In this series of blog posts I try to explain GILTI (Global Intangible Low Taxed Income) in simple terms. In the first post I discussed a public comment made on behalf of the Israeli Ministry of Finance on the recent proposed GILTI regulations. My second post explained the rationale behind GILTI. The third post talked about how GILTI was measured focusing on US domestic corporations, the target of these provisions in the first place. This post will look at how these rules, that were written for Apple and Google, play out for individuals owning small businesses in the “foreign” country where they live. For those who want to get into the detail, there’s a technical appendix on our wiki.
[This post has been updated on 16 March 2019]
So, what have we learnt so far? GILTI applies to US Shareholders of Controlled Foreign Corporations (CFCs). The aim was to tax globally mobile intangible income that multinationals can easily move to tax havens to minimise their worldwide tax bill. However, what is being measured is much broader, picking up much of the active business income of CFCs regardless of whether that income is being sheltered from US tax in a tax haven.
One takeaway is that GILTI doesn’t apply unless a business is organised as an entity that is treated as a corporation for US tax purposes. Under the “entity classification rules”, certain types of non-US businesses are required to be classified as a corporation for US tax purposes, while others can elect to be treated as either a corporation or a disregarded entity (essentially a sole proprietorship or partnership). In a post-GILTI world, classification as anything BUT a corporation may be optimal.
As we’ll find below, the rules that apply to individual US Shareholders of CFCs mean that they will be paying higher tax rates than corporate shareholders because:
- The 50% deduction applies only to corporate shareholders, and
- Without a special election (§962), individual shareholders cannot offset GILTI with foreign tax credits.
The result is that US tax will be owed on GILTI unless the foreign tax rate exceeds 26.25%, double the rate that applies to corporate shareholders.
Basic rules for individual shareholders
The rules we discussed in the prior post apply to US domestic corporations that own CFCs. While the calculation of GILTI is essentially the same for individual shareholders (GILTI = CFC income not already taxed by the US less deemed tangible income), the tax computation is completely different.
Corporate shareholders are allowed a deduction of 50% of their gross GILTI, but this deduction is not available to individual shareholders. Furthermore, individual shareholders will be taxed using the individual tax rate schedule, with marginal tax rates rising as high as 37%, instead of the new corporate tax rate of 21%. [Update March 2019 – in the §250 proposed regulations issued on 4 March 2019, the IRS relented and amended the §962 regulations to allow the 50% deduction to individuals electing to be taxed as a corporation under §962]
It is important to remember that corporations are taxed separately from their shareholders – they are separate taxable entities. This means that, absent a provision such as GILTI (or subpart F), shareholders do not pay tax on corporate income. If/when the corporation determines that it has excess cash to distribute, it will declare a dividend, which will be taxed to the shareholder.
When a corporation pays foreign taxes, those taxes are generally not treated as paid by the shareholder – that is, the shareholder cannot usually take a foreign tax credit for tax paid by the corporation. There are two instances when a shareholder is allowed to treat the tax paid by their CFC as if they had paid it themselves:
- A domestic corporation that is a US Shareholder in a CFC is deemed to have paid the foreign taxes paid by the CFC that apply to any subpart F income (broadly defined to include GILTI and the transition tax).
- An individual that is a US Shareholder in a CFC can elect (annually) to pay the corporate tax rate on all subpart F income (broadly defined to include GILTI and the transition tax) and use the corporate shareholder rules to receive FTC for taxes actually paid by the CFC. This is called a §962 election. We will discuss this election in detail later.
If an individual shareholder does not make the 962 election, GILTI will result in double taxation. This is because the foreign tax credit computation for GILTI is quarantined from foreign taxes paid on all other types of income. The only foreign tax that can possibly offset GILTI is the tax paid by the CFC – and without a §962 election an individual shareholder cannot use the tax paid by the CFC as a foreign tax credit.
To recap, under the normal rules an individual US Shareholder of a CFC will include in their taxable income 100% of GILTI (computed the same way that a corporate shareholder computes GILTI), and will pay US tax on the entire amount of GILTI at their marginal tax rate, up to 37%, with no credit for foreign taxes paid. This is the situation that was mentioned in the public comment made on behalf of the Israeli Ministry of Finance that I discussed in my first post.
Using the §962 election
In order to reduce or eliminate double taxation, we need to understand how a §962 election works. In a nutshell, the election allows individual US Shareholders of CFCs to compute their foreign tax credit as if they were a domestic corporation and use the corporate tax rate. The cost of this election is potentially higher US tax when dividends are paid.
