Current Taxation Issues – GILTI Tax
Implications for Corporations and Pass-Throughs
In the last several months, much has been written about the implications of the Tax Cuts and Jobs Act (TCJA).1 For owners of flow through entities (including sole proprietorships, partnerships, and S corporations), most of the commentary has focused on the new 20% deduction available for qualified business income (Sec. 199A).2 Of course, the reductions in the corporate and non-corporate tax rates also have received ample attention.3 Collectively, these new provisions raise questions about whether it remains more beneficial to own domestic businesses in a flow through structure rather than a corporate structure. In the international context, however, ownership of a foreign corporation by a U.S. flow through taxpayer may produce unwelcome results under the TCJA.4
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) (even upon repatriation).5 Aspects of the TCJA aimed at transitioning taxpayers to the new system, however, as well as the system itself, treat flow through taxpayers that own CFCs considerably differently than corporate shareholders. This article explores an area of concern for U.S. flow through taxpayers that own an interest in one or more CFCs: the new tax imposed on “global intangible low-taxed income” (GILTI).6
The new tax on GILTI
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.7 The primary exception historically has been a series of rules generally referred to as the “Subpart F rules,” which require the inclusion of certain types of income earned by a CFC on a current basis, regardless of whether a distribution is received.8 Thus, a U.S. taxpayer that structured its operations in a manner that was mindful of the Subpart F rules generally was able to defer U.S. tax on income earned by a CFC until the U.S. taxpayer received a dividend (the amount of which could then be used to fund the payment of the associated U.S. tax liability).
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, 2017.9 Similar to the taxation of Subpart F income, a 10% U.S. shareholder of one or more CFCs will be required to include its GILTI currently as taxable income (in addition to any Subpart F 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 flow through 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.10 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.11 Tested income or loss generally is calculated as a CFC’s gross income after excluding items of high-taxed foreign base company income, Subpart F income, related-party dividends, certain foreign oil and gas extraction income, and income of the CFC taxable in the United States as effectively connected income, less deductions allocable to tested income.12 Thus, in the simple case where a single shareholder owns 100% of a CFC with none of the categories of excluded income, net CFC tested income will equal the CFC’s net income.
The exclusion for high-taxed income found in Sec. 951A(c)(2)(A)(i)(III) appears to only exclude high-taxed income that is considered foreign base company income (i.e., income of a CFC that potentially gives rise to a Subpart F inclusion). Thus, high-taxed income that is not foreign base company income is included as tested income under the statute. For pass through taxpayers who do not benefit from foreign tax credits on GILTI (discussed below), this limiting of the exclusion does not make sense — high-taxed potential Subpart F income is excluded, but similarly high-taxed income that is not subject to Subpart F is not. One would expect Sec. 951A to provide an exclusion for income that “would be subject to the high-tax exception if such income were foreign base company 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 used in the production of tested income held by each CFC owned by the U.S. shareholder, multiplied by 10% (subject to certain adjustments); less (2) the amount of interest expense taken into account under Sec. 951A(c)(2)(A)(ii) in determining the shareholder’s net CFC tested income for the tax year to the extent the interest income attributable to such expense is not taken into account in determining the shareholder’s net CFC tested income.13 For this purpose, Sec. 951A(d)(3) provides that tax basis is determined by applying depreciation on a straight-line basis.14
Example 1: As of Dec. 31, 2018, a U.S. shareholder owns 100% of CFC. CFC has $80,000 of tested income and a tax basis in its tangible assets of $200,000. The U.S. shareholder will have net CFC tested income of $80,000 (100% × $80,000). The U.S. shareholder will have a net deemed tangible income return of $20,000 (10% × $200,000). The U.S. shareholder’s 2018 GILTI will be equal to $60,000 ($80,000 – $20,000).
