The Tax Cuts and Jobs Act (“TCJA”) represents the most significant tax reform package enacted since 1986. Included in this reform are a number of crucial changes to existing international tax provisions. While many of these international changes relate directly to U.S. corporations doing business outside the United States, they nevertheless will have a substantial impact on U.S. individuals with the same overseas activities or assets.
One notable change under the new law was the reduction of the maximum U.S. corporate income tax rate from 35% to 21%. Not surprisingly, this change will have a corresponding impact on the ability of U.S. shareholders (both corporations and individuals) of controlled foreign corporations (“CFCs”) to qualify for the Section 954(b)(4) “high-tax exception” from Subpart F income. This is because the effective foreign tax rate imposed on a CFC that is needed to qualify for this purpose must be greater than 90% of the U.S. corporate tax rate. Therefore, this exception now will be available when the effective rate of foreign tax is greater than 18.9% (as opposed to 31.5% under prior law).
In addition to the reduction in corporate tax rates, the TCJA includes a partial shift from a worldwide system of taxing such U.S. corporate taxpayers to a semi-territorial system of taxation. This “territorial” taxation is achieved through the creation of a dividends received deduction (“DRD”) for such domestic corporate taxpayers under Section 245A.[1] This provision will allow a U.S. C corporation to deduct the “foreign-source portion” of any dividends it receives from a 10%-or-more-owned foreign corporation (other than a PFIC), as long as the recipient has owned the stock of the payor for more than one year during the prior two year period. Assuming the foreign payor has no income that is effectively connected to a U.S. trade or business (“ECI”) and no dividend income from an 80%-owned U.S. subsidiary, the entire dividend generally will be exempt from U.S. federal income tax under this provision.[2] In a corresponding change to Section 1248, when the relevant stock of a CFC is sold or exchanged, any amount of gain that is recharacterized as a dividend to a corporate U.S. shareholder under Section 1248 also is eligible for this DRD assuming the stock has been held for at least one year.
Despite these shifts toward partial territoriality, the new law retains the Subpart F rules that apply to tax currently certain income earned by CFCs (i.e., foreign corporations that are more than 50% owned by 10% U.S. shareholders (under the new law, both the 10% and 50% standards are measured by reference to either vote or value), as well as introducing a new category of income puzzlingly called “global intangible low-taxed income” (GILTI), though it has almost nothing to do with income from intangibles.[3] GILTI will include nearly all income of a CFC other than ECI, Subpart F income (including Subpart F income that is excludible under the Section 954 (b)(4) high-tax exception), or income of taxpayers with very significant tangible depreciable property used in a trade or business.
The GILTI tax, imposed under Section 951A, applies to U.S. shareholders (both corporate and individual) of CFCs at ordinary income tax rates. Accordingly, U.S. individual shareholders of CFC typically will be subject to tax on GILTI inclusions at a 37% rate (the new maximum individual U.S. federal income tax rate). U.S. C corporations that are shareholders of CFCs, on the other hand, are entitled under new Section 250 to deduct 50% of the GILTI inclusion, resulting in a 10.5% effective tax rate on such income. Additionally, such corporate shareholders are permitted to claim foreign tax credits for 80% of the foreign taxes paid by the CFC that are attributable to the relevant GILTI inclusion. Accounting for the 50% deduction and foreign tax credits, if any, a corporate U.S. shareholder’s GILTI inclusion that is subject to a rate of foreign income tax of at least 13.125% should result in no further U.S. federal income tax being due.[4]
In addition to the above GILTI provisions, Section 250 also permits U.S. corporations to deduct 37.5% of “foreign-derived intangible income” (FDII), resulting in an effective U.S. federal income tax rate of 13.125% on such income. FDII is the portion of the U.S. corporation’s net income (other than GILTI and certain other income) that exceeds a 10% rate of return on the U.S. corporation’s tangible depreciable business assets and is attributable to certain sales of property (including leases and licenses) to foreign persons or to the provision of certain services to any person located outside the United States.
Impact on Individual U.S. Taxpayers
While the TCJA substantially reduced the top U.S. corporate tax rate from 35% to 21%, individual U.S. income tax rates were not materially altered (i.e., the maximum individual U.S. federal income tax rate was reduced from 39.6% to 37%). Nevertheless, the reductions in corporate tax rates and other relevant entity-level changes should be expected to have a dramatic impact on outbound U.S. tax planning for individual shareholders of CFCs.
