The taxation of international activity by the IRS has always been a complex area of the Internal Revenue Code (IRC). As you probably know by now, the Tax Cuts and Jobs Act (TCJA), signed by President Donald Trump in December 2017, drastically changed the taxation of multinational activity. The treatment of earnings in foreign subsidiaries was a major focus of the TCJA and it triggered substantial effects in the financial statements of major multinational corporations.1 Under prior law, U.S. taxes were generally deferred until foreign profits were repatriated. The TCJA eliminated this deferral by implementing a one-time tax on undistributed profits of foreign subsidiaries.
To understand the law, one must remember the impetus behind the tax legislation—particularly the international provisions—was to eliminate the incentive for generating profits in foreign countries and then keeping the earnings outside the U.S. by reinvesting in foreign operations. To eliminate the barrier prospectively, the TCJA included new IRC §245A, which provides a participation exemption for dividends from foreign subsidiaries. One must note, however, that the deduction under §245A only is available to domestic corporations, not to S corporations or individuals who own foreign corporations directly or through partnerships. Privately held business entities frequently adopt these flow-through structures but will not be able to leverage the deduction under §245A. Distributions through these pass-through entities will continue to be taxable.
Global Intangible Low-Taxed Income
Realizing the new participation exemption would allow companies to generate profits in foreign jurisdictions and repatriate without U.S. tax, Congress also wanted to impose a disincentive for such behavior prospectively. The TCJA introduced a new concept: Global Intangible Low-Taxed Income (GILTI). The concept of GILTI is that “excess earnings” in a controlled foreign corporation (CFC) are deemed distributed to U.S. shareholders, similar to subpart F income. New §245A is not available to shield the profits deemed distributed from taxation in the United States.
While the definition of excess earnings is complicated, the general concept is to permit a foreign subsidiary to earn a 10 percent rate of return on its qualified business asset investment (QBAI). QBAI is a quarterly average of a CFC’s basis in specified tangible property that is used in a trade or business and subject to a deduction for depreciation. For example, where a CFC has €1 million of QBAI and earns a profit of €300K, €200K of the profit would be GILTI and would be required to be recognized ratably by the CFC’s U.S. shareholders.
Domestic corporate shareholders can claim a deduction equal to the lesser of 50 percent of GILTI or taxable income.2 With the corporate rate at 21 percent, the net effective tax rate on GILTI is 10.5 percent, assuming the domestic corporation is otherwise in a profitable situation.
C corporation shareholders also are permitted to claim a foreign tax credit (FTC) for foreign taxes paid on GILTI; however, the FTC is limited to 80 percent of the foreign taxes paid. So, while GILTI is intended to be a disincentive for corporations to generate profits overseas, there is not a net tax cost to doing so, as long as the foreign taxes available for credit are at least 13.125 percent. To expand on the example above, if the foreign corporation paid foreign taxes of €100K on its €300K earnings (tax at a 25 percent rate on the pretax equivalent of €400K), there would be no net cost to the corporation from the GILTI. While a 13.125 percent minimum foreign tax rate may be a substantial increase in foreign taxes for many multinational corporations, it may not be much of a deterrent for foreign earnings—but read on to understand how the GILTI provision can have a tax cost even where the foreign corporation is paying tax at a 13.125 percent rate or higher.
GILTI for Pass-Through Entities
Up to this point, this article has examined the effect of GILTI on domestic C corps. Privately held businesses that use flow-through structures for their domestic holdings but treat their foreign subsidiaries as foreign corporations, i.e., not flow-through entities, may be in for a shock when they realize:
- GILTI will apply to the extent foreign subsidiaries have excess earnings
- No 50 percent deduction is applicable
- GILTI is not eligible for the capital gain tax rate (as qualified dividend income ) under §1(h)(11)
- No FTC for the foreign taxes paid by the CFC will be available
Using the same example as above, if an individual owns 100 percent of the shares of an S corp, and the S corp owns 100 percent of a CFC, the individual would be required to recognize the €200K of GILTI as ordinary income resulting in tax—assuming a top rate of 37 percent—of the USD equivalent of €74K.
If not for a little-known election included in the Subpart F statutes, the comparative results between an individual owning CFCs and a domestic corporation owning CFCs would have had Main Street screaming for the treatment available to Wall Street. Little-known and frequently misunderstood §962 permits a U.S. individual, or trust, to elect to be taxed as a corporation just for purposes of GILTI and Subpart F. As a fictitious corporation, the individual is taxable only on the GILTI income and would be entitled to claim the FTC. Recently issued proposed regulations confirm the U.S. Department of the Treasury (Treasury) will permit these deemed corporations to claim the 50 percent deduction available to corporations on their GILTI.3 So, as a result of a §962 election, a CFC that has paid foreign income taxes on its GILTI at a rate of at least 13.125 percent should not trigger an additional tax liability for the CFC’s individual owner until the earnings are repatriated as a real dividend.
The calculation of GILTI is very complex, and particularly so where a CFC has a complex operating structure and multiple classes of income. While not described in this article, the calculation of GILTI requires a thorough understanding of a CFC’s activities and classes of income, as well as detailed accounting records. For a closer look at some of the stumbling blocks GILTI may impose on taxpayers, check out this related article. Contact Tom or your trusted BKD advisor for more information on how GILTI may affect you in 2018 and beyond.
1 For example, Apple disclosed the deemed repatriation tax would cost it $38 billion. ↩
2 The limitation is actually 50 percent of GILTI plus 37.5 percent of Foreign Derived Intangible Income (FDII), the new export incentive available to C corps. The topic of FDII is addressed in another article. ↩
3 Treasury has made public comments that the 50 percent deduction would be permitted to an individual making a §962 election. ↩