This requirement to allocate domestic interest expense against foreign income has the effect of altering the fraction that limits the foreign tax credit. For example, a company, before the interest expense allocation, may earn half of its profits outside of the United States. This means the foreign tax credit would be limited to half of the U.S. tax liability. However, expense allocation may shift expenses out of the U.S. and into a foreign jurisdiction.
If/when the corporation determines that it has excess cash to distribute, it will declare a dividend, which will be taxed to the shareholder. In the first post I discussed a public comment made on behalf of the Israeli Ministry of Finance on the recentproposed GILTI regulations. The third post talked about how GILTI was measured focusing on US domestic corporations, the target of these provisions in the first place. This post will look at how these rules, that were written for Apple and Google, play out for individuals owning small businesses in the "foreign" country where they live. For those who want to get into the detail, there’s a technical appendix on our wiki.
The GILTI system of taxation is similar in its design to an alternative minimum tax. At a very high level, because we no longer have deferral, GILTI will tax the operating income of controlled foreign corporations on an annual basis. Once the QBAI is calculated an entity calculates the net deemed tangible income return by multiplying the QBAI amount by 10 percent then subtract any interest expense paid to unrelated parties. The deemed tangible income return is the exclusion amount used to offset the amount of net tested income which results in the Global Intangible Low-Tax Income. The Global Intangible Low-Taxed Income tax was put in place to counter-act profit shifting to low-tax jurisdictions.
Under the statute, gross tested income excludes any gross income "taken into account" in determining subpart F income. The final rules adopt comments suggesting that the foreign base company "de minimis" and "full inclusion" rules be taken into account for this purpose. Accordingly, the final rules clarify that income excluded from FBCI under the de minimis rule and full inclusion amounts excluded from FBCI under the high-tax exception are included in gross tested income, while income included in FBCI under the full inclusion rule is excluded from gross tested income.
Prior to the Act, however, most foreign-source income that was earned by a U.S. person indirectly – as a shareholder of a foreign corporation that operated a business overseas – was not taxed to the U.S. person on a current basis. Instead, this foreign business income generally was not subject to U.S. tax until the foreign corporation distributed the income as a dividend to the U.S. person. The significant reduction in the corporate tax rate relative to the individual rate is likely enough of an incentive, by itself, to cause some individual USS to elect to be treated as a domestic corporation under Sec. 962. This election was added to the Code over 55 years ago, at the same time that the CFC rules under subpart F were enacted. According to its legislative history, Sec. 962 was enacted to ensure that an individual’s tax burden with respect to a CFC was no greater than it would have been had the individual invested in a domestic corporation that was doing business overseas.
The consolidated return rules in the 2018 proposed regulations adopted an aggregation approach to GILTI, whereby consolidated group members’ GILTI items were aggregated and then allocated to members in proportion to their share of the group’s tested income. In general, this had the effect of allowing tested losses or QBAI attributable to CFCs owned by one consolidated group member to offset tested income attributable to CFCs owned by another member of the group. The 2018 proposed regulations stopped short, however, of mandating that all GILTI computations occur as if members of a consolidated group were a single U.S.
This process goes through a calculation of reducing a CFC’s total tested income by the net deemed income from tangible assets. The variance can be considered income from a CFC’s intangible assets which is included in the shareholder’s income. Before the enactment of the TCJA in December 2017 entities with valuable intangible assets would set up a controlled foreign corporation in a low-tax foreign country to hold their intangible assets. The United States parent company would pay a licensing fee for use of the intangible property which resulted in shifting income from the US to the low-tax jurisdiction.
The problem is that many taxpayers and practitioners fail to properly test for these items. This can create a larger problem on audit where a taxpayer may assume that they have a GILTI inclusion that’s taxed at a reduced rate but they actually have a much higher taxed Subpart F inclusion.
No doubt, many of these individuals have been waiting to see whether the IRS would address the application of the "50-percent deduction" in the context of a Sec. 962 election. Following the reduction of the corporate tax rate and the enactment of the GILTI rules, many tax practitioners turned to the Sec. 962 election as a way to manage and reduce the tax liability of individual USS of CFCs. The election also causes the individual USS to be treated as a domestic corporation for purposes of claiming the 80-percent FTC attributable to this income; thus, the USS would be allowed this credit.
To add to the confusion, note that the entire amount of the foreign tax is used for the §78 "add-back", but only 80% for the foreign tax credit. It is important to remember that corporations are taxed separately from their shareholders – they are separate taxable entities. This means that, absent a provision such as GILTI , shareholders do not pay tax on corporate income.