Planning Using Section 962
Section 962, which has been a part of the Code since 1962, allows an individual (or trust or estate) U.S. shareholder of a CFC to elect to be subject to corporate income tax rates on amounts which are included in income under Section 951(a) (i.e., subpart F inclusions and amounts included under Section 956). The purpose behind this provision is
…to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. This provision gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.[5] (emphasis added).
The U.S. federal income tax consequences of a U.S. individual making a Section 962 election are as follows. First, the individual is taxed on amounts included in his gross income under Section 951(a) at corporate tax rates. Second, the individual is entitled to a deemed-paid foreign tax credit under Section 960 as if the individual were a domestic corporation. Third, when an actual distribution of earnings is made of amounts that have already been included in the gross income of a U.S. shareholder under Section 951(a), the earnings are included in gross income again to the extent they exceed the amount of U.S. income tax paid at the time of the Section 962 election.[6]
Historically, elections under Section 962 were made infrequently. Under the new law, however, this is likely to change as such elections will have much more significance to many more U.S. individual shareholders of CFCs. As noted above, the new GILTI provisions will cause U.S. individual shareholders of CFCs to be subject to U.S. federal income tax at a 37% rate on a new category of income, which will be taxed in the same manner as Subpart F income (including with respect to eligibility to make a Section 962 election as to such income).[7]
The lower 21% corporate income tax rate under the new law coupled with the inability of individual shareholders to claim indirect foreign tax credits under Section 960 mean that, in some cases, U.S. individuals investing in CFCs through U.S. corporations will be better off from a tax perspective under the TCJA than U.S. individual shareholders making such investments in CFCs directly. For this reason, individual U.S. shareholders should consider whether it is beneficial to make Section 962 elections going forward, which would allow them to claim indirect foreign tax credits on any amounts included under subpart F, as well as under the GILTI provisions.[8]
Some of the unanswered questions facing taxpayers in this context are, first, whether individuals owning their CFC interests through S corporations or partnerships may make a Section 962 election at all. The IRS previously refused to issue a requested private letter ruling confirming the availability of the election in such cases,[9] though it appears based on informal discussions with Treasury and IRS officials as well as a footnote in the legislative history to Section 965 that the IRS may have since adopted a different view.[10]
Another issue that is not clear is whether an individual U.S. shareholder who makes a Section 962 election is eligible to claim the 50% GILTI deduction under Section 250 (which would have the effect of reducing the effective U.S. tax rate on such income to 10.5%). Based on the clear intent behind Section 962, which is to ensure that an individual U.S. shareholder who has an inclusion under Subpart F (including for this purpose, inclusions under Section 951(A) is subject to tax under Section 11 as if the shareholder invested abroad through a U.S. C corporation, such deduction should be allowed. The IRS seems to have agreed with this logic in FSA 200247033, when it cited to the legislative history behind Section 962 and calculated the tax on a U.S. individual shareholder who made a Section 962 election as if the taxpayer actually invested through a separate U.S. C corporation doing business abroad. The IRS noted that “…section 962 was enacted to relieve a U.S. individual shareholder of a CFC from a hardship that might otherwise result from a section 951(a) inclusion by ensuring that the tax burden for such individual would be ‘no heavier’ than it would be if the individual had instead invested in a U.S. corporation doing business abroad. If the amount included in income under Section 951(a) were derived by a taxpayer’s domestic corporation, such amount would have been subject to tax at the applicable corporate rates.” It also should be pointed out that while the regulations under Section 962 specifically state that the hypothetical corporate taxpayer may not reduce its taxable income by any deductions of the U.S. shareholder[11] the regulations make no mention of any prohibition against corporate level deductions, such as the 50% GILTI deduction allowable under Section 250 (emphasis added).
Finally, a third potential issue that may arise in this context is the tax characterization of an actual distribution of earnings and profits that were previously included in the U.S. shareholder’s gross income under Section 951(a). This issue arises whenever the CFC is located in a non-treaty jurisdiction, such that dividends paid by such a CFC could not qualify for the reduced “qualified dividend” rate under Section 1(h)(11). When an actual distribution is made from such a company, the question is whether the distribution should be treated as coming from the CFC (and therefore be classified as ordinary income), or instead as coming from the deemed C corporation created by the Section 962 election (and thus be classified as qualified dividends). As explained above, the objective behind Section 962 is to tax the individual U.S. shareholder in the same amount that she would have been taxed had the investment in the CFC been made through a domestic C corporation. To achieve this objective and avoid exposing the shareholder to a significantly higher rate of tax in the United States, where962 election is in place, any distribution of earnings and profits by the CFC must be treated as coming from a domestic C corporation. This issue is currently pending in the United States Tax Court.
