The U.S. Department of the Treasury on March 4, released proposed regulations dealing with the application of the recent U.S. tax reform to U.S. shareholders of a controlled foreign corporation (CFC). The proposed regulations (REG-104464-18) provide relief from some of the provisions of the U.S. tax reform that apply to individual U.S. citizens or tax residents and U.S. trusts and estates who own stock in a CFC.
While the relevant provisions of the applicable U.S. tax law are quite detailed, this article provides a general summary of the relief provided to individuals.
A foreign corporation is a CFC if its stock is more than 50 percent owned (by vote or value) by “United States shareholders” (such as U.S. citizens or tax residents, U.S. corporations, U.S. trusts and U.S. estates that directly or indirectly own stock in the foreign corporation).
Historically, the general rule was that the U.S. shareholders of a CFC were not taxed on the CFC’s income until it was distributed to them (with the exception of certain specific types of income earned by the CFC). This allowed significant opportunities for U.S. shareholders to defer U.S. tax on the foreign income earned by the CFC.
This all changed under the Tax Cuts and Jobs Act (TCJA) enacted at the end of 2017. Under the TCJA, a U.S. shareholder of a CFC is taxed on the global intangible low-taxed income (GILTI) of the CFC. Essentially, with a few exceptions, GILTI includes all of the CFC’s net income, less a deemed 10 percent return on the CFC’s adjusted basis in its tangible, depreciable business assets.
Therefore, under the new GILTI rules, it is far more challenging (and in some cases impossible) for U.S. shareholders of a CFC to achieve deferral of U.S. tax on the foreign income earned by the CFC.
Treatment of GILTI to Individual U.S. Shareholders
Many have noted that the international tax provisions of the TCJA are more beneficial to corporations than to individuals. This is particularly true with respect to the taxation of GILTI.
For example, under the TCJA, a U.S. individual is taxed on the GILTI that he earns at rates of up to 40.8 percent. (The maximum ordinary income rate is currently 37 percent, and there is a 3.8 percent net investment income surtax.) The U.S. individual may also be subject to state and local tax on the GILTI.
On the other hand, under the TCJA, U.S. corporations are in general taxed at a flat corporate tax rate of only 21 percent. Moreover, they are allowed a 50-percent deduction (reduced to 37.5 percent in 2026) for GILTI income, which results in a tax rate of 10.5 percent. This 50 percent GILTI deduction is not allowed to U.S. individuals.
In addition, corporations, unlike individuals, are allowed a foreign tax credit for up to 80 percent of the foreign taxes paid or accrued by the CFC on the GILTI. This credit can offset and even eliminate the U.S. taxes paid by a U.S. corporation on GILTI. On the other hand, individuals are not allowed a foreign tax credit for the foreign taxes paid by the CFC, resulting in double taxation.
Section 962 Election to the Rescue
Many U.S. individuals have been hoping to minimize these adverse consequences by making an election under Section 962 of the Internal Revenue Code. The Section 962 election allows a U.S. individual (including trusts and estates, which are treated as individuals) to be taxed on CFC income inclusions (such as GILTI) as a U.S. corporation.
There has been no question that the Section 962 election would allow a U.S. individual to benefit from 80 percent foreign tax credit for the foreign taxes paid by the CFC on GILTI income.
However, there has been considerable uncertainty as to whether the 50-percent deduction for GILTI income would apply where a Section 962 election is made. The lack of a 50-percent GILTI deduction would cause serious tax inefficiencies to many U.S. individuals, and the uncertainty has left U.S. individuals who own stock in a CFC in a difficult position.
Fortunately, the proposed regulations answer this question and allow the 50-percent GILTI deduction where a U.S. individual makes the Section 962 election.
The new GILTI rules can potentially tax a U.S. shareholder of a CFC on all or most of the income earned by the CFC. Without proper planning, the new GILTI rules tax U.S. individuals more harshly than corporations. However, under the proposed regulations, a U.S. individual who owns stock in a CFC may minimize or eliminate some of the adverse consequences imposed by TCJA by making a Section 962 election.
U.S. shareholders of CFCs should consult their tax advisers for further guidance.
William B. Sherman is chair of Holland & Knight’s tax team and a resident of the firm’s Fort Lauderdale office. He concentrates his practice in the areas of domestic and international taxation and provides sophisticated tax planning for mergers and acquisitions, restructurings, joint ventures and investments.
Seth Entin is a tax partner in the firm’s Miami office who focuses on federal income taxation, with an emphasis on international taxation. He has experience handling international taxation of high-net-worth individuals, international and domestic corporate taxation, Internal Revenue Service international tax audits and offshore voluntary disclosures.