If there is criminal exposure, the Voluntary Disclose Program should be considered. This program is less defined than the former Offshore Voluntary Disclosure Program, and will very likely come with the highest penalties, but it will give criminal protection.
This disparate treatment of GILTI taxation of corporate and individual US taxpayers clearly resulted in an unfair result to individual US shareholders of a CFC. A corporate taxpayer could pay little or in many cases no tax on GILTI amounts, whereas individual taxpayers would be subject to tax on these CFC earnings at higher individual rates with no deferral. US shareholders1 of a CFC have long been subject to US federal income taxation on the "Subpart F" income of the CFC.
This income inclusion rule applies to both individual and corporate U.S. shareholders. For tax years beginning on or after January 1, 2019, Iowa fully conforms with the federal deduction for FDII under IRC section 250. Generally, taxpayers will not need to make additional Iowa adjustments to the federal deduction amount included in their Iowa taxable income, except for certain taxpayers who file federal consolidated returns, as described below. For taxpayers who own foreign subsidiaries, managing GILTI will become an exercise in financial management.
Both of these methods have pros and cons which require examination to pick the best option. While these are the main choices, there may be other unique paths to compliance that could be taken making it very important that each case has a detailed analysis of the risks, exposure, and options.
Accordingly, the GILTI inclusions were to be calculated at the partnership level and reported on each shareholder’s Schedule K-1. That meant any US partner who was part of a partnership that was a US shareholder in a CFC had to include GILTI on their US tax return, even if they individually owned less than 10% interest in the CFC.
The US government did not like the idea of easily avoiding US income tax on this intangible revenue so they decided to make a change by enacting a tax on Global Intangible Low-Tax Income, IRC §951A. The income and tax associated with GILTI is eligible for certain deductions and foreign tax credits for US Corporations only. company are not entitled to the 80% credit that a U.S. corporate parent is entitled to. The GILTI rules are designed to prevent deferral of tax on CFC income and the rules apply differently to U.S Corporate Shareholders and U.S. Higher taxes levied on taxpayers earning more than $400,000, including higher tax rates on ordinary income as well as capital gains and dividends, would raise another $1.2 trillion over 10 years.
For example, the GILTI rules will apply to Dr. Smith, a Canadian resident / US citizen doctor, if he operates a medical practice through a Canadian corporation ("Medco") that earns an amount of income that exceeds 10% of Medco’s tangible business assets. Assuming Medco earns $400,000 from medical services, owns $20,000 of medical equipment, and pays a $100,000 annual salary to Dr. Smith, $298,000 of Medco’s income will be reportable on Dr. Smith`s US tax return and taxed at rates of up to 37%. The one drawback of the proposed regulation, however, is its applicability date. The proposed regulation, if finalized, would apply to tax years of foreign corporations beginning on or after the date of publication of the final regulations, and to tax years of a U.S. person in which or with which such tax years of foreign corporations end. In most cases, this would probably mean that the expansion of the high-tax exception would apply starting with the 2020 tax year.
It is no different with GILTI and this article will help outline some of the more common errors we’ve come across. However, it should be noted that when an actual distribution is received in later years from the relevant CFC, part of the income will be taxable at the individual’s marginal tax rate.
Under the statute, net DTIR is reduced by interest expense that reduces tested income or increases tested loss, to the extent the related interest income is not taken into account in determining the U.S. The 2018 proposed regulations adopted a favorable netting approach for determining the relevant interest expense (the "specified interest expense"). Under this approach, which is retained in the final rules, specified interest expense is the excess of a U.S. Shareholder’s aggregate tested interest expense with respect to each of its CFCs over its aggregate pro rata share of tested interest income of each CFC.
A CFC with a large amount of specified tangible property, generally tangible fix assets used in the production of tested income, may need to go back many years to figure out the tax bases under the GILTI rules. A tested loss CFC has no QBAI, even if the CFC is a tested income CFC in other tax years. Foreign income subject to GILTI is defined as the excess of the US shareholder’s "net CFC tested income" over a "net deemed tangible income return". Net CFC tested income generally means the CFC’s gross income less allowable deductions. Thus generally, all income earned by a CFC other than certain types of income will be included in the base for the GILTI tax.
