The world of U.S. taxation is fraught with rules, Internal Revenue Service (IRS) and Treasury Department regulations, and laws, not to mention potentially massive pitfalls for not complying with your tax liability. This risk is especially the case when it comes to international income tax. Adding to the complexity are acronyms such as CFC, FBAR, FATCA, and, now, the mother of all acronyms, GILTI. But what is GILTI, or global intangible low-taxed income? More importantly, what is the impact of the GILTI rules, does GILTI apply to you, and what are the planning considerations for global individuals and business owners, whether U.S.-based or non-U.S.?
What is Global Intangible Low-Taxed Income (GILTI)?
The Internal Revenue Code (IRC), enforced by the IRS, sets out a complex approach to tax specific income of certain non-U.S. entities owned by U.S. shareholders under the global intangible low-taxed income or GILTI regime. The Tax Cuts and Jobs Act of 2017 (TCJA) is a tax policy that had few but significant elements to contradict the territorial tax approach, and one of them was promulgated as the GILTI regime.
Previously excluded under the subpart F regime, certain earnings of controlled foreign corporations (CFC) have become taxable income thanks to the TCJA, and specifically, under the GILTI regime.
But before we discuss GILTI, we should specify what constitutes subpart F income. Enacted in the year 1962, IRC §952 defines subpart F income in relation to a CFC as the sum of insurance income, foreign base company income, international boycott income, illegal bribes, kickbacks, or other illegal payments made by the CFC, or income derived from certain disfavored countries. It does not include any income effectively connected to a U.S. trade or business. It is important to note that income that is not categorized as foreign base company income and insurance income, if taxable in a foreign jurisdiction at an effective tax rate of more than 90% of the top U.S. corporate tax rate (high-tax exclusion), would be considered income subject to GILTI. Therefore, a CFC’s subpart F income would not include an income effectively taxed at more than 18.9% (i.e., 90% of 21%) in a foreign country. Stated another way, GILTI income is any income that is not considered subpart F income. The impact here is that GILTI often results in double taxation of a CFC’s earnings. Learn more about Subpart F in our blog _____
Structure and Purpose of GILTI
Before the TCJA, U.S. shareholders and owners could defer income tax on the active earnings of foreign entities until those earnings were repatriated to the U.S. in the form of dividends.
IRC §951A, which contains the GILTI rules, was added to the tax code by the TCJA. One of the features of the TCJA was to provide corporate shareholders a 100% dividends received deduction (DRD) on dividends from foreign corporations. However, to prevent taxpayers from shifting income offshore to low- or no-tax jurisdictions, Congress passed tax reform via the GILTI rules. These require U.S. shareholders of CFCs to include GILTI in gross income each year.
Specifically, GILTI is a 10.5% percent minimum tax enacted on this income to dissuade U.S. taxpayers from engaging in profit-shifting.
And although the TCJA lowered the top corporate income tax rate in the U.S. to 21% from 35%, many countries still have a corporate tax rate lower than that in the U.S.
Who Does it Impact?
Do GILTI Rules Apply To Your Organization?
The GILTI rules impact both U.S. individual shareholders and U.S. corporate owners. “In this scenario, a U.S. shareholder is a person who owns directly, indirectly, or constructively 10% or more of the vote or value of a foreign corporation. A U.S. person includes a U.S. citizen or resident, a domestic partnership, a domestic corporation, any estate (that is not foreign), and any trust if a U.S. court has jurisdiction over its administration and one or more U.S. persons have the authority to control all substantial decisions of the trust.” A CFC is any foreign corporation in which U.S. shareholders own more than 50% of the vote or value directly, indirectly, or constructively.
Applicability to U.S. Taxpayers
It is important to note that the GILTI rules do not impact non-U.S. corporate owners and taxpayers. However, constructive rules of ownership may be looked into to determine whether a U.S. subsidiary of a non-U.S. holding company should make an election. It should also be noted that U.S. companies that have no foreign operations are not impacted by these rules. On the other hand, it is safe to say that multinationals generally would be impacted by these rules. Finally, one should avoid being bamboozled by the acronym GILTI, because as we will explain in the next section, it impacts a lot more than just intangible assets or taxable income.
While it will be difficult, if not impossible, to demonstrate an entire understanding of GILTI taxation in this limited space, we can share various concepts here to provide an overview. We recommend contacting us for a more specific analysis of your case.
