United States: Recent Proposed Regulations Could Mitigate Harsh US Taxation Of Individuals Under GILTI Rules

The US Internal Revenue Service and the US Department of Treasury recently released proposed regulations (Proposed Regulations) that may provide relief to individual US Shareholders (as defined below)¹ of "controlled foreign corporations" (CFCs) that are harshly taxed under the "global intangible low-taxed income" (GILTI) rules enacted as part of the Tax Cuts and Jobs Act (Tax Act). As discussed in more detail below, the Proposed Regulations provide an individual US Shareholder of a CFC who makes a so-called "Section 962 election" the same 50% deduction from GILTI available to corporate US Shareholders.

Background

Generally, a CFC is a non-US corporation greater than 50% owned in the aggregate by one or more US persons who each own directly, indirectly or constructively at least 10% of the corporation (US Shareholders). The CFC rules historically provided an anti-tax deferral regime under which certain types of passive and related party income (Subpart F income) were taxed to the US Shareholders when earned by the CFC, without regard to actual distributions.

The Tax Act expanded the CFC anti-tax deferral rules by creating a new category of income called "global intangible low-taxed income" or "GILTI" that is taxable to its US Shareholders, whether or not distributed. Generally, GILTI includes the income of the CFC that is not Subpart F income and certain other excluded items (with a deduction generally allowed for a deemed 10% return on the adjusted tax basis of certain depreciable tangible personal property of the CFC).

A corporate US Shareholder is taxed more favorably on GILTI than an individual US Shareholder because a corporate US Shareholder generally can (1) reduce taxable GILTI by a 50% deduction (37.5% for tax years after 2025) and, (2) subject to certain limitations, offset its US federal income tax liability on GILTI by 80% of the non-US income taxes paid by the CFC with respect to such earnings (i.e., an "indirect" foreign tax credit). As a result of these benefits, subject to certain limitations, a corporate shareholder generally is not subject to additional US federal income tax on GILTI of a CFC if the CFC is subject to an effective non-US tax rate on such GILTI of at least 13.125% (16.406% for tax years after 2025). Individual US Shareholders, by contrast, pay full tax on GILTI at a rate of 37%, with no credit for any non-US taxes paid by the CFC on such income.

As a result of the GILTI rules, there is limited opportunity for an individual US Shareholder of a CFC to defer US federal income tax with respect to the CFC's earnings.

Section 962 Election

In general, an election under Section 962 of the US Internal Revenue Code (a Section 962 election) allows a US individual to be taxed on CFC income inclusions (such as GILTI) in the same manner as a US corporation, i.e., an electing US individual would be taxed on Subpart F income and GILTI at the 21% corporate income tax rate and would benefit from indirect foreign tax credits with respect to Subpart F income and GILTI. In light of the disparate taxation under the GILTI rules of individual and corporate US Shareholders, tax professionals have been increasingly considering the benefits of a Section 962 election.

Prior to the Proposed Regulations, it was unclear whether an individual US Shareholder making a Section 962 election could obtain the benefit of the 50% GILTI deduction that is available to corporate shareholders. However, the Proposed Regulations expressly allow an electing individual to claim the 50% GILTI deduction. In light of the Proposed Regulations, if a CFC is subject to non-US tax at a rate of at least 13.125% (16.406% for tax years after 2025), an individual US Shareholder making a Section 962 election should, subject to the following, be able to defer US federal income tax imposed on GILTI until such earnings actually are distributed. Note that there may still be some level of US federal income tax imposed on GILTI as a result of the application of the foreign tax credit annual limitation and the expense allocation rules, which could limit the ability to use the indirect foreign tax credits to offset the tax on GILTI.

If a US Shareholder is subject to US federal income tax on the earnings of a CFC as Subpart F income or GILTI, a subsequent distribution by the CFC of such earnings to the shareholder generally is tax-free. However, if a Section 962 election is made with respect to a CFC's earnings, the electing individual is subject to additional US federal income tax when the CFC makes an actual distribution of those earnings (reduced by any taxes paid on the initial income inclusion). This raises the question of whether the taxable distribution from the CFC constitutes "qualified dividend income" (QDI) taxable at preferential capital gain rates. QDI is available for distributions from a US corporation or from a "qualified foreign corporation" (i.e., generally a qualified resident of a jurisdiction with an income tax treaty with the United States if certain requirements are met). A recent Tax Court opinion (Barry M. Smith, et ux. v. Commissioner), although considering different facts, appears to suggest that QDI treatment would be available if the CFC were a qualified foreign corporation. Thus, if a CFC were a qualified foreign corporation and subject to sufficient levels of non-US tax, an individual US Shareholder making a Section 962 election generally should be able to defer US federal income tax on the CFC's earnings until actually distributed and reduce the US federal income tax rate on such distributed earnings from 37% to 20% (in each case, subject to an additional 3.8% "net investment income tax").

A Section 962 election may be made only by an individual who is a US Shareholder (including indirectly through a partnership or S corporation). A Section 962 election can be made annually, but is applicable to all CFCs with respect to which the electing US Shareholder has a GILTI or Subpart F inclusion for that year. A US Shareholder makes a Section 962 election by filing a statement with his or her US federal income tax return for the tax year for which the election is intended to apply. There are additional annual tax filings and ongoing accounting requirements if a Section 962 election is made.

The rule in the Proposed Regulations relating to Section 962 elections is proposed to apply to tax years of a non-US corporation ending on or after March 4, 2019, and the taxable year of a US person in which or with which such tax year ends. However, the guidance provides that taxpayers may rely on such rule for prior tax years.

ALTERNATIVES TO SECTION 962 ELECTION

Rather than make a Section 962 election, a US Shareholder could interpose an actual US corporation between the shareholder and the CFC with similar results. Where the CFC is not a qualified foreign corporation, use of an actual US corporation would have the benefit of providing the US Shareholders with QDI. However, in addition to the tax and non-tax transaction costs and reporting obligations associated with creating and maintaining an additional US corporation in the CFC ownership structure, under some circumstances the transfer of the shares of the CFC to the US corporation could be a taxable transaction in the non-US jurisdiction in which the CFC is organized or operates.

Another alternative to a Section 962 election by the US Shareholder is for the CFC (if eligible) to make a "check-the-box" election to be treated as a partnership (or, if there is only one owner, a disregarded entity) for US federal income tax purposes. The election would effectively allow the individual US Shareholders to benefit from indirect foreign tax credits with respect to the non-US entity. However, US Shareholders would be taxable on all of the earnings of the non-US entity, without regard to actual distributions, and there may be additional US federal income tax due on such earnings after taking into account foreign tax credits.

Footnotes

1. This alert does not address certain residual tax issues for a US person that is a tax resident in a high-tax non-US jurisdiction.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.