The bottom line is that one must still test for all of these items as part of any tested income analysis before the IRS tests for it. In our international tax practice, we both prepare and review a large number of Global Intangible Low-Taxed Income ("GILTI") tax calculations and US corporate and individual tax returns related to same. As is common with most new tax rules, especially those as complex and wide ranging as GILTI, practitioners and taxpayers stumble until they familiarize themselves with calculation and reporting requirements.
As we will focus on further below, it also does not include income excluded from Subpart F by virtue of the so-called "high tax" exception. Changes introduced in the final regulations may lead to potential tax savings for shareholders that own less than 10% of a pass-through entity. However, for partners to receive potential tax savings, any already-filed 2018 US partnership or S corporation return that calculates GILTI at the entity level should be reviewed and amended to comply with final GILTI regulation changes. Under proposed regulations, a US partnership could be considered a US shareholder of a CFC.
The GILTI regime requires U.S. shareholders of a CFC to include, as income, a deemed distribution equal to their allocable share of the earnings and profits that are considered GILTI earnings. The deemed distribution creates what is referred to as "phantom" income for U.S. taxpayers--money that taxpayers are taxed on even though they have not received any cash related to that income. Any changes in entity structure require careful modeling and consideration of tax and non-tax consequences to determine the best overall option.
Consideration will be given to book income projections, taxable temporary differences , intercompany transfer pricing policies, foreign source income and FTCs, as well as the new export incentive for foreign derived intangible income. Taxpayers who are not managing these variables are likely to be in for a huge surprise when preparing their tax provisions and tax returns for the 2018 tax year.
Instead, the calculation allows for a 10% return on a fixed asset base, anything above this return is deemed "intangible" income. First, a 10% return is relatively low for some assets, and this would seem to penalize anyone making productive use of their fixed assets. Next, not all businesses use fixed assets, such as a sales entity or consulting company. Also, the fixed asset base is calculated after depreciation and many assets could have a useful life well after their depreciable life. Overall, a tax on intangible income that does not have intangible income anywhere in the calculation is bound to have its problems in application.
The final rules apply to tax years of foreign corporations beginning after December 31, 2017, and to tax years of U.S. The effect of this rule is that a domestic partnership cannot have a GILTI inclusion amount (because it does not own stock of the foreign corporation under section 958) and, therefore, the partners in the partnership will not have a distributive share of any GILTI inclusion. Rather, partners in a domestic partnership are treated as owning proportionately the stock of a CFC owned by the partnership, and a partner that is a U.S. When earnings are distributed to shareholders as dividends, shareholders will pay tax on those dividends. The qualified dividend tax rates remained unchanged at 0%, 15% and 20%, depending on your personal income tax bracket.
The payroll tax increase for high-income households would generate around $800 billion in additional revenue over 10 years. Caps the tax benefit of itemized deductions to 28 percent of value, which means that taxpayers in the brackets with tax rates higher than 28 percent will face limited itemized deductions. Therefore, if you are the 100% owner, or greater than 50% owner, you alone can cause your company to be subject to these rules.
The CFC’s controlling domestic shareholders would be responsible for making the election by attaching a statement to an amended or filed return for the inclusion year. Under the regulations, the election would be revocable, but once revoked, a new election generally could not be made for any CFC inclusion year that begins within five years after the close of the CFC inclusion year for which the election was revoked. "Net CFC tested income" is defined, in brief, as all of a CFC’s gross income less certain deductions such as interest expense and taxes, but it does not include income effectively connected with a U.S. trade or business, Subpart F income, and dividends from related persons.
Step 1 includes calculation of the CFC-tested items at each CFC level in U.S. dollars using the appropriate foreign exchange rates. A CFC with tested income is called a tested income CFC while a CFC with tested loss, a tested loss CFC. QBAI, a new defined term for GILTI, is the aggregate of all tested income CFCs’ average quarterly adjusted bases of specified tangible property determined under special rules.
Additionally, if the taxpayer has signature authority on the business bank accounts, or is deemed to have a direct financial interest because they own greater than 50%, an FBAR might be needed. Generally, the minimum penalty for not filing an FBAR is $10,000/year but could be as high as $10,000/account/year for a non-willful violation, and up to 100% of the account balance if the non-filing is deemed willful. Assuming there is not any criminal exposure, which requires analysis with a qualified tax attorney, taxpayers would most likely use either the streamlined program or file under reasonable cause to get into compliance.
The 962 election is made by filing a statement, with additional information, along with the individual’s U.S. tax return. The election automatically applies to all CFCs of the individual having amounts included in income during the year under the pass-through rules of Section 951. The election must be made each year the benefits of Section 962 are requested. Note the effect of the 80 percent FTC limitation, which essentially raises the effective tax rate borne by this firm under this provision. If the host country imposed no tax, the rate would decline to 10.5 percent, because the value of the limitation on the FTC would be zero.
