Next major international tax provision coming into effect soon (Hint: “GILTI”)
By Kyle Lodder, CPA
In December 2017, Congress passed into law sweeping tax reform with the Tax Cuts and Jobs Act. There are a few provisions that impact international taxation quite significantly.
One major change went into effect immediately during the 2017 tax year – the Section 965 repatriation tax. We’ve previously written on this topic. You can read more about this law here. It’s a one-time transition tax that won’t impact taxpayers going forward.
A second major change is the creation of a new system, namely the Global Intangible Low-Taxed Income (“GILTI”) tax system as codified in the Internal Revenue Code Section 951A.
Perhaps the name is misleading. It doesn’t give us too much indication of the law’s broad reach. Don’t be fooled! This system will impact many U.S. taxpayers who own an interest in a non-U.S. corporation.
This tax provision comes into effect for the 2018 tax year. Barring any change by the legislators, this system is here to stay for years to come. As such, it’s important to have some base knowledge of the system and to plan accordingly.
We’ll dive into the basics of this new GILTI tax system and offer some tax planning ideas that should be considered, perhaps even before year-end.
U.S. citizens or residents report their worldwide income on the U.S. individual income tax return. The general rule is that income earned within a foreign (or domestic) corporation is not treated as income on the U.S. shareholder’s U.S. federal income tax return. This allows the taxpayer the opportunity to defer recognition of the corporate income until a later date when the accumulated profits are distributed in the form of a taxable dividend to the shareholder.
Decades ago, U.S. lawmakers enacted certain anti-tax deferral provisions in response to perceived abuse of this general rule to disincentivize U.S. taxpayers from holding passive investments in foreign corporations. If thresholds are met, adverse tax implications will apply to the taxpayer.
GILTI is the latest addition of the anti-tax deferral regimes. Although GILTI impacts multi-national corporations, our focus here is related to individuals who are shareholders of non-U.S. corporations.
Basics of the GILTI system
A U.S. taxpayer who owns a non-U.S. corporation may be subject to the GILTI system if the person is deemed to own shares in a Controlled Foreign Corporation (“CFC”). If U.S. persons have stock ownership control of the corporation by vote or value, then CFC status may be met. There are specific rules that should be analyzed when making the determination. If the company is not a CFC, then GILTI does not apply but other onerous anti-tax deferral rules may apply.
If a taxpayer has determined that he owns shares in a CFC, then the anti-tax deferral rules should be analyzed for applicability. The well-established Subpart F rules should first be considered. Then the newly issued GILTI rules need to be considered.
The GILTI definition is essentially as follows:
GILTI is the excess, if any, of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return. The shareholder’s net deemed tangible income return is an amount equal to 10% of the aggregate of the shareholder’s pro rata share of the qualified business asset investment of each CFC with respect to which it is a U.S. shareholder.
There are many terms within this GILTI definition that also need to be defined. For our purposes, we will oversimplify the terms so that we can ensure a base understanding of the rules. Obviously, this doesn’t replace the more sophisticated analysis necessary for real-life situations.
In basic terms, the net CFC tested income is perhaps best understood as the shareholder’s pro-rata share of the corporate taxable income, with some adjustments. If a taxpayer owns multiple CFCs, then we’d net the pro-rata income amongst all companies to get an aggregated figure.
The term “qualified business asset investment” is essentially the adjusted cost basis of tangible depreciable property used in the ordinary course of business.
A very basic example
U.S. taxpayer owns 100% of a non-U.S. corporation. The corporation provides engineering services in a foreign country. The corporation generates $300,000 USD of corporate net income. No dividends are paid to the owner. The company’s only tangible depreciable property is computer equipment and office furniture with a total adjusted cost basis of $10,000.
GILTI equals $300,000 minus ($10,000 multiplied by 10%). The result is GILTI of $299,000.
The GILTI amount is included as an income inclusion on the shareholder’s U.S. federal income tax return. It’s not treated as a qualified dividend taxed at preferential rates. Rather, it’s treated as ordinary income taxed at the graduated rates.
