By Chris McElroy, CPA, and Marko Zivanov, CPA, JD
As part of the 2017 Tax Cuts and Jobs Act (TCJA), Congress implemented a new anti-deferral tax on certain earnings of controlled foreign corporations (CFCs), known as global intangible low-taxed income (GILTI). Similar to the taxation of subpart F income, a U.S. shareholder of 10% or greater of one or more CFC is required to include GILTI as U.S. taxable income, in addition to any subpart F, regardless of whether the U.S. shareholder receives a distribution.
This law may have been devised to target technology and pharmaceutical companies with significant overseas income and discourage them from using intellectual property to shift profits outside of the United States. As written, though, there is no actual attempt to identify income from intellectual property, resulting in unintended consequences for noncorporate taxpayers.
GILTI is defined as income in excess of a 10% return on tangible assets. Based on this approach, CFC income in excess of this amount must relate to intangible assets. Congress believes these high-value assets are geographically mobile and should remain within the United States, and if they do not remain directly within the United States they should be subject to some level of minimum global tax. Note, the TCJA actually incentivizes U.S. corporate taxpayers to keep intangible assets within the United States via the Foreign Derived Intangible Income (FDII) deduction – the “carrot” to GILTI’s “stick.”
Lawmakers determined that 10.5% (through 2025 and 13.125% beginning in 2026) is the appropriate minimum global tax rate that should apply to intangible income. To arrive at this tax rate, corporate taxpayers are entitled to a special 50% deduction (37.5% starting in 2026) against the GILTI inclusion, as well as a deemed paid foreign tax credit for taxes paid by the U.S. corporation’s CFCs. The mechanics of the GILTI calculation should theoretically result in no incremental U.S. corporate tax as long as the required minimum level of tax is paid on CFC income outside of the United States. Keep in mind that the IRC Section 250 deduction and deemed paid foreign tax credit only apply to U.S. corporate taxpayers.
For U.S. corporate taxpayers, where a domestic corporation has a net operating loss (NOL) carryforward, the IRC Section 250 deduction is limited to 50% of taxable income after the NOL. If the NOL eliminates taxable income, GILTI will eat into the NOL, dollar for dollar (i.e., no 50% deduction). So, where a domestic corporation has an NOL that it will otherwise use, GILTI will effectively result in a 21% tax rather than the anticipated 10.5% tax. Also, consider where a CFC has an NOL carryforward (or foreign country incentives) and uses it to eliminate local country taxable income. In this scenario, a U.S. corporate taxpayer may have GILTI for the current year with no deemed foreign tax credit available – thereby eliminating the benefit of the foreign NOL. Whether or not these results were unintended, they must be given proper consideration by U.S. corporate taxpayers.
Noncorporate U.S. taxpayers also get roped in if the GILTI rules apply. Specifically, individuals – including partners in partnerships and shareholders in S corporations – must include their pro rata share of GILTI income in their individual income tax returns. The GILTI income is subject to ordinary federal income tax rates as high as 37%. Furthermore, individuals are not entitled to the special 50% deduction or deemed paid foreign tax credit. Thus, the tax consequences associated with GILTI inclusions to individuals are more severe than those to U.S. corporations. Limited relief from GILTI is available for some U.S. taxpayers under IRC Section 962 (insertion of a fictitious corporation between the individual and CFC), but this election is not appropriate in all situations.
The surprising result is that the GILTI rules tax U.S. individual shareholders even when a CFC pays income tax in its local jurisdiction at or above the minimum rate. Keep in mind, because the GILTI rules make no attempt to identify income from intangible assets, the threshold for a GILTI inclusion by an individual shareholder, directly or through a pass-through entity, is income of a CFC in excess of 10% of the CFCs tangible assets (a fairly low threshold). As a result, many noncorporate taxpayers have been severely hit by GILTI, as they are subject to U.S. tax of up to 37% without the 50% deduction or deemed paid foreign tax credit (without regard to an election under IRC Section 962). These are not the taxpayers Congress had envisioned with this provision.
One apparent oversight is the inclusion of a “high-taxed exception” that applies to subpart F income. This provision generally excludes from subpart F all items already taxed at a sufficiently high rate in foreign jurisdictions. However, this statutory exception seemingly only excludes high-taxed income if such income would otherwise be subject to subpart F income. Therefore, many U.S. individuals (directly or via pass-through entities) have been required to pay tax on GILTI, irrespective of the fact that they have a CFC paying tax in a high-tax foreign jurisdiction. Taxpayers in this situation are now motivated to have their income be subpart F income so they can take advantage of the existing high-taxed exception. This is counterintuitive for tax practitioners who have spent their careers advising clients how to mitigate subpart F.
It appears relief is on the way. On June 14, 2019, the U.S. Treasury Department and IRS released proposed regulations whereby taxpayers may elect to exclude high-taxed income from GILTI, regardless of whether the underlying item of income would be includible as subpart F income. Accordingly, income that is subject to a tax rate in a foreign jurisdiction that exceeds 90% of the U.S. tax rate imposed on corporations (18.9%) may qualify for this new exclusion. The proposed rule asserts that once a taxpayer makes an election to exclude high-tax income from a CFC, it must continue to do so for five years.
There are a couple points to consider here. First, there’s a gap between the 18.9% high-tax exception rate and Congress’s intent to tax as GILTI the intangible income of a CFC taxed outside of the United States at a rate of less than 10.5% (13.125% beginning after 2025). It’s a gap, but a step in right direction nonetheless. Second, the GILTI high-tax exception is only included in proposed regulations. Therefore, taxpayers cannot currently rely on these regulations.
Every U.S. shareholder of a CFC will be affected by the GILTI rules. For corporate taxpayers, GILTI may have surprising consequences in scenarios involving domestic and foreign NOLs. For noncorporate taxpayers that have been scrambling to address GILTI, the “high-tax exception” of the proposed regulations should provide some relief when these regulations are issued in final form. In the meantime, practitioners must look to the various elections (i.e., IRC Section 962) and planning techniques (e.g., affirmative use of subpart F) to minimize the impact of GILTI on their clients.
Chris McElroy, CPA, is a shareholder with Schneider Downs & Co. Inc. Marko Zivanov, CPA, JD, is a manager with Schneider Downs.
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