The US Tax Cuts and Jobs Act 2017 (TCJA) introduced from 2018 a lower corporate tax rate of 21%, but also a new anti-abuse tax regime applicable to controlled foreign corporations (CFCs).
The global intangible low-taxed income (GILTI) regime is designed to discourage US-based multinational groups from shifting corporate profits to controlled subsidiaries based in low-tax jurisdictions.
Without GILTI, the new dividends received deduction (DRD) could be gamed to eliminate all US tax as income is earned and then distributed to a corporate parent In the US. For example, a US-based group could reduce its US tax liabilities by shifting profit-making activities to its CFCs that could generate low-tax profits abroad. These profits could then be distributed to the US parent on a tax-free basis as a result of the operation of the DRD.
Other changes made by TCJA include an interest restriction limiting interest deductions to 30% of earnings before interest, depreciation and taxes (EBITDA), subject to certain tax adjustments, and changes to the loss relief rules. In relation to accumulated foreign earnings, under the TCJA a US parent pays a one-time tax on all post-1986 accumulated foreign earnings and is then entitled to a DRD of 100% of dividends paid from 2018 onwards.
Operation of GILTI
Each 'US Shareholder' of a CFC must include in its gross income its share of GILTI for the tax year.
A non-US corporation is a CFC if more than 50% of the voting power or value of all shares outstanding are owned by one or more US Shareholders. A 'US Person' is a 'US Shareholder' if he or she or it owns at least 10% of the voting power or value of all outstanding shares of the foreign corporation. Included in the definition of a US Person are US citizens, US residents, US corporations, and US partnerships and LLCs treated as partnerships. In applying the definition of a CFC, shares may be held directly, indirectly, or constructively through attribution from another person such as a family member or a trust in which the US Person is a beneficiary.
Once the US Shareholders and CFCs are identified, the GILTI of each CFC must be computed. At this stage, certain items of the CFC’s gross income are eliminated. These include (i) business income that is subject to net-basis taxation in the US, (ii) dividends from a related person F, and (iii) all other income of a CFC that result in an immediate US tax under Subpart F for its US Shareholders.
Under Subpart F, certain types of income earned by a CFC are subject to tax in the hands of the CFC’s US Shareholders in the year earned, even if the CFC does not distribute the income to its shareholders in that year.
The remaining income is referred to as 'Tested Income'. In determining how much 'Tested Income ' is treated as GILTI, actual economic drivers for generating income are ignored. Instead, all items of CFC income are deemed to arise from either depreciable tangible property used in the business or intangible property used in the business.
The investment in tangible depreciable property is deemed to generate a 10% yield computed with reference to the adjusted basis of the property. That is reduced by interest expense unrelated to interest income. The balance of the income is attributable to intangible property, which gives rise to GILTI
At this point, the positive and negative GILTI results for each CFC owned by the US Shareholder are aggregated. The US Shareholder reports the net amount of GILTI on its US Federal tax return.
Foreign Tax Credit for Corporations
When a US Shareholder is a corporation, a deemed-paid foreign tax credit is allowed. As a result, several additional computations are required to calculate the foreign tax credits attributable to GILTI.
Because the foreign tax credit relates to taxes actually paid by the CFC but attributed to the corporate US Shareholder that is subject to US tax on GILTI – sometimes called an indirect credit – the income tax for which the credit is claimed must be added to the amount otherwise reported as taxable. This is referred to as a gross-up. Its purpose is to equate the deemed-paid credit to a direct foreign tax credit on a branch of the US corporation. There, the payment of the creditable tax does not reduce taxable income – just as the Federal income tax does not reduce taxable income.
GILTI and the taxes attributable to GILTI are placed in a separate foreign tax credit limitation 'basket.' US tax law requires foreign-source income to be divided into various 'baskets' to prevent foreign income taxes on certain income in one category from reducing US tax on other income in a different category. Because GILTI is thought of as being an item of low-tax income, the separate basket ring-fences the income and creditable taxes so that the US tax on GILTI cannot be offset by excessive taxes on income in other baskets.
One problem with the foreign tax credit for GILTI is that only 80% of the deemed-paid tax can be claimed as a foreign tax credit even though all of the foreign tax is grossed up into income. Foreign tax on GILTI that cannot be claimed as a credit is lost forever.
Once the gross amount of GILTI is determined, a US corporation is entitled to a 50% deduction (reduced to 37.5% in later tax years) based on the amount of GILTI included in income. Because the rate of corporate tax in the US is 21%, a corporate US Shareholder’s effective tax rate on GILTI plus the foreign tax credit gross-up generally will be 10.5% (increased to 13.125% in later tax years).
Only corporations are entitled to the 50% deduction and the deemed-paid foreign tax credit.
As a result, an individual who is a US Shareholder of a CFC generating GILTI may find that a tax liability arises but cash may not be available in the CFC to fund the payment of dividends to pay the tax. In order to ameliorate the problem of tax without cash, US tax law allows an individual who is taxed under GILTI to elect to be taxed as a US corporation with regard to GILTI reported on a US tax return. Corporate treatment is limited to the GILTI and items of Subpart F income.
The corporate tax rate of 21% applies, the deemed-paid foreign tax credit for foreign taxes in the GILTI basket is allowed, and the 50% deduction is granted. When the individual receives an actual dividend from the CFC, it is treated as a dividend received from a US corporation to the extent of the amount that was taxed previously. Because the dividend is deemed to come from a U.S. corporation, it is a qualified dividend that is taxed at rates that do not exceed 20%.
The TCJA is notable for the adoption of different treatment for corporations and individuals and for some purposes between large and small corporations. For example, the interest ceiling which caps interest expense deductions for business does not apply to small corporations having not more than $25 million of gross receipts on average for each of the preceding three taxable years.
Certainly, the combination of GILTI and the allowable 50% deduction provides corporations with a better result than individuals. Nonetheless, by promoting the use of corporate tax treatment, for individuals faced with a GILTI inclusion, individuals benefit from receiving dividends that are treated as qualified dividends at least in part even if the CFC is based in a jurisdiction that does not have an income tax treaty in effect with the US. That, itself, can be a major plus for an individual as favorable long-term capital gains tax rates apply to qualified dividend income.
This update was produced with assistance from Elizabeth V. Zanet and Stanley C. Ruchelman of Ruchelman P.L.L.C, New York City