Foreign tax credits may be applicable to offset the U.S. tax liability associated with the deemed GILTI income inclusion on the shareholder’s U.S. federal tax return. However, this may be quite limited unless certain restructuring or elections are made.
GILTI not only eliminates deferral. It also generally increases the effective tax rate on the income to the U.S. taxpayer. Furthermore, these rules are causing many shareholders of non-U.S. operating corporations to now be subject to the anti-tax deferral rules. Service companies and similar companies with very limited depreciable assets will most certainly be subject to GILTI and be required to recognize the corporate earnings as income on the U.S. personal tax return.
What planning options are available to mitigate the adverse U.S. tax implications?
Taxpayers should look to time the income recognition in the U.S. with the foreign country. The simplest approach would be to distribute the corporate profits. This can be done with a dividend or by paying additional salary to the shareholder. This often results in an efficient use of foreign tax credits to avoid double taxation.
Another option is to make certain tax elections. The individual shareholder may want to consider making a Section 962 election to be treated as a corporation for these tax purposes. This may allow the income to be taxed at lower corporate rates. There is a special corporation-only GILTI deduction that the individual may be able to utilize. Finally, they should be eligible for at least some benefit of corporate foreign income taxes paid as a foreign tax credit at the U.S. individual shareholder level. This approach is more complex, but it could make sense for certain taxpayers.
Rather than making the Section 962 election, the U.S. individual taxpayer may want to consider transferring his or her shares in the non-U.S. corporation to a U.S. domestic C corporation. Although GILTI would be included as income to a U.S. C corporation, the foreign corporate taxes paid would be eligible to be claimed as a foreign tax credit on the U.S. federal corporate tax return to offset the U.S. tax associated with the GILTI income inclusion. One downside though is that there is additional tax on actual distributions.
Another tax election is to make the “check-the-box” election to treat the foreign corporation as a partnership or disregarded entity for U.S. federal income tax purposes. The result is that the income from the foreign entity flows-through and is taxed at the individual shareholder level. This approach avoids the complex GILTI computations. It also allows the foreign corporate income taxes paid to be used as a foreign tax credit. Also, dividends to the shareholder will be tax-free. Care should be taken with the switch from corporate to flow-through status, as significant tax could result from the conversion.
There are certain entity types in the foreign country of residency and business operations which may make better sense than the standard foreign corporate structure. In Canada, for example, the use of an unlimited liability company (“ULC”) could make sense. It’d be treated as a corporation for Canadian tax purposes, but treated as a flow-through entity for U.S. purposes. GILTI would be avoided and the foreign corporate taxes paid could be used on the U.S. return to reduce the U.S. tax liability. Again, care should be taken to watch out for U.S. tax related to the conversion.
Another thought would be to restructure the shares so that the U.S. shareholder isn’t eligible for any distribution rights. The U.S. shareholder is not attributed pro-rata share of the GILTI if they don’t have any distribution rights. This may be a viable option for U.S. shareholders who own a foreign corporation with others.
It should be noted that the planning has only considered federal tax law considerations. There are state income tax implications that should be considered, which may differ from the federal rules.
In conclusion, the new GILTI tax provision is very complex and nuanced. There are many complexities in the calculation itself. Certain tax elections and restructuring options should be considered to mitigate the federal and state income tax liability.
Taxpayers would be well advised to seek the help of qualified U.S. international tax advisors to navigate these complexities.
If you require additional information on any aspect of these complex rules, please contact Kyle Lodder at 360.599.4340 or firstname.lastname@example.org. Kyle Lodder is a Certified Public Accountant and is the owner of Lodder CPA PLLC, a U.S. international tax firm.
The material appearing in this communication is for informational purposes only and should not be construed as legal, accounting, or tax advice or opinion provided by Lodder CPA PLLC. This information is not intended to create, and receipt does not constitute, a legal relationship, including, but not limited to, an accountant-client relationship. Although these materials have been prepared by a professional, the user should not substitute these materials for professional services, and should seek advice from an independent advisor before acting on any information presented. Lodder CPA PLLC assumes no obligation to provide notification of changes in tax laws or other factors that could affect the information provided.