In this podcast, international tax and estate planning attorneys Megan Ferris and Paul J. D’Alessandro, Jr. provide an overview of how individuals and corporations are taxed under the GILTI regime and discuss why section 962 has come back into the spotlight in a post-2017 Tax Act world.
Transcript:
PAUL D’ ALESSANDRO
Good morning, everybody, and welcome to our first Bilzin Sumberg Tax Talk podcast. My name is Paul D’Alessandro, and I’m a tax associate here with our international private client group. I focus my practice on inbound planning and estate planning for international high net worth individuals. I’m here today with my colleague, Megan Ferris. How are you doing this morning, Megan?
MEGAN FERRIS
Hi, Paul. My name is Megan Ferris. I am an international tax associate with Bilzin Sumberg in Miami, Florida. I focus primarily on inbound and outbound tax structuring for businesses, typically closely held businesses. Our hope with this podcast is to bring you current issues related to various tax, trust, and estate matters.
PAUL D’ ALESSANDRO
Thanks, Megan, and I think we have a great topic for you this morning. Our first topic to kick off our podcast series. And we’re going to be talking about Section 962 and why it’s come back into the spotlight as of late. So, I think we’re going to hop right into it. And, Megan, I think a good way to start would be, can you give us a quick overview of the way individuals and corporations are taxed under the new GILTI regime in a post-2017 Tax Act world?
MEGAN FERRIS
Sure. Generally speaking, and especially when it comes to CFCs, the Tax Cuts and Jobs Acts of 2017, or the Tax Reform Act, treats U.S. corporations much more favorably than U.S. individual shareholders. First, at a high level, individuals are taxed in the U.S. on their ordinary income at graduated rates up to 37%, plus an extra 3.8% net investment income tax on their passive income. Corporations, on the other hand, are taxed at a flat 21% rate on their net taxable income. Next, the Tax Reform Act introduced a handful of new across border taxes and anti-deferral measures. One of these is Section 951A which, is called Global Intangible Low Tax Income, or GILTI, as you referred to it, which basically applies to the active operating-income of the CFC. Now pre-tax reform, this income would not be taxed to the CFC’s U.S. shareholders until it was distributed, but today that income is taxed annually at the shareholder’s ordinary income rate. Congress, however, went a step further by introducing Section 250, which gives U.S. corporations, and only U.S. corporations, a 50% deduction on their GILTI income and that essentially results in a 10.5% tax rate. But wait, there’s more. U.S. corporations can also take a foreign tax credit for up to 80% of the foreign taxes paid by the CFC. So essentially, if the CFC paid at least a 13.2% tax rate, or specifically a 13.125% tax rate in its local country, then a U.S. corporate shareholder can use foreign tax credits to offset its entire U.S. income tax liability for that underlying GILTI income. And that’s great for corporations. An individual shareholder, on the other hand, has no Section 250 deduction and no foreign tax credit for taxes paid by the CFC. The individual pays up to 37% U.S. tax on GILTI, end of story. So, as you can see, the disparity between individual and corporation taxation can be quite dramatic. And I guess that brings us back to the theme of today’s podcast, which is how some individual tax payers might use Section 962 to avail themselves of these benefits that are available only to domestic corporations.
PAUL D’ ALESSANDRO
Thanks, Megan. So that was a great overview I think of the general operating rules for the taxation of offshore income in a post-2017 Tax Act world. So as Megan alluded to, and our next question here in our podcast is, what is a 962 election, and how might an individual consider using the 962 election?
MEGAN FERRIS
Right. So, in short, Section 962 allows individual U.S. shareholders of CFCs to elect to be taxed as domestic corporations. The election is available to direct and indirect shareholders of CFCs, so if an individual owned their interest through a partnership or certain trusts, they would still be able to make the election. So now I’ll get into the mechanics of the election, but first I think it would help to give some historical context. Section 962 first became effective beginning in the tax year 1963 along with the rest of subpart F. Back then, the top individual tax rate in the U.S. was 91%, and the top corporate rate was 52%. So if you think we have it bad today, just be thankful we’re not in the 1960s. Anyhow, with the introduction of subpart F and the new concept of taxing the U.S. individual shareholder on a CFCs income that the shareholder didn’t actually receive, Congress decided to give taxpayers a break and the means of reducing that current tax burden to the lower corporate tax rate of then only 52%. In addition, taxpayers were permitted to claim deemed paid tax credits under Section 960 for foreign taxes that were paid by that CFC. Now the legislative history under Section 962 tells us that, and I quote, “The purpose of Section 962 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. Section 962 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.” So, as far as tax policy goes, that’s a breath of fresh air for the taxpayers. Okay, now the mechanics. This is how a U.S. individual is taxed under a Section 962 election. First, the individual is taxed on amounts that are included in gross income under Section 951a and now Section 951A, which is GILTI, at a corporate tax rate, which are currently 21%. Second, the individual is entitled to a deemed paid foreign tax credit under Section 960 with respect to the subpart F or GILTI inclusion as if the individual were a domestic corporation. Third, when an actual distribution of earnings is made from amounts that were already included in the U.S. shareholder’s gross income under Sections 951a and Section 951A, and just a reminder Section 951a is subpart F income, 951A is GILTI, those earnings are included in gross income again, but only to the extent that they exceed the amount of U.S. income tax paid at the time of the Section 962 election. So, if an individual initially used foreign tax credits to offset his or her entire U.S. tax liability related to GILTI income in the year that the income was reported, then when the income is actually distributed, it will be includable again as dividend income. If the underlying CFC is in a treaty jurisdiction, then that individual will benefit from qualified dividend rates, which are currently 20% plus a 3.8% tax on passive income, that brings us to a total U.S. effective tax rate of 23.8%.
