The U.S. Department of the Treasury on March 4, 2019, released proposed regulations (the Proposed Regulations) dealing with the application of the recent U.S. tax reform to U.S. shareholders of a "controlled foreign corporation" (CFC). The Proposed Regulations (REG-104464-18) provide relief from some of the provisions of the U.S. tax reform that apply to individual U.S. citizens or tax residents and U.S. trusts and estates who own stock in a CFC.
While the relevant provisions of the applicable U.S. tax law are quite detailed, this Holland & Knight alert provides a general summary of the relief provided by the Proposed Regulations.
Background
A foreign corporation is a CFC if its stock is more than 50 percent owned (by vote or value) by "United States shareholders" (such as U.S. citizens or tax residents, U.S. corporations, U.S. trusts, and U.S. estates). A foreign corporation can be deemed a CFC even if its stock is only indirectly owned by U.S. shareholders, and the tax law also contains certain "constructive ownership" rules that can treat stock of a foreign corporation as owned by a U.S. shareholder even if the stock is legally owned by another individual or entity.
Historically, the general rule was that the U.S. shareholders of a CFC were not taxed on the CFC's income until it was distributed to them (with the exception of certain specific types of income earned by the CFC, such as passive income and income from certain related party transactions). This allowed significant opportunities for U.S. shareholders to "defer" U.S. tax on the foreign income that they earned through a CFC.
This all changed under the U.S. tax reform enacted at the end of 2017, known as the "Tax Cuts and Jobs Act" (TCJA). Under the TCJA, a U.S. shareholder of a CFC is taxed on the "global intangible low-taxed income" (GILTI) of the CFC. The term "intangible low-taxed income" is rather misleading, as the sweep of GILTI is extremely broad, and is not limited to what is typically thought of as "intangible" income or income that is low-taxed. Essentially, with a few exceptions, GILTI includes all of the CFC's net income, less a deemed 10 percent return on the CFC's adjusted basis in its tangible, depreciable business assets.
Therefore, under the new GILTI rules, it is far more challenging (and in some cases impossible) for U.S. shareholders of a CFC to achieve deferral of U.S. tax on the foreign income earned by the CFC as they did before.
Treatment of GILTI to Individual U.S. Shareholders
Many practitioners and commentators have noted that the international tax provisions of the TCJA are more beneficial to corporations than to individuals. This is particularly true with respect to the taxation of GILTI.
For example, under the TCJA, a U.S. individual is taxed on the GILTI that he or she earns at rates of up to 40.8 percent. (The maximum ordinary income rate is currently 37 percent, and on top of that there is a 3.8 percent net investment income surtax.)
On the other hand, under the TCJA, U.S. corporations are in general taxed at a flat corporate tax rate of only 21 percent, and on top of that, they are allowed a 50 percent deduction (reduced to 37.5 percent in 2026) for GILTI income, which results in a tax rate of 10.5 percent. This 50 percent GILTI deduction is not allowed to U.S. individuals.
In addition, corporations, unlike individuals, are allowed a foreign tax credit for up to 80 percent of the foreign taxes paid or accrued by the CFC on the GILTI. This credit can offset and even eliminate the U.S. taxes paid by a U.S. corporation on GILTI. On the other hand, individuals are not allowed a foreign tax credit for the foreign taxes paid by the CFC, which results in double taxation.
To take a simple example, assume that a U.S. corporation owns 100 percent of the stock of a CFC that earns $1 million of net income outside the U.S. and pays corporate tax in its home country at a rate of 30 percent. The U.S. corporation will be subject to a U.S. federal corporate income tax rate of 10.5 percent (21 percent, less the 50 percent deduction for GILTI). And even this low tax may be offset by credits for the foreign corporate taxes paid by the CFC (subject to certain limitations). Even if the U.S. corporation eventually distributes dividends to its U.S. shareholders, the U.S. shareholders would be taxed at favorable qualified dividend rates on the dividends that they receive (currently, up to 20 percent, plus the 3.8 percent net investment income surtax).
Assume, however, that the same CFC is owned by an individual U.S. citizen or tax resident. That individual U.S. citizen or tax resident will be taxed on the CFC's GILTI at a rate of more than 40 percent, with no ability to credit the foreign corporate taxes incurred by the CFC against his GILTI inclusions. This would result in an effective worldwide tax rate (home country corporate tax plus U.S. tax) to the U.S. individual of close to 60 percent.
Section 962 Election to the Rescue
Many U.S. individuals have been planning to try to minimize these adverse consequences by making an election under Section 962 of the Internal Revenue Code (often referred to as a "Section 962 election"). The Section 962 election allows a U.S. individual (including trusts and estates, which are treated as individuals, and individuals who are partners in a partnership or S corporation shareholders) to be taxed on CFC income inclusions (such as GILTI) as a U.S. corporation. As noted above, the taxation of U.S. corporations on GILTI is more favorable than the taxation of U.S. individuals on GILTI.
There has been no question that the Section 962 election would allow a U.S. individual to benefit from 80 percent foreign tax credit for the foreign taxes paid by the CFC on GILTI income. This itself is of significant benefit, although it may not entirely eliminate GILTI taxation.
However, there has been considerable uncertainty as to whether the 50 percent deduction for GILTI income would apply where a Section 962 election is made. While there have been reasoned arguments made on both sides of the debate, suffice it to say that the lack of a 50 percent GILTI deduction would cause serious tax inefficiencies to U.S. individuals, and the uncertainty of whether this deduction is allowed has left many U.S. individuals who own stock in a CFC in a difficult position.
Fortunately, the Proposed Regulations answer this question and allow the 50 percent GILTI deduction where a U.S. individual makes the Section 962 election. This is welcome relief to many individual U.S. shareholders of CFCs.
Conclusion
The new GILTI rules can potentially tax a U.S. shareholder of a CFC on all or most of the income earned by the CFC. Without proper planning, the new GILTI rules tax U.S. individuals more harshly than corporations. However, under the Proposed Regulations, a U.S. individual who owns stock in a CFC may minimize or eliminate some of the adverse consequences imposed by TCJA by making a Section 962 election.
The rules concerning CFCs, the Section 962 election and foreign tax credits are quite complicated. U.S. shareholders of CFCs should consult their tax advisors for further guidance.