GILTI High-Tax Election a Welcome Alternative to a Section 962 Election
With the introduction of global intangible low-taxed income (GILTI) and other changes to the international tax regime at the end of 2017, there was a quick reintroduction of the Section 962 election. Many individual taxpayers owning foreign corporations found that their foreign earnings were no longer deferred and were subject to ordinary income tax rates. As a result, some individual taxpayers have used §962 as a tax planning strategy. Ironically, while enacted in 1962, prior to 2018 this section was not that commonly used. With the introduction of the GILTI high-tax exception regulations, taxpayers now have another strategy available that can be even more beneficial.
In general, §962 allows an individual U.S. shareholder who owns at least 10 percent of a controlled foreign corporation (CFC) to elect to treat their foreign earnings in their 10 percent or more owned CFCs as “if” they were taxed as a corporation. Therefore, the §962 election allows GILTI income to be eligible for a §250 deduction (currently 50 percent) and to offset those earnings with 80 percent of the related foreign tax credits (FTC). Without the §962 election, an individual taxpayer is taxed at ordinary rates and not eligible to either take the §250 deduction or claim FTCs arising at the CFC level against their GILTI income. The §962 results in the taxpayer with an eligible GILTI inclusion to be taxed at 10.5 percent, under current law, on those GILTI earnings before claiming FTCs. Assuming the U.S. effective tax rate of those CFC earnings is above 13.165 percent, then generally there are no additional U.S. taxes due in the current year.
However, under §962, while previously taxed earnings and profits (PTEP) are created, there is a second layer of tax that taxpayers need to consider. To the extent the §962 earnings and profits (E&P) result in a tax liability at the U.S. individual level, then a distribution of this E&P is taxed to the extent it did not create a tax inclusion under the §962 election. This means that when those earnings are later distributed, they are taxable as a dividend to the individual if no tax was due when the election was made. Only qualified dividends are eligible for the current reduced dividend rate of 20 percent, plus net investment income tax (NIIT) of 3.8 percent, if applicable. However, if the taxpayer’s CFC is located in a nontreaty country, then ordinary rates apply on the later distribution. Therefore, the taxpayer must carefully analyze their tax position to determine whether a §962 election is beneficial.
There also is a state tax implication of §962, which many states have provided limited guidance on to date. If the taxpayer moves after making the §962 election, this also may impact the taxation of the future distribution of the §962 E&P.
If a taxpayer’s GILTI inclusion has an effective tax rate of at least 18.9 percent (90 percent of the current U.S. corporate rate of 21 percent), calculated based on U.S. tax principles, the GILTI high-tax election (HTE) may be the better alternative. Treasury swiftly proposed these regulations in 2019 and finalized them in 2020. The regulations allow a 24-month period to amend returns and apply the regulations. The HTE allows for an election to be made on the current return (or amended) via a single statement claiming the election. No further specific tracking of that E&P for future distributions is required. This is a welcome compliance relief as §962 election is more burdensome in the actual reporting in the return and future tracking of that E&P.
There are some circumstances in which a §962 election may be more beneficial such as net operating loss carryforwards in local countries lowering the normal rate of tax on those earnings, and CFCs taxed below 18.9 percent, among others. A §962 election also may be beneficial if there is a risk a CFC may have §956 income. This can result from a loan from the CFC to the U.S. shareholder or if more than 66.66 percent of the CFC’s assets are pledged as collateral against a U.S. loan. In this situation, the PTEP created in §962 may mitigate such an inclusion.
Both the §962 election and the GILTI HTE are made annually on the taxpayer’s return, allowing for the taxpayer to determine which may be most beneficial. However, all earnings eligible for either §962 or the GILTI HTE must follow the election and the earnings cannot be “cherry-picked.”
Many taxpayers started using §962 in 2018, but the transition to using the GILTI HTE is often a viable alternative and may save time and expense down the road.
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