PAUL D’ ALESSANDRO
Interesting, Megan. So it seems like there’s definitely some benefits to be gained potentially under Section 962, but how does an individual taxpayer make a Section 962 election?
MEGAN FERRIS
An individual would typically file a Section 962 election with his or her timely filed tax return for the year to which the election relates, although in certain circumstances, case law would permit a retroactive election. The election is made on an annual basis, meaning each year you have the option to make the election or not, and you also have the opportunity to miss it, so be careful about that. Once made, the election applies to all Section 951a and 951A, included to the U.S. shareholder for all CFCs for that year.
PAUL D’ ALESSANDRO
So that’s an interesting point there you made at the end and something our readers — our listener’s rather, might want to pick up on. The election applies to all CFCs that are owned by the individual. So keep that in mind when you’re analyzing Section 962 and whether it makes sense to make the election based on your facts and circumstances. So I think we kind of gave an overview here of Section 962 and why it matters now. But what we’re going to do now is drill really down into the pros and cons of 962, what are the benefits to be gained, and what are some of the drawbacks as well by making the selection. So, Megan, do you want to start by taking us through the benefits of the 962 election?
MEGAN FERRIS
Sure. If the circumstances are right for the taxpayer, then the benefits should certainly outweigh any drawbacks for making this election. For example, the subpart F inclusions and the GILTI inclusions, and those are under Section 951a, and Section 951A are subject to tax at the lower corporate tax rate, which is now 21%. There is a 50% deduction available for the GILTI inclusions. With a Section 962 election, an individual can take a credit for up to 80% of the foreign taxes paid by the CFC to offset the tax paid on the subpart F and the GILTI. But keep in mind that the individual would still be subject to tax on any Section 78 gross-up based on foreign taxes. With the Section 962 election, there is no corporate restructuring required that would otherwise take time and money to implement. There’s no impact on the other shareholders of the CFC, whether there’s domestic shareholders or foreign shareholders. And finally, there’s no double tax on the future sale of the CFC. Now on the downside, when those previously taxed earnings are distributed, they are taxed again to the extent that the distribution exceeds the tax paid on the initial inclusion. Now, if the CFC is not in a treaty country, then under Smith v. Commissioner, ordinary tax rates would apply because the dividends are treated as coming from the CFC and not from the deemed U.S. corporation. And lastly, on the downside, any basis increase in CFC stock as a result of the subpart f or GILTI inclusion is limited to the amount of tax paid on the inclusion. So, I’ll give an example. We recently did some tax planning for a client, an individual U.S. tax resident who owned an S corporation that, in turn, owned a Mexican CFC. The CFC operates hotels throughout Mexico and pays a 30% income tax in Mexico on its net income. From the U.S. federal tax perspective, that CFC’s operating income is all GILTI income to our client. And so under his existing structure, the GILTI would flow up to him, and he would be subject to 37% tax on that income without any offset for the Mexican taxes paid. We recommended making a Section 962 election, which he did. Now, under his current structure, the client is treated, for U.S. federal income tax purposes, as if the GILTI is earned by a domestic corporation. U.S. tax is fully offset with the foreign tax credits for the next to get income taxes paid. And when CFC eventually distributes the income, the client is taxed on their distribution. However, because the U.S. and Mexico have an income tax treaty in effect, the clients benefit from qualified dividend rates, which total 23.8%. So in effect, we helped our client reduce his effective U.S. federal income tax rate with respect to GILTI from 37% to 23.8%.
PAUL D’ ALESSANDRO
So there you have it; 962 potentially can result in a lower effective tax rate for an individual, you get the benefit of the lower corporate tax rate, the 50% GILTI deduction, the 80% indirect foreign tax credit. On the downside, you have to watch out for actual distributions because there’s less PTI than there would have been otherwise. So a little bit of balancing based on the facts and circumstances to see if 962 is going to make sense in your case. I think we’re going to wrap up now. Megan, you alluded to it earlier, but, you know, why has Section 962 come back into the spotlight this past year or two, and really when might a person consider making a 962 election?
MEGAN FERRIS
That’s a great question, Paul. Now, in the decade since Section 962 was passed, it was rarely used planning tool unless the CFC was located at a high tax treaty country, like Mexico or France. But fast forward to February 1, 2018, when tax reform became effective, now everything has changed because the corporate tax rates dropped from 35% to 21%. And the effective tax rate on GILTI emerged at 10.5% for U.S. corporations. Now finally, it’s an attractive option because even when you account for the 23.8% shareholder level dividend tax, the effective tax rate is still lower with a Section 962 election than if the CFC shares were treated as owned directly by the individual. As far as U.S. tax planning goes, the Section 962 election can be an incredibly useful and cost-saving tool for the taxpayer who fits the profile that I alluded to, and that would be a U.S. shareholder of a CFC that generates GILTI or subpart F income where CFC has foreign taxes paid in this local country where the CFC is located in a treaty jurisdiction. Now these individual U.S. shareholders can take advantage of the lower corporate tax rate, they can take advantage of the 50% deduction for GILTI income, and they can obtain a foreign tax credit for foreign taxes paid by the CFC, all without any restructuring required. On the other hand, if the CFC is not organized in a treaty jurisdiction, then the election may not