In the last several months much has been written about the implications of the Tax Cuts and Jobs Act (TCJA). For owners of flowthrough entities (including sole proprietorships, partnerships, and S corporations) and indivduals, most of the commentary has focused on the new 20% deduction available for qualified business income (Sec. 199A).
Of course, the reductions in the corporate and noncorporate tax rates also have received ample attention. Collectively, these new provisions raise questions about whether it remains more beneficial to own domestic businesses in a flowthrough or individual structure rather than a corporate structure. In the international context, however, ownership of a foreign corporation by a U.S. flowthrough or induvial taxpayer may produce unwelcome results under the TCJA.
In general, the TCJA shifts the U.S. corporate taxation of foreign earnings to a “quasi-territorial” system, which, for corporate taxpayers, may result in no U.S. tax with respect to income of a controlled foreign corporation (CFC).
This brief article outlines the new global intangible low-taxed income (“GILTI”) tax regime that may affect your foreign structure and how you are taxed in the US.
Under pre-TCJA law, U.S. shareholders (whether corporations or individuals) that owned 10% or more of the voting stock in a foreign corporation classified as a CFC generally were taxed on the CFC’s earnings only upon receipt of a dividend (except under certain circumstances, such as Subpart F income). Thus, a U.S. taxpayer that structured its operations properly generally was able to defer U.S. tax on income earned by a CFC until the U.S. taxpayer received a dividend.
Under the TCJA, Congress has implemented GILTI as a new anti-deferral tax on certain earnings of a CFC, effective starting with the first tax year of the CFC beginning after Dec. 31, 2017. As such, a 10% U.S. shareholder of one or more CFCs will be required to include its GILTI currently as taxable income, regardless of whether any amount is distributed to the U.S. shareholder.
The tax on GILTI essentially serves to tax the U.S. shareholder currently on its allocable share of CFC earnings for a tax year to the extent such earnings exceed a 10% return on the shareholder’s allocable share of tangible assets held by CFCs. The tax on GILTI applies equally to U.S. shareholders that are corporations or flowthrough/Individual taxpayers.
Specifically, a U.S. shareholder’s GILTI is calculated as the shareholder’s “net CFC tested income” less “net deemed tangible income return” determined for the tax year. Net CFC tested income is calculated by determining the U.S. shareholder’s pro rata share of tested income or tested loss of each CFC held by the U.S. shareholder, and aggregating those amounts. Thus, for simplicity sake, where a single shareholder owns 100% of a CFC, net CFC tested income will equal the CFC’s net income.
Once the net CFC tested income is determined, it is reduced by the shareholder’s “net deemed tangible income return” to arrive at the shareholder’s GILTI. This amount generally is calculated as the excess of: (1) a U.S. shareholder’s allocable share of the U.S. tax basis of depreciable tangible assets held by each CFC owned by the U.S. shareholder (on a straight-line basis), multiplied by 10% less (2) the amount of interest expense.
Where the U.S. shareholder holds multiple CFCs, GILTI is effectively determined on an aggregate basis.
Once the amount of GILTI has been determined, a U.S. corporate taxpayer may claim a deduction, subject to certain limitations, equivalent to 50% of its GILTI. Prior to the consideration of U.S. foreign tax credits, this results in a 10.5% minimum tax on a corporate U.S. shareholder’s GILTI (50% × 21%). In addition to this “GILTI deduction,” a foreign tax credit may be claimed by a corporate taxpayer for 80% of the foreign income taxes paid by a CFC attributable to the shareholder’s tested income multiplied by the corporation’s inclusion percentage. The application of the deduction and the tax credit eliminates the U.S. tax owed on the U.S. corporate shareholder’s GILTI if the tested income is subject to an effective foreign income tax rate above 13.125%.
Considerations for flowthrough and individual taxpayers
Though the amount of a U.S. shareholder’s GILTI is calculated the same for corporate and flowthrough/Individual taxpayers, only corporate taxpayers are entitled to the GILTI deduction and related indirect foreign tax credits. Thus, a flowthrough or individual taxpayer subject to tax on GILTI is taxed on a current basis on the entire amount of its GILTI. Accordingly, under most circumstances, noncorporate U.S. taxpayers will pay a current tax on GILTI at a rate up to 37% (the newly enacted highest marginal rate for individuals).
Once the tax on the GILTI is paid, the U.S. tax system generally allows the CFC to distribute an amount equal to the previously taxed GILTI to the U.S. shareholder free of additional U.S. income tax.
Under the TCJA, many corporate U.S. shareholders will no longer be subject to U.S. tax on their CFC earnings because of the 100% dividends-received deduction available for qualifying dividends. Accordingly, unless a CFC has GILTI (that is not ultimately offset by deductions or credits), a corporate U.S. shareholder of a CFC will not pay any U.S. tax on the CFC’s earnings, even when distributed.
Flowthrough and individual taxpayers are not eligible for the new Sec. 245A dividends-received deduction, and, as the application of the tax on GILTI described above demonstrates, they will be subject to a current tax on their GILTI (without the benefit of the special GILTI deduction or offsetting foreign tax credits).
Noncorporate U.S. taxpayers that own CFCs directly or through a flowthrough entity, or that are considering engaging in new foreign operations, should carefully consider the implications of the new tax on GILTI for their business structures.
Please feel free to contact us at firstname.lastname@example.org to discuss how the GILTI tax regime may affect your current structure and what to do to reduce the exposure to this new tax.
This article carries no official authority, and its contents should not be acted upon without professional advice. For more information about this topic, please contact our office.