If a Form 5471 has not been filed, the compliance options need to be analyzed for penalty exposure. Failure to file a Form 5471 carries a $10,000/year penalty, and depending on foreign account and asset values a Form 8938 could be required which also has a $10,000/year penalty.
The 962 election is designed to ensure an individual taxpayer is not subject to a higher rate of tax on the earnings of a directly-owned foreign corporation than if he or she owns it through a U.S. corporation. A CFC’s "net deemed tangible income return" is measured by multiplying the adjusted tax basis of the CFC’s "qualified business asset investment" ("QBAI") by a deemed return of 10 percent. A CFC’s QBAI for a tax year is the average of its aggregate adjusted bases in "specified tangible property" used by the CFC in a trade or business and for which a deduction is allowable under Section 167 of the Code. Rules that are part of the foreign tax credit limitation also require companies to allocate certain domestic expenses to foreign income.
GILTI is supposed to reduce the incentive to shift corporate profits out of the United States by using intellectual property . IRC Sec. 951A, effective for taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end. Because these foreign subsidiaries are not treated as corporations for U.S. tax purposes, they are not CFCs. Therefore, neither the GILTI nor the subpart F anti-deferral rules apply to them.
The thinking behind taxing this income is because the IRS feels the only reason to hold an intangible asset generating income in a low tax jurisdiction is for tax purposes. Since it is an intangible asset, there is no reason it could not be held within the U.S.
The Treasury and IRS must decide whether or not individuals making the §962 election receive the 50 percent deduction on GILTI. This will have a big impact for many closely held businesses and is something for which taxpayers and their professional advisors need guidance. U.S. taxpayers that have interests in overseas corporations need to act quickly to determine the impact that the new GILTI regime will have on their 2018 U.S. tax returns--and future foreign operations. Given the sweeping changes that the TCJA had on the U.S. taxation of international transactions, taxpayers have had very little time to study and digest the changes, much less prepare for reporting and plan intelligently for the future. The global intangible low-taxed income rules that were enacted by the 2017 TCJA created a new anti-deferral regime.
This could potentially result in an overall higher tax rate for the U.S. shareholder. Therefore, an election under Section 962 should be considered and planned carefully based on each taxpayer’s unique tax situations.
This inclusion amount is intended to subject income earned by a CFC to U.S. tax on a current basis and is determined using a formula. A 10% return is attributed to certain tangible assets , and each dollar of certain income above that is effectively treated as intangible income. This inclusion amount is treated similarly to a Subpart F income inclusion, but it is determined in a fundamentally different manner. When deciding how to address this issue, taxpayers fall into two categories, those that have filed a Form 5471 and those that haven’t. A Form 5471 is required for several situations regarding foreign corporations, but always required for a CFC.
As a result, foreign profits may fall to, say, 25 percent of overall profits. The foreign tax credit would then be limited to one quarter of U.S. tax liability—a far smaller foreign tax credit. GILTI is a newly-defined category of foreign income added to corporate taxable income each year. In effect, it is a tax on earnings that exceed a 10 percent return on a company’s invested foreign assets. GILTI is subject to a worldwide minimum tax of between 10.5 and 13.125 percent on an annual basis.
Subpart F income consists generally of types of income that are easily shifted from one jurisdiction to another, including passive income. The purpose of the CFC rules is to prevent the deferral of US taxation through the use of lower-taxed non-US entities. The 2017 Tax Cuts and Jobs Act significantly expanded the scope of the CFC anti-deferral tax regime applicable to US shareholders of CFCs with the introduction of current taxation on GILTI amounts. If this were a normal subpart F inclusion (remember, that’s generally passive income earned inside the CFC), then the entire $3 of foreign tax would be available as a credit against US tax on the $10. But, since the GILTI provisions limit the foreign tax credit to 80% of foreign tax paid, only $2.40 is available to offset US tax on the $10.
Also, these are the same rules that require you to file Form 5471 as a Category 5 filer. Therefore, if all your taxes have been done correctly, you can simply check if you are filing this type of form and you will know GILTI applies to you, or at least needs to be taken into consideration. Lastly, there are also attribution rules that can cause you to be considered the owner of the stock of your family members or other foreign corporations. Again, a tax professional can analyze these rules for you, your job is just to give them all the information.