Taxes paid by the CFC
Making the §962 election means that the individual shareholder can look into the CFC and treat foreign taxes paid by the corporation as if the shareholder had paid those taxes directly. To understand what this means, consider a case where a CFC has $7 of GILTI that the shareholder must include in income and the CFC has already paid $3 of foreign tax on that income. The $7 of GILTI is computed after deducting the $3 of foreign tax, so in order to use that foreign tax as a credit, it must be added back to taxable income to get the $10 of pre-tax income that became GILTI. Adding the foreign tax back is required under §78 of the tax code.
If this were a normal subpart F inclusion (remember, that’s generally passive income earned inside the CFC), then the entire $3 of foreign tax would be available as a credit against US tax on the $10. But, since the GILTI provisions limit the foreign tax credit to 80% of foreign tax paid, only $2.40 is available to offset US tax on the $10. To add to the confusion, note that the entire amount of the foreign tax is used for the §78 “add-back”, but only 80% for the foreign tax credit.
[revised 16 March 2019 – the following strikeout paragraphs have been replaced by the paragraph below them]
The §962 election sounds like it might allow an individual US Shareholder to compute the tax on GILTI as if they were a corporation. That’s not quite correct. The election allows the shareholder to compute the tax credit like a corporation, and to use a flat 21% tax rate, but it does not allow the shareholder to use any deductions against the GILTI inclusion. That’s why the 50% deduction allowed to corporations under §250 cannot be used by an individual US Shareholder, even if a §962 election is made. In the simplified example above, the $10 of GILTI would be taxed at 21% for a tax of $2.10. This would be fully offset by the foreign tax credit of $2.40. Note that the extra $0.30 is lost (as is the difference between actual foreign tax and the 80% allowed as a credit). The carry-forward rules for foreign tax credits do not apply to foreign tax credits on GILTI. The loss of the 50% deduction means that, for individual US Shareholders, GILTI is essentially a minimum tax of 26.25% – a rate that is higher than the US domestic corporate tax rate!
The §962 election allows an individual US Shareholder to compute the tax on GILTI as if they were a corporation. On 4 March 2019, the US Treasury issued proposed regulations in which they changed their position on the availability of the 50% deduction to individuals making an election under §962. In spite of the fact that §962 does not allow deductions, the preamble to the proposed regulations argues that Congressional intent in enacting §962 was that individual US Shareholders were to be treated no worse than if they had made their foreign investment via a domestic corporation rather than direct ownership in a CFC. To ensure that this intent is respected, individuals making a §962 election will be allowed to take the 50% deduction allowed by §250. The Technical Appendix to this blog post has been updated to take the proposed regulations into account. With the §962 election, an individual US Shareholder owning a CFC that pays more than 13.125% of tax locally will end up in exactly the same position as under prior law – they will have no current US tax on their active business income, and no Previously Taxed Earnings and Profits (PTEP).
What happens when the CFC pays a dividend?
Under the basic rules (without the election), any dividend paid out of earnings that have been previously taxed (including GILTI) are not included in US taxable income. Of course, the shareholder will probably pay tax where they live, but there will be no additional US income tax. The story is a bit different if the §962 election was made to reduce tax payable on GILTI. The cost of the election is that the shareholder only gets to treat an amount equal to the actual US tax paid (after FTC) as previously taxed, so most of the dividend will be taxable. This may not make much of a difference, however, as any tax paid where the shareholder lives will be available as a credit to offset US tax on the dividend.
In sum, the GILTI rules were written with large multinational corporate structures in mind. The rules for corporate US shareholders provide for LOWER US tax rates on non-US income than on US income. These corporate rules generally work as advertised to provide a minimum tax rate of 13.125% on CFC income classified as GILTI. However, individual US shareholders cannot take advantage of the provisions that reduce the US tax rate on GILTI below the corporate tax rate. For individual US Shareholders, the effective total tax rate on GILTI will be either their marginal US tax rate (if no §962 election is made), or the greater of 26.25% or their local (foreign to the US) tax rate (with a §962 election). This will be in addition to any tax paid on subsequent dividend distributions.
UPDATE 7 December 2018:
John Richardson and I have done a series of three videos on GILTI. The third is based on this post.
UPDATE 16 March 2019:
On 6 March 2019, I joined John Richardson and Monte Silver in a discussion of the proposed regulations:
 Net Investment Income Tax (NIIT) may apply at a rate of 3.8%.