Individuals from the United States who are shareholders (including estates and trusts) of controlled foreign corporations (CFCs) face a difficult path in how to structure these investments in a tax-effective manner. The Tax Cuts and Jobs Act of 2017 (TCJA) treats U.S. corporate shareholders more favorably than U.S. individuals with regard to investments in CFCs. The TCJA has a new global intangible low-taxed income (GILTI) inclusion as part of the U.S. Subpart F anti-deferral rules that expands inclusions from CFCs to individual shareholders who are federally taxed at up to 37%. It also creates a double taxation event because individuals are not entitled to a credit for underlying foreign taxes paid in the income included. Corporations are taxed more favorably on their GILTI inclusions, as discussed below.
For individuals, a Section 962 election might be beneficial in this situation. Section 962 of the Internal Revenue Code was enacted in 1962, along with the rest of the U.S. anti-deferral Subpart F provisions. At that time, the top individual income tax rate was 91% and the top corporate income tax rate was 52%. With this concept of taxing the phantom income of a CFC under Subpart F, Congress provided a means of reducing the tax burden for individuals through credits for the foreign taxes paid on the foreign income inclusions. Congress allowed this to create parity between individuals investing directly in a foreign CFC and investing in a U.S. corporation that invested in a foreign CFC. Prior to the TCJA, a Section 962 election was rarely made and generally required a fairly unique set of facts to be beneficial.
A Section 962 election provides individual shareholders of a CFC with the option to tax Subpart F income from CFCs at a hypothetical U.S. C corporation’s lower rate of 21%. Also, the hypothetical C corporation is entitled to the 50% Section 250 (GILTI/foreign-derived intangible income) deduction on the GILTI inclusion, which results in a tax rate of 10.5% on the GILTI income. Then, the hypothetical C corporation is permitted 80% of the deemed paid foreign taxes on the GILTI. Therefore, if the foreign income included in the hypothetical C corporation is taxed at a rate of at least 13.125%, then no residual U.S. tax results for the hypothetical C corporation – a potentially much better result than not making a Section 962 election. When the foreign earnings are subsequently distributed out of the CFC, they are taxed as dividends at the U.S. individual level. If the CFC is located in a country that has a treaty with the United States that contains an exchange of information clause, then the dividends may be taxed at the 20% qualified dividend rate, otherwise it may be taxed at up to 37% (plus the 3.8% Net Investment Income Tax).
In certain circumstances, a Section 962 election can be made on an amended return. The election is made annually, so an individual can choose to make it one year and not make it in another year if it is not beneficial.
A comparison and projection should be made to determine if a Section 962 election should be made or whether the CFC should be transferred to an actual U.S. C corporation. Further, the projection should consider whether a check-the-box election should be made on the foreign investments (assuming this can be done tax-effectively) to flow through foreign income and foreign taxes as a credit against the foreign income taxed by the United States. Some factors to be considered (although others may arise depending upon the circumstances) are as follows:
- What is the do-nothing cost?
- What tax rate is imposed on the foreign earnings?
- What are the distribution projections of the foreign earnings?
- Do subsequent distributions qualify for the 20% qualified dividend U.S. individual tax rate?
- What are the state income tax implications?
- What are the projections for double tax from a disposition when a CFC is transferred to an actual U.S. C corporation?
- What might happen with future U.S. tax legislation and the potential for rising U.S. corporate tax rates if the parties in the U.S. Senate and presidency shift, and can the structure be modified in a tax-effective way if necessary?
As a side note, Treasury issued proposed regulations that would contain a high-taxed exception for GILTI income taxed in a foreign jurisdiction at a rate greater than 18.9%, but taxpayers cannot rely on this exception until the year after the regulations are final, which is not expected to occur until, at earliest, in late 2019. This would be a helpful exception if it is included in final regulations.
A Section 962 election may be an effective tool for mitigating the impact of enhanced U.S. tax inclusions from the GILTI provisions enacted in the TCJA for individuals. However, it needs to be carefully considered based on the circumstances: a modelling exercise should be undertaken that outlines and calculates the pros and cons of each alternative.
Andrew M. Bernard Jr., CPA, is a managing director for Andersen Tax LLC in Philadelphia and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.