A U.S. shareholder’s GILTI inclusion is the excess of their pro-rata share of net CFC tested income over their net deemed tangible income return (net DTIR).
But what is tested income? It is the aggregate pro-rata share of income minus the aggregate pro-rata share of loss (but not less than zero). Net DTIR is defined as 10% of the U.S. shareholder’s pro-rata share of aggregate qualified business asset investment (QBAI), less specified interest expense.
But what is QBAI? It is the CFC’s average quarterly basis in depreciable tangible property used in a trade or business for the production of tested income. Stated another way, GILTI, with respect to any U.S. shareholder, is net CFC tested income less net DTIR.
Does GILTI Really Work as Intended?
For all intents and purposes, GILTI is, in essence, a form of minimum tax on the profits of CFCs. This calculation generally equals the CFC’s total income in excess of its net deemed tangible income return, which equals 10% of the CFC’s investment in depreciable, tangible business assets minus certain interest expenses.
The income tax on GILTI is particularly significant for CFCs whose profits are high with respect to their investment in tangible or fixed assets, such as those providing software and services. Therefore, this presents a potentially significant problem for taxpayers in specific industries, but it is certainly not limited to these taxpayers.
Further, GILTI is reported on U.S. tax forms such as Form 5471 (and its various schedules), Form 8992, and Form 1040 (for individual taxpayers). Given the complexity of the GILTI inclusion and calculations, not to mention the IRS’ numerous filing requirements, it is highly advisable to enlist the services of a qualified international tax advisor and preparer to ensure that one is appropriately filing the correct forms and in such a way as to minimize income tax and eliminate risk exposure.
What Should Companies Do?
For U.S. corporate owners, a CFC’s earnings excluded under the ‘high-tax exclusion’ election are not treated as ‘previously taxed profits.’ Accordingly, foreign tax credit paid for such prior earnings would not be eligible for adjustment and may not be eligible to claim dividend deduction (unless conditions of IRC §245A are satisfied). The possible tax cost of CFC’s earnings excluded pursuant to the ‘high-tax exclusion’ election should be evaluated against the possible foreign tax credit to decide the situation that is more beneficial to U.S. shareholders.
A corporate U.S. shareholder can claim a 50% deduction of the GILTI and is eligible for 80% of foreign tax credit that was either accrued or paid by a CFC. In comparison, an individual U.S. shareholder is not eligible for it unless they make an election under IRC §962 to be treated as a corporate U.S. shareholder for U.S. federal tax purposes with respect to taxation of a CFC’s earnings.
Opportunities and Risks
For U.S. individual shareholders, the burden of GILTI is more than a corporate U.S. shareholder. To be at par with a corporate shareholder, an individual taxpayer may make an election to be treated as a corporate shareholder. This would allow GILTI deduction and foreign tax credit within permissible limits. Structural reforms in the business concerning individual ownership in the U.S. should be revisited where global owners propose to become U.S. residents. The cost of compliance should be weighed against the election for ‘high-tax exclusion.’ Additionally, the tax consideration at the time of accrued and actual distribution might result in double taxation.
Further, a proposed regulation published in June 2019 was issued covering IRC §§951, 951A, 954, 956, 958, and 1502. The 2020 Regulations have finalized aspects covered under IRC §951A and §954 related to GILTI’ high-tax exclusion’, but other provisions are still pending.
The 2020 Regulations cover the below items concerning GILTI’ high-tax exclusion’:
- Conform to implement a unitary approach towards ‘high-tax exclusion’ for subpart F and GILTI: The unitary approach towards ‘high-tax exclusion’ would provide relief to a U.S. shareholder whose CFC’s earnings have already been taxable at an effective tax rate higher than 18.9% and no more part of GILTI inclusion.
- Redefine ‘tested unit’: A ‘tested unit’ now includes a CFC, an interest in a pass-through entity held by a CFC (which is not treated as a flow-through entity under a foreign country’s law) certain branches of a CFC.
- Consolidated group: The manner of computing ‘tested income’ for the consolidated CFC group is consistent with that of a single CFC.
- Annual election: U.S. shareholders owning more than 50% of the shares (directly or indirectly) may elect for high-tax exclusion annually. They should, however, weigh the cost of compliance as the election continues to apply unless revoked. The election could be made or revoked on an amended federal income return subject to specific requirements.
- Applicability: The ‘high-tax exclusion’ applies on or after July 23, 2020. But U.S. shareholders may apply for a period after December 31, 2017, to July 22, 2020, under the 2020 Regulations.
