New GILTI Rules Target U.S. Shareholders of Controlled Foreign Corporations
As a general rule, the earnings of a foreign corporation are not subject to U.S. taxation until such earnings are distributed as dividends. The Subpart F rules have long been in place to subject the earnings of a controlled foreign corporation (CFC) to U.S. taxation whether or not such earnings are actually distributed. The tax reform legislation passed in Dec. 2017 imposed an additional anti-deferral rule referred to as GILTI (Global Intangible Low-Taxed Income). The new GILTI inclusion rules function in a manner similar to the existing Subpart F regime.
The GILTI rules apply to U.S. Shareholders of CFCs. A U.S. Shareholder for this purpose is a U.S. person that owns at least 10 percent directly or indirectly, of the vote or value of a foreign corporation. A U.S. person includes an individual, partnership, S corporation, C corporation, estate, and trust. A foreign corporation is a CFC when U.S. Shareholders own more than 50 percent of the corporation’s stock by vote or value.
Despite the name Global Intangible Low-Taxed Income, the GILTI inclusion amount is a formulaic approach that does not consider intangible assets and does not consider the amount of foreign taxes paid on such foreign earnings. The GILTI inclusion amount can be summarized as the CFC’s income in excess of 10 percent of the CFC’s adjusted basis in its tangible fixed assets increased by the CFC’s net interest expense. This is an oversimplified statement and there are many complexities and nuances that are beyond the scope of this summary, but it is important to note that all U.S. Shareholders of CFCs must consider the potential impact of the new GILTI inclusion rules.
C corporations are eligible for a special 50 percent deduction (37.5 percent starting in 2026) against the GILTI inclusion amount as well as a deemed paid foreign tax credit. Thus, the effective tax rate on a C corporation’s GILTI inclusion is 10.5 percent and is further reduced by available foreign tax credits.
Individuals, including partners in partnerships and shareholders in S corporations, must include their pro-rata share of GILTI income on their individual income tax returns. This GILTI income is subject to ordinary federal income tax rates as high as 37 percent. Individuals are not entitled to the special 50 percent deduction or deemed paid foreign tax credits. Thus, the tax consequences associated with GILTI inclusions to individuals are more severe than similar inclusions to C corporations.
The GILTI inclusion applies to tax years of a CFC beginning after Dec. 31, 2017 and is determined as of the end of the CFC’s tax year. Thus, U.S. Shareholders of a calendar year CFC will have GILTI inclusions based on the ownership of CFC stock as of Dec. 31, 2018. Therefore, individuals that may be impacted by the new GILTI rules must consider if any restructure alternatives should be pursued before year end.
The various alternative structures available to individuals each have advantages and disadvantages. The alternatives include making a Section 962 election, imposing a C corporation blocker, and making an entity classification election to treat the foreign corporation as a flow-through entity. The Section 962 election is made with the individual income tax return. However, alternatives such as a C corporation blocker or entity classification election will require action before year end to make it effective for Dec. 31, 2018.
The facts and circumstances of each situation will dictate the appropriate alternative. U.S. Shareholders of CFCs should discuss their facts with their KSM advisor. The following information will help determine the size and scope of the potential GILTI inclusion:
- Detailed organizational charts to clarify direct and indirect ownership percentages of foreign entities
- Projected 2018 earnings for all foreign corporations owned directly or indirectly, including interest income and interest expense
- Projected 2018 fixed assets and accumulated depreciation (note that accumulated depreciation must be determined using ADS methods)
- Any foreign income taxes paid or accrued in 2018 with respect to the 2018 earnings
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