Impact Under Section 1248(b)
Another outbound provision that should become more relevant to U.S. individual shareholders of CFCs is the limitation imposed under Section 1248(b) when a U.S. shareholder, directly or indirectly, sells the shares of a CFC. Under Section 1248(a), gain recognized on a U.S. shareholders’ disposition of stock in a CFC is treated as dividend income to the extent of the relevant earnings and profits accumulated while such person held the stock. Significantly, where the U.S. seller is a C corporation, under the new quasi-territorial system, this conversion of gain into a dividend triggers an exemption from tax pursuant to the Section 245A dividends received deduction.
With respect to individual U.S. shareholders who sell stock in a CFC, recharacterization under Section 1248(a) also remains significant due to the rate differential between the taxation of qualified dividends and long-term capital gains (which are subject to a maximum federal income tax rate of 23.8% under Section 1(h)(11)), and non-qualified dividends (which are subject to a maximum federal income tax rate of 40.8%).
Section 1248(b), however, provides for a ceiling on the tax liability that may be imposed on the shareholder receiving a Section 1248(a) dividend if the taxpayer is an individual and the stock disposed of has been held for more than one year. The Section 1248(b) ceiling consists of the sum of two amounts. The first amount is the U.S. income tax that the CFC would have paid if the CFC had been taxed as a domestic corporation, after permitting a credit for all foreign and U.S. tax actually paid by the CFC on the same income (the “hypothetical corporate tax”). For example, assume a Cayman Islands CFC has $100 of income and pays $0 of foreign taxes. Also assume the Cayman CFC would be in the 21% income tax bracket for U.S. federal income tax purposes under Section 11 based on its taxable income levels if it were a domestic corporation. In this case, the hypothetical corporate tax would be $21 ($21 U.S. tax minus $0 of foreign tax credits).
The second amount is the addition to the taxpayer’s U.S. federal income tax for the year that results from including in gross income as long-term capital gain an amount equal to the excess of the Section 1248(a) amount over the hypothetical corporate tax (the “hypothetical shareholder tax”). Continuing with the same example and assuming the shareholder’s gain on the sale is $100, this hypothetical shareholder tax would be 23.8% of $79 ($100 Section 1248(a) amount less the hypothetical corporate tax of $21), or $18.80.
Adding together the hypothetical corporate tax and the hypothetical shareholder tax in this example thus yields $39.80 in U.S. tax on the $100 gain, for an effective tax rate of 39.8%. Given that the CFC in this example is not resident in a treaty country (i.e., the United States does not have an income tax treaty with the Cayman Islands), the amount of gain that is recharacterized as a dividend under Section 1248(a) (i.e., $100) would be taxable at a maximum federal rate of 40.80%, resulting in $40.80 of tax. Because this is greater than the Section 1248(b) ceiling of $39.80, the ceiling will apply, and the U.S. shareholder will pay U.S. tax of $39.80. As a consequence of the significant reduction in U.S. corporate tax rates, it appears that the Section 1248(b) limitation will now always yield a lower effective tax than the tax that would be imposed under Section 1248(a). While this may seem somewhat odd, it makes sense given that the U.S. corporate tax rate (which the hypothetical corporate tax rate is based on) was reduced from 35% to just 21%.
As illustrated in the above example, going forward, even where no foreign corporate income taxes are paid, the Section 1248(b) limitation will result in a lower tax liability than the tax that would be imposed under Section 1248(a). As the foreign tax burden increases, the Section 1248(b) limitation becomes more significant. In fact, as long as the foreign corporate tax rate is at least 21%, the Section 1248(b) limitation will yield an effective tax rate of 23.8%, which is equal to the maximum individual U.S. federal income tax rate on qualified dividends. Therefore, if a U.S. individual shareholder sells shares of stock in a CFC that is tax resident, for example, in Ecuador (a non-treaty country which currently has a corporate tax rate of 22%), the effective tax rate imposed on such shareholder based on the Section 1248(b) limitation will be the same as if the CFC were resident in a treaty country.
