Revised GILTI provisions offer reprieve to U.S. individual investors

Commencing in 2017, the December 2017 Tax Cuts and Jobs Act required  U.S. persons to be taxed on accumulated profits, generally derived from active business income of controlled-foreign corporations (“CFC”s) under section 965 of the IRS Code. This was also known as the transition or repatriation tax. Currently and prior to 2017, specific types of income earned by the CFC, primarily investment income, had to be accrued annually and taxable to the CFC shareholder if certain exclusions and exemptions were not available.

For subsequent taxation years, annual active business income as defined as global intangible low-tax income (“GILTI”) under section 951A of the IRS Code must be included in income. This is the continuation of the repatriation tax but in a different form.

U.S. corporate investors of CFC

Where the U.S. person is a U.S. C corporation, the GILTI provisions provided for a flat 50% deduction of the GILTI under  Section 250 of the IRS Code bringing the tax rate to 10.5% from  the 21% U.S. corporate rate.

An election is available under section 960  of   the IRS Code for the C corporation to take an indirect foreign tax credit up to 80% of  the foreign tax incurred by the CFC. Where the effective CFC tax rate was at least 13.12%, this election resulted in no tax to the C corporation on GILTI.

U.S. individual investors of CFC

For individual U.S. investors, GILTI is included in  their reported adjusted gross income reported on the U.S. 1040  tax return, taxed at their marginal tax rate that could be as high as 37%. However, a similar indirect foreign tax credit as outlined in section 960 available to the C corporation investor is available under section 962 of the IRS Code to the individual.

With an annual section 962 election, the IRS Code pretends that the individual is  a corporation and in lieu of including GILTI in adjusted gross income taxed at the marginal tax rate of the individual,  one could compute separately the tax on GILTI by applying the 21% corporate rate  with a foreign tax credit up to 80% of the foreign corporate tax. This section 962 tax payable is reported on a separate  line of the U.S. 1040.

Prior to the recent released proposed regulations, it was perceived that in computing the section 962 tax, this “notional” corporation could not take the 50% section 250 deduction. Therefore, only where the CFC’s effective  tax rate was at least 26.25%, the section 962 election resulted in no tax on GILTI to the U.S. individual. When the effective rate to the Canadian corporation was lower than 26.25%, the section 962 election still resulted in tax payable.

For 2018,  the annual tax rate on active business income on the first $500K could be in the 13% range (depending on the province) due to the  federal & provincial Canadian  small business deduction. Income above this $500K threshold is a taxed at around 26.5%.

With a low effective Canadian corporate rate, the section 962 election without an available section 250 deduction could result in about a 10.6% incidence of U.S. tax on GILTI, still better than 37%  without the election, but not as generous as with a C corporation shareholder of the CFC. 

This is the double tax issue for U.S. individual investors of the CFC,- U.S. taxation on undistributed profits in one year and Canadian individual taxation in a subsequent year when the distribution occurs

New rules for U.S. individual investors

Recently issued  proposed regulations to sections 250 and 962 of the IRS Code clarify to allow U.S. individuals to claim this section 250 50% deduction. This means with an effective  CFC tax rate of at least 13.12%, there would be no tax on GILTI, same as if the actual owner of  the CFC was a C corporation.

Payment of dividends by the CFC

It is generally understood that under Subpart F of  the IRS Code, any inclusion of corporate earnings prior to a distribution thereof would increase the basis of the CFC’s shares for U.S. tax purposes. Likewise, receipt of previous taxed income (“PTI”) would not be taxable and would reduce basis. These rules are complex with specific ordering provisions and accounting.

When a section 962 election is made, its related regulations have defined taxable S962 earnings and profits (“E&P”) and excludable S962 E&P for the purpose of determining what portion of the actual distribution relating to S962 E&P is taxable.

Excludable S962 E&P is the amount of tax paid by the taxpayer with respect to the S962 election in the prior year. Taxable S962 E&P is the excess of S962 E&P over excludable S962 E&P.

The  portion of  the distribution that is considered a taxable dividend may be classified as a “qualified dividend” attracting a maximum federal tax rate of 20%,  eligible for a full foreign tax credit for the higher Canadian tax rate levied on the dividend. If the CFC operates in a non-treaty country, the taxable dividend is not a qualified dividend, subject to the taxpayer’s individual marginal tax U.S. tax rate.

With the  proposed regulations, a valid timely-filed  section 962 election and a low effective Canadian tax rate, the U.S. individual shareholder of the CFC residing in Canada should not be presented with a double tax issue where undistributed earnings of the CFC are taxable in a year prior to the year of distribution

IRS Reporting requirements

As one can perceive, the annual compliance costs for U.S. investors of a CFC will rise as a result of the changes in the tax law. Where there are a series of foreign corporations such as investment holding corporations and/or sister corporations, the foregoing computations, ordering provisions and accounting are more complex and time consuming. This complexity under Subpart F of the IRS Code was present before the passing of sections 965 and  951A. Now it is more complex!

IRS Form 5471 (the annually filed U.S. information return by a U.S. shareholder of the CFC)  has been significantly revised, requiring additional schedules and revisions to earlier schedules. New IRS  Form 8992 reporting the computation of GILTI and IRS Form 8993 for the computation of the section 250 deduction  must be completed and filed with the timely-filed (including allowable extensions) U.S. person’s income tax return. The 5471 information return for each CFC carries a minimum $10KU.S. penalty for failure to timely file or failure to file a complete information return.

Currently there is no prescribed form for the section 962 election. Per its regulations, the election has certain information that must be presented and attached to the  timely-filed income tax return for the election to be considered valid.

U.S. filing extensions should be filed if  the  June 15th  automatic due date for U.S. individual filers residing outside of  the United States cannot be met. Any tax payable by  the individual U.S. investor is due still due by April 15th