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 (reduced to 37.5% for tax years starting after 2025).15 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.16 The inclusion percentage is the corporation’s GILTI divided by the aggregate amount of the corporation’s pro rata share of the tested income of each CFC of which the corporation is a shareholder. 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%, for tax years before 2026, and 16.406% thereafter.17 From an after-tax cash perspective, the TCJA likely will result in corporate taxpayers’ having significantly more cash from foreign operations to deploy in the United States and abroad.
Considerations for flowthrough taxpayers
Though the amount of a U.S. shareholder’s GILTI is calculated the same for corporate and flow through taxpayers, only corporate taxpayers are entitled to the GILTI deduction and related indirect foreign tax credits. Thus, a flow through taxpayer subject to tax on GILTI is taxed on a current basis on the entire amount of its GILTI. Further, because the tax on GILTI arises from foreign business operations, flow through taxpayers that would otherwise potentially qualify for the new Sec. 199A deduction cannot include the amount of the GILTI in the base for determining that deduction.18 Accordingly, under most circumstances, non-corporate U.S. taxpayers will pay a current tax on GILTI at a rate up to 37% (the newly enacted highest marginal rate for individuals). A noncorporate taxpayer may make the election under Sec. 962(a) to be taxed as a C corporation and generally obtain the benefits of the lower tax rate applicable to C corporations and associated foreign tax credits (but, likely, not the 50% GILTI deduction). However, making such an election generally requires future distributions of what would otherwise be a return of previously taxed profits to be taxable.19
The effects of the tax on GILTI will vary widely based on the nature of the CFC’s business, the number and different tax profiles of the CFCs owned, and the level of capital investment in tangible assets.
Example 2: A U.S. LLC (taxed as a partnership and owned by U.S. individuals) owns a CFC engaged in the business of providing technical services in its foreign country of organization and is taxed in the foreign jurisdiction at an effective rate of 15%. Under pre-TCJA law, the United States generally would tax the CFC’s income only when the CFC paid a dividend to the U.S. shareholder. Under the TCJA, however, the U.S. shareholder would be subject to tax currently on the GILTI of the CFC (which, as a services business, conceivably could be virtually all of its net income) at a maximum rate of 37%.
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.20 Because cash can be returned tax-free after the tax is paid, the application of the tax on GILTI for a flow through taxpayer may be justified as a minimum tax imposed on foreign earnings attributable to nontangible assets. In practice, however, CFCs with operations that give rise to GILTI may have very real restrictions and additional costs associated with distributing cash to pay the tax. These restrictions could include burdensome foreign withholding taxes, local country capital needs that were budgeted based on historic tax rules, or lender-imposed covenants that prohibit distributions.
Noncorporate U.S. taxpayers that own CFCs directly or through a flow through 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. In certain circumstances, U.S. flow through taxpayers will benefit from owning CFCs through a U.S. corporate subsidiary. Under other circumstances, however, it will be advantageous to hold such operations through a foreign flow through entity that will not qualify as a CFC, or through a CFC and electing the application of Sec. 962. Clearly, no single approach applies to every existing or planned foreign investment, and prudent taxpayers will need to structure their operations only after taking into account all the relevant factors that will influence their available after-tax cash flow.
Endnotes
1The TCJA was enacted on Dec. 22, 2017, with most provisions effective for tax years beginning on or after Jan. 1, 2018.
2Sec. 199A generally allows U.S. individuals that earn qualified business income directly or through a flowthrough entity (such as an S corporation or partnership) to deduct up to 20% of their business income in determining their income tax liability. The deduction does not apply equally to all business income, and several limitations may reduce or eliminate a taxpayer’s ability to claim the deduction. Germane to this article, the deduction does not apply to income that is not effectively connected with a U.S. trade or business. See Sec. 199A(c)(3)(A)(i).
3The top corporate tax rate was reduced by the TCJA to 21%. The top individual rate was reduced to 37% for 2018 through 2025. See Secs. 1(j) and 11(b).
