Now that you own a controlled foreign corporation (CFC), are you GILTI?
An overview of Global Intangible Low-Taxed Income (GILTI)
Prior to the enactment of the 2017 Tax Cuts and Jobs Act (“TCJA”), the United States generally taxed US taxpayers on their worldwide income. However, US tax on foreign subsidiaries’ active business earnings could be deferred until such earnings were repatriated to the United States. The Global Intangible Low-Taxed Income (“GILTI”) provision, added by TCJA, significantly broadened the scope of foreign earnings that are subject to current US taxation, regardless of whether such earnings are distributed to a shareholder. Effectively, the GILTI regime subjects US shareholders of a controlled foreign corporations (“CFC”) to current taxation on most income earned by the CFC to the extent that such income is in excess of a 10% return on the CFC’s tangible assets (“QBAI”), reduced for certain interest expense. A US shareholder for this purpose generally is a US person that directly, indirectly, or constructively owns at least 10% of the voting power or value of a CFC on any day during the year, and who directly or indirectly owns any amount of CFC stock on the last day of the CFC’s taxable year during which it is a CFC.
The annual GILTI inclusion is generally computed by determining the taxable income/loss of a CFC as if the CFC were a US person. The following is then subtracted:
- CFC’s income that is effectively connected with a US trade or business,
- Income that is otherwise subpart F income (generally passive income, e.g. interest, royalties, rent and capital gains),
- Income that is not subpart F income because it is subject to an exception for income that is highly taxed,
- Related party dividends, and
- Oil and gas extraction income.
The resulting amount is further reduced by:
- An amount calculated as 10% of tangible property used in the CFC’s business; and
- Certain interest expenses associated with tangible assets.
A US shareholder calculates a single GILTI inclusion based on all of its CFCs. A GILTI inclusion increases US shareholder’s basis in its CFC stock and results in “previously taxed earnings” (PTI) equal to the GILTI inclusion. PTI is not subject to US tax when it is distributed to a US shareholder.
Corporate versus individual US shareholders
US shareholders that are corporations are allowed to reduce their GILTI inclusion (and related gross-up for foreign taxes paid) by 50%, subject to a taxable income limitation. When a full deduction is allowed, the domestic corporation’s effective tax rate on its GILTI inclusion is 10.5% (without taking into account foreign tax credits). The deduction percentage is reduced to 37.5% in 2026, which results in the effective tax rate of 13.125%. Additionally, US shareholders that are C corporations are allowed to claim an indirect foreign tax credit (limited to 80%) with respect to foreign taxes paid on the earnings of the CFC. Neither the 50% reduction of the GILTI inclusion nor an indirect foreign tax credit is available to an individual US shareholder under general rules applicable to individual US shareholders.
What is available to an individual US shareholder, however, is an Internal Revenue Code section 962 election. In general, an individual that makes a section 962 election is subject to US tax on the individual’s GILTI inclusion as if the individual was a domestic corporation – i.e., making a section 962 election allows an individual US shareholder to claim both the 50% deduction and an indirect foreign tax credit.
GILTI high tax exception
On July 20, 2020, the Treasury and the IRS finalized regulations for the GILTI high tax exception (the “Exception”). The Exception allows a US shareholder of a CFC to exclude GILTI tested income from the US shareholder’s US taxable income. It applies in instances where a CFC is taxed on its earnings in a foreign jurisdiction at an effective rate that is greater than 90% of the US federal income tax rate – i.e., 18.9%.
The application of the Exception is optional. To utilize the Exception, controlling US shareholders of the relevant CFC make an annual election, binding to all US shareholders, to use the Exception. To do so, they must attach a statement to their US federal income tax returns and provide notice of the election to all non-controlling shareholders of the CFC. When such an election is made, it applies to all CFCs in the group. If the election is made for GILTI, it also applied to subpart F income (an anti-deferral provision outside the scope of this article).
GILTI rules are complex and GILTI calculations can be tedious. Please contact your tax adviser at USTAXFS to discuss how these rules apply to your specific set of facts or contact us via our contact us page