Even more interesting is the fact that it would appear to be possible to qualify for the reduced qualified dividend rates caused by the Section 1248(b) limitation even in situations where the foreign tax rate is less than 21%. This is due to the ability of such shareholders to take deductions for purposes of the hypothetical U.S. tax computations that may not be available under relevant foreign law. At least one federal court has confronted this issue. In Hoover v. the United States,[12] for purposes of determining the amount of corporate taxes that would have been paid if the CFC had been a domestic corporation, the U.S. District Court for the Central District of California allowed the hypothetical corporation to claim the former deduction available under Section 922 for Western Hemisphere Trade Corporations. This special deduction is available only to domestic corporations all of the business of which was conducted in North, Central, or South America, or in the West Indies, if, among other items, at least 95 percent of the company’s gross income was derived from foreign sources during a three-year testing period. Clearly this deduction is not available for U.S. federal income tax purposes when computing the earnings and profits of a CFC, so it is noteworthy that the court allowed the taxpayer in Hoover to claim this special deduction in calculating the hypothetical corporate tax under Section 1248(b).
While the Section 922 deduction for Western Hemisphere Trade Corporations no longer exists, other relevant provisions are available that may provide a benefit to U.S. taxpayers in calculating the hypothetical corporate tax under Section 1248(b). For example, as noted above, Section 250 now provides a 37.5% deduction on FDII. This provision could provide a major income tax benefit to a U.S. taxpayer that owns a CFC that sells goods or provides services to non-U.S. persons when calculating the hypothetical corporate income tax under Section 1248(b). This results from the fact that FDII is subject to an effective corporate tax rate of only 13.125% (which is much lower than the current 21% corporate tax rate).
Conclusion
As illustrated above, despite the negligible reduction of maximum U.S. individual tax rates from 39.6% to 37%, individual shareholders of CFCs nevertheless will benefit greatly from the more significant reduction in U.S. corporate tax rates. While there are a number of unanswered questions relating to the interaction between Section 962, GILTI, and qualified dividends, direct or indirect U.S. individual shareholders of CFCs now, more than ever, should seriously consider the impact of making a Section 962 election, especially where the CFC is tax resident in a treaty country and/or is subject to a relatively high rate of tax.
[1] All Section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury Regulations promulgated under the Code.
[2] No foreign tax credits are permitted as to such dividends for which a foreign-source DRD is allowed.
[3] Unlike subpart F inclusions, there is no high-tax exception to GILTI inclusions under Section 951A. Instead subpart F income that is excluded from a U.S. shareholder’s gross income under the Section 954(b)(4) high-tax exception also is excluded from the GILTI provisions. Query whether it makes sense to cause certain non-subpart F income that is otherwise subject to an effective foreign tax rate greater than 18.9% to be recharacterized as subpart F income in order to avoid GILTI (e.g., by creating a related party transaction).
[4] For tax years after 2025, the deduction is scheduled to decrease from 50% to 37.5%, resulting in an effective tax rate of 13.125% rather than 10.5% assuming corporate rates remain capped at 21%.
[5] S. Rep. No. 1881, 87th Cong., 2d Sess. (1962), reprinted at 1962-3 C.B. at 798.
[6] Section 962(d); Treas. Reg. Section 1.962-3. The most obvious reason why a taxpayer would choose to make a Section 962 election is the ability to defer the U.S. federal income tax on the actual distribution from the CFC, as well as the possibility of obtaining “qualified” dividends under Section 1(h)(11) on the subsequent distribution.
[7] Section 951A(f)(1)(A).
[8] Section 951A(f)(1)(A). See also TCJA Conference report at p. 517
[9] See Rubinger and LePree, “IRS Takes Flawed Approach to Inclusion under Subpart F,” Tax Notes, v.123, no.7, 2009 May 18, p.903-910.
[10] Section 965(a) imposes a one-time deemed repatriation tax on any deferred earnings of certain “specified foreign corporations.” This tax applies to C corporations as well as U.S. individual shareholders of these corporations. A Section 962 election also may be useful when calculating the tax due under Section 965 for an individual.
[11] Treas. Reg. Section 1.962-1(b)(1)(i).
[12] Hoover v. United States, 348 F. Supp. 502, 504 (CD Cal. 1972).