GILTI Planning for Closely Held Companies
April 8, 2022
At a glance
- The main takeaway: While more foreign income is now subject to current U.S. federal income tax after the 2017 tax reform bill, there are certain actions that individual U.S. shareholders may be able to take to minimize their exposure under the global intangible low-taxed income (GILTI) provision.
- Impact on taxpayers: GILTI requires a U.S. shareholder (i.e., 10% vote or value ownership) of a controlled foreign corporation (CFC) (i.e., U.S. shareholders own more than 50% of the vote or value) to include its share of CFC income in its taxable income currently.
- Next steps: Consult with international tax specialists and advisors to conduct appropriate tax planning before making the move. Aprio’s International Tax team stands ready to help.
Schedule a consultation with Aprio today
The full story:
The 2017 Tax Cuts and Jobs Act (TCJA) retained the subpart F anti-deferral provisions and created a new class of income called GILTI, which is another anti-deferral provision intended to prevent base erosion from attribution of foreign profits to low-tax jurisdictions.
GILTI results in income earned by foreign subsidiaries to be subject to current U.S. taxation at the U.S. shareholder level. The state-law treatment of GILTI varies amongst the states. Although the computational aspects of the GILTI provision are outside the scope of this article, we provide key considerations for proper planning below.
Planning for closely held companies
Individual U.S. shareholders are disadvantaged under the GILTI provision because a foreign tax credit for foreign taxes attributable to GILTI and a statutorily allowed 50% GILTI deduction apply only to domestic corporations. Unless an affected individual U.S. shareholder engages in planning to minimize their GILTI exposure where possible, they will be required to include GILTI as gross income subject to tax typically at the highest marginal federal tax rate of 37%. The result is double taxation and, in many cases, a high effective rate of tax on such foreign income after application of foreign and U.S. federal income tax.
The C corporation blocker
To improve the GILTI profile, a U.S. individual could form a U.S. C corporation (“NewCo”) and contribute its CFC shares to NewCo in a tax-free transaction. Since NewCo would be the U.S. shareholder of the CFC for purposes of GILTI, NewCo should be entitled to claim a 50% GILTI deduction and an 80% foreign tax credit. Unlike an individual U.S. shareholder, depending on the location of the CFC and the amount of its foreign income taxes paid, in many cases, NewCo may not have a federal tax liability with respect to its GILTI.
This planning can also be useful if an U.S. individual owns a CFC in a non-treaty jurisdiction which pays a dividend from non-previously taxed earnings. If the individual received such a dividend, the dividend income generally will not be qualified dividend income subject to a reduced rate of tax (i.e., 23.8%). By forming NewCo, the same dividend income may qualify for a 100% dividend-received deduction, provided all the requirements are satisfied. Subsequently, when NewCo pays a dividend to its individual shareholder, the dividend income will constitute qualified dividend income, because it is paid by a domestic corporation. In addition, some U.S. tax treaties upon qualification may also provide a more favorable foreign withholding tax rate on distributions to NewCo as a C corporation shareholder.
One downside of the NewCo structure is that there is the potential for double taxation on the sale of the CFC. If NewCo sells the CFC shares at a gain, it could be subject to U.S. federal corporate tax, and upon a distribution of the sales proceeds to its shareholder, the shareholder would be subject to tax on the dividend income.
The section 962 election
Another solution to improve the U.S. federal income tax consequences is for an individual U.S. shareholder of a CFC to make a section 962 election. The U.S. federal income tax consequences of GILTI generally will be the same as if NewCo above was used. The U.S. individual shareholder would be allowed a 50% GILTI deduction and an 80% foreign tax credit and would be subject to the corporate tax rate on GILTI income (i.e., 21%). If the CFC makes a distribution and the distribution is attributable to section 962 earnings, it will be included in shareholder gross income and subject to tax on the amount of the distribution that exceeds the amount of tax previously paid on the original GILTI inclusion. One critical factor is whether such distribution is a qualified dividend eligible for the reduced tax rate — this will not be the case if the CFC is located in a jurisdiction in which the U.S. does not have a tax treaty. If the CFC is not in a treaty country, then investing through a U.S. corporation may be more tax-efficient but query whether the CFC anticipates distributions or will reinvest offshore.
A potential benefit of this planning as compared to the NewCo structure is the U.S. federal income tax consequences upon an exit. Because the election is made annually, the shareholder can choose to not make it in the year of sale and avoid double taxation.
An additional planning idea to consider is whether it makes sense to liquidate the CFC. A liquidation could occur actually or by making a check-the-box election. If the CFC is located in a high-tax jurisdiction and it is disregarded or classified as a partnership for U.S. tax purposes, liquidation is generally more favorable because the individual U.S. shareholder may be entitled to claim a foreign tax credit for foreign taxes paid. However, if the foreign entity is in a jurisdiction with no tax or a low-tax jurisdiction, it may make sense to retain CFC status.
Prior to any check-the-box election, consideration should be given to whether:
- the CFC is on the “per se” list and not available to make a check-the-box election without additional planning;
- the liquidation would qualify as tax-free for U.S. federal income tax purposes;
- the individual U.S. shareholder would incur a deemed dividend of the “all earnings and profits amount,” which would create an additional tax expense to the individual U.S. shareholder.
The high-tax election
Finally, the IRS has finalized regulations which provide another planning tool, the GILTI high-tax exception. Under a GILTI high-tax exception election, a CFC’s income is generally not taken into account in determining U.S. shareholder GILTI to the extent that such income is subject to an effective foreign tax rate of 18.9% or higher.
The bottom line
The aforementioned planning ideas could minimize an individual U.S. shareholder’s exposure under the GILTI provision. Of course, at the outset, it can be unclear which is most optimal. The above generally highlights certain considerations with respect to a complex set of rules, but modeling out the scenarios is necessary to properly evaluate what makes sense.
If you want to learn more about the benefits of certain GILTI planning options, contact Aprio’s International Tax team for guidance.
About the Author
Jed is a Tax Partner at Aprio who counsels clients on international tax matters and M&A transactions. Jed has a deep knowledge of federal tax law and transactional tax planning, including serving more than a decade as in-house counsel for technology corporations and as a member of multinational professional services firms. He routinely advises multinational clients on a broad array of inbound and outbound U.S. and international jurisdiction tax matters, including repatriation planning, international tax credit planning, holding company and financial structures, foreign exchange matters, internal reorganizations and post-acquisition integrations. His background is invaluable as he works with clients to develop tax saving strategies.