GILTI: A Classic Misdirection
While the U.S. Congress no doubt had many goals when it came to passing the TCJA, in particular, to address issues with international profit-shifting and repatriating foreign income, what actually ended up happening is that the tax code became even more complex, rather than simple or streamlined, which was probably not the intended goal of this tax policy. Further, the GILTI rules made the U.S. tax system even more global than before, and as a result, made tax reform more complicated. Therefore, taxpayers must carefully manage their international operations or risk facing the wrath of these new regulations.
GILTI requires taxpayers to potentially apportion interest expenses as well as general and administrative expenses. This allocation of expenses may reduce the GILTI inclusion below the amount of the foreign income on which the CFC paid at least a 13.125% foreign effective tax rate. Due to this, a U.S. shareholder may have foreign taxes that exceed the U.S. tax on GILTI. This foreign tax credit limitation results in excess foreign tax credits. In other words, these would be tax credits that the taxpayer cannot claim to the extent the tax credits exceed the pre-credit U.S. tax on GILTI.
However, the opposite will occur in some cases, and taxpayers will pay additional U.S. tax on their GILTI income because the number of foreign tax credits associated with a GILTI inclusion will not cover the full amount of U.S. tax. One way around this is to treat a portion of the taxpayer’s CFC stock as an exempt asset, which would reduce the expense apportionment to the GILTI inclusion and will help the taxpayer claim foreign tax credits. Most taxpayers will likely pay some U.S. tax on their GILTI inclusions since the foreign tax credit is limited to 80% of the taxes associated with a GILTI inclusion.
QBAI: The Cliff Effect
As discussed previously, net DTIR is defined as 10% of the U.S. shareholder’s pro-rata share of aggregate qualified business asset investment (QBAI), less specified interest expense. To the extent a U.S. shareholder’s pro-rata share of CFC net tested income exceeds net DTIR, there will be a GILTI inclusion. Stated another way, the U.S. shareholder is allowed a 10% rate of return on assets as exempt income before being subject to GILTI.
It is important to note that CFCs with a tested loss are considered to have zero QBAI. Therefore, taxpayers should be careful of this QBAI cliff, a situation in which it is all-or-nothing.
Calling All Intangibles
While it appears that the U.S. Congress attempted a formulaic approach when writing the GILTI rules, what actually ended up happening was that due to the general nature of the GILTI rules (in that anything not subpart F income is GILTI income), nearly every U.S. multinational would be affected by these rules, even if they do not have any foreign-derived intangible income, thus apparently defeating the purpose of the regulations.
A discussion of net operating losses (NOL) should be considered when we discuss GILTI, as this is a common topic when considering business taxes. However, in this scenario, it is not clear whether a tested loss carryover can be used for GILTI purposes. We know that domestic corporations may generally carry over an NOL to subsequent years. Therefore, it is reasonable to extend this treatment to CFCs. However, that does not appear to be the case here, and a U.S. shareholder who has a profit in one year and a loss in the next, would receive no benefit from the loss in the second year and would be subject to GILTI tax in the first tax year.
Coordinated Global Tax Planning
The taxpayer’s exposure to being treated as a U.S. shareholder in a CFC results in additional U.S. income tax under subpart F and GILTI regimes. A timely discussion with your tax advisor to evaluate the different parameters to determine the global effective tax rate could assist you in deciding the impact and addressing income tax leakages, not to mention ensuring that you are compliant with IRS tax filing requirements and pay the necessary tax liability. Indeed, as more and more taxpayers look to take advantage of technology and mobility to benefit from international arbitrage, it is crucial to consider the impact that GILTI may have on you and your business before embarking on such a move.
A Time for Reexamination
It goes without saying that the GILTI rules introduced many changes in the world of international business. This requires taxpayers, directors, shareholders, and tax advisors to remain vigilant and reexamine their methods when it comes to tax planning and preparation. Further, it is unlikely that the GILTI rules will go away, and therefore, it has become even more important than ever to stay up-to-date with international tax law and regulations, especially in light of the possibility that treasury departments across the world may try to capture any shortfalls with similar tax legislation, under the guise of tax reform. Therefore, given that this sort of tax policy may become increasingly ubiquitous worldwide, multinationals need a good offense and a good defense, and that involves engaging the services of a firm specialized in dealing with guiding clients through the complexity in order to avoid needless tax liability.