an election to exclude certain high-taxed GILTI from its gross income under the GILTI high-tax exclusion.
GILTI High-Tax Exclusion as an Additional Planning Tool
In June 2019, Treasury and IRS issued proposed regulations (REG-101828-19) (the “Proposed Regulations”) providing US shareholders with the ability to exclude GILTI tested income subject to a foreign tax rate in excess of 18.9% from its GILTI determination (the “GILTI high-tax exclusion”).
Many practitioners viewed the GILTI high-tax exclusion in the Proposed Regulations as having limited utility, since the GILTI high-tax exclusion applied for all future tax years once elected, and if revoked, US shareholders were prevented from re-electing the GILTI high-tax exclusion for 60 months. The Proposed Regulations also provided that the GILTI high-tax exclusion applied only for a CFC’s tax year beginning on or after the rules were finalized.
On July 23, 2020, Treasury and the IRS published final regulations on the GILTI high-tax exclusion (85 FR 44620) (the “Final Regulations”). The Final Regulations include several similarities to the Proposed Regulations, including that the GILTI high-tax exclusion must be elected by a “controlling domestic shareholder” of a CFC (generally, US shareholders who own more than 50% of the vote), that the election is binding on all other US shareholders of the CFC and that the election applies to all CFCs in a “controlling domestic shareholder group” (despite several taxpayer comments requesting that the election be made on a CFC-by-CFC basis).
Despite these similarities, the Final Regulations make several significant changes that may impact whether noncorporate US shareholders may consider electing the GILTI high-tax exclusion. In particular, the Final Regulations provide US shareholders with additional flexibility by permitting US shareholders to elect the GILTI high-tax exclusion on an annual basis without imposition of the 60-month limitation. The Final Regulations also permit US shareholders to choose to apply the GILTI high-tax exclusion retroactively to taxable years of CFCs that begin after December 31, 2017.
Conformity with Subpart F High-Tax Exception
On the same day as issuing the Final Regulations, Treasury and the IRS also issued proposed regulations on the Subpart F high-tax exception under section 954(b)(4) (REG-127732-19). These proposed regulations generally conform the Subpart F high-tax exception to the GILTI high-tax exclusion. As a result, a noncorporate US shareholder analyzing the benefits of electing the GILTI high-tax exclusion should include in its modeling any Subpart F income items that may so qualify for the Subpart F high-tax exception. See our On the Subject for a more complete description of the proposed regulations on the Subpart F high-tax exception.
Benefits and Costs of the GILTI High-Tax Exclusion
Opportunity for Deferral
In many cases, noncorporate US shareholders have already reduced the effect of GILTI by either making a section 962 election or by contributing the shares of CFCs to a domestic C corporation. While these tools offer a substantial benefit for US shareholders, especially those with high-taxed CFCs (i.e., since the foreign tax credit mechanism generally results in no residual US taxation where the foreign effective tax rate exceeds 13.125%), noncorporate US shareholders should also consider the potential utility of the GILTI high-tax exclusion.
The GILTI high-tax exclusion may provide noncorporate US shareholders the ability to defer US taxation on net tested income in certain cases, which may help improve short-term or medium-term cash flow requirements for noncorporate US shareholders as well as the businesses they operate. For example, a noncorporate US shareholder that made a section 962 election or that contributed the shares of CFCs to a domestic C corporation, could use the GILTI high-tax exclusion to mitigate any residual US taxation on GILTI where the application of the expense allocation and apportionment provisions results in a foreign tax credit limitation under section 904 principles, or where the utilization of losses adversely impacts the taxable income limitation under section 250.
Because the GILTI high-tax exclusion may be made on an annual basis, noncorporate US shareholders have the ability to alternate between the GILTI high-tax exclusion and the section 962 election on an annual basis to the extent that may prove advantageous.
Modeling the Tax Impact of the GILTI High-Tax Exclusion
Since gross income earned by high-taxed CFCs is not included in the US shareholder’s GILTI amount, noncorporate US shareholders should model the impact of corresponding tax attributes on its overall GILTI tax liability. Specifically, each high-taxed CFC’s qualified business asset investment (QBAI) and foreign taxes paid or accrued can no longer be included in determining each US shareholder’s GILTI tax liability. This is especially important because GILTI tax liability is determined on a net basis, aggregating all CFCs a US shareholder owns. If some CFCs are subject to a high tax rate and others subject to a low tax rate, the high-tax exclusion will eliminate the benefit of the high-tax CFCs’ foreign tax credits being netted against the GILTI generated by the low-tax-rate CFCs. Similarly, to the extent that high-tax CFCs may have a large amount of QBAI, making the election will result in the loss of that QBAI, potentially increasing GILTI amounts generated by low-tax CFCs’ tested income.
Noncorporate US shareholders should also take into account whether electing the GILTI high-tax exclusion may impact any investments in US property, since gross income earned by high-taxed CFCs will no longer generate previously taxed earnings and profits (PTEP), but instead, will generate untaxed earnings and profits (E&P) that may be included as part of the CFC’s “applicable earnings” that could be treated as a section 956 inclusion to the US shareholder.
Moreover, a noncorporate US shareholder should consider whether distributions from its high-taxed CFCs may be eligible for the 20% qualified dividend income tax rate (i.e., if the CFC is incorporated in a jurisdiction that has entered into a tax treaty with the United States). A noncorporate US shareholder of a non-treaty jurisdiction CFC may be subject to lower tax rates on distributed income by not electing the GILTI high-tax exclusion or a section 962 election. Alternatively, such shareholder may consider converting the CFC into a transparent entity or by changing the place of incorporation of the CFC to a country that has entered a tax treaty with the United States.
The GILTI high-tax exclusion offers a certain simplicity with respect to the US taxation of CFC operations, insofar as it avoids the complexity of applying the foreign tax credit limitation provisions, as well as tracking new classes of “section 962 earnings and profits.” Although certain noncorporate US shareholders could find this appealing, such shareholders should balance this simplicity with other kinds of complexity created by the Final Regulations.
Whereas the Proposed Regulations applied a qualified business unit (QBU) approach to identify the relevant items of income that may be eligible for the GILTI high-tax exclusion, the Final Regulations replace the QBU-by-QBU approach in the Proposed Regulations with a new “tested unit” standard. By any measure, the tracking and reporting of “tested units” will create additional administrative burdens for taxpayers, especially for noncorporate US shareholders that may not have the internal tax and bookkeeping resources that large US multinationals do. A more robust summary of the key changes found in the Final Regulations is found in our On the Subject.
Noncorporate US shareholders now have another tool in their arsenal to mitigate the GILTI tax liability resulting from the harsh application of GILTI. In certain circumstances, the GILTI high-tax exclusion could prove useful for noncorporate US shareholders to mitigate their GILTI tax liability, even in conjunction with other planning tools. Noncorporate US shareholders should carefully analyze the merits of the GILTI high-tax exclusion and would be well advised to model the benefits of GILTI high-tax exclusion with, and against, other planning tools.