4References here to “flow through taxpayers” are intended to refer to U.S. noncorporate taxpayers owning an interest in a foreign corporation directly or through ownership of an interest in a flow through entity (such as a partnership or S corporation).
5The TCJA implements a new 100% dividends-received deduction for U.S. corporate taxpayers that eliminates the tax on dividends received from foreign corporations if certain ownership and holding period requirements are met (see Sec. 245A). No similar deduction is available for noncorporate taxpayers. Additionally, certain deductions and foreign tax credits discussed here often will reduce or eliminate any current taxation relating to the new anti-deferral tax on global intangible low-taxed income (GILTI) (discussed below) for corporate U.S. shareholders of CFCs.
6For U.S. flow through taxpayers that engage in foreign activities through a noncorporate form in the local jurisdiction, the TCJA is less transformative. Generally, such taxpayers will continue to be currently taxed on their worldwide income and receive a direct foreign tax credit under Sec. 901 for foreign income taxes paid, subject to applicable limitations.
7A CFC is defined in Sec. 957(a) as a corporation greater than 50% owned by U.S. shareholders, measured by vote or value (after considering applicable rules of attribution). For purposes of calculating ownership, only U.S. shareholders that own 10% or more of the vote or value of the foreign corporation are considered (see Sec. 951(b), as amended by the TCJA, effective Jan. 1, 2018). Prior to the TCJA, the Sec. 951(b) definition referred only to “voting power” and not value. References here to U.S. shareholders (whether with respect to the tax on GILTI or the repatriation tax discussed below) are intended to refer only to U.S. shareholders who hold the requisite 10% interest necessary to be considered a U.S. shareholder within the meaning of Sec. 951(b).
8Subpart F income is defined in Sec. 952 to generally include: (1) insurance income defined in Sec. 953, and (2) foreign base company income. Foreign base company income is defined in Sec. 954 and generally includes foreign personal holding company income (passive income) and certain income earned with the involvement of related parties that includes commercial elements outside the CFC’s country of organization. Importantly, a U.S. shareholder also is required to include its pro rata share of income described in Sec. 956, which addresses investments in U.S. property by a CFC. Prior proposed versions of the TCJA would have eliminated Sec. 956 for corporate taxpayers, but the final law retains Sec. 956 for all taxpayers.
9See TCJA §§14201(a) and (d).
10Sec. 951A(b).
11Sec. 951A(c). For this purpose, the U.S. shareholder’s pro rata share of a CFC’s tested income or loss is determined under the principles for determining a pro rata share of Subpart F income under Sec. 951(a)(2) (see Sec. 951A(e)(1)).
12Sec. 951A(c)(2).
13Secs. 951A(b)(2) and (d). Tax basis is determined at the end of each calendar quarter and then averaged before applying the 10% limitation. The resulting tax basis amount is then further reduced to the extent of any interest expense taken into account in determining the shareholder’s net CFC tested income for the tax year to the extent the interest income attributable to such expense is not taken into account in determining the shareholder’s net CFC tested income.
14As enacted, the TCJA included two provisions as Sec. 951A(d)(3). The final placement of this provision will depend on the renumbering of Sec. 951A pursuant to a subsequent technical corrections bill.
15Secs. 250(a)(1)(B) and (a)(3). The deduction also includes 50% of the Sec. 78 inclusion associated with the permissible amount of tax credits available to corporate taxpayers in respect of GILTI, as described below.
16Sec. 960(d). A foreign tax credit is permitted for 80% of the corporate taxpayer’s GILTI over the taxpayer’s tested income, times the aggregate foreign taxes paid that are attributable to tested income.
17See H.R. Conf. Rep’t No. 115-466, 115th Cong., 1st Sess. 626 (2017).
18Sec. 199A(c)(3)(A)(i).
19Sec. 962(d).
20However, the subsequent dividend, although not subject to graduated income tax, may be subject to the 3.8% net investment income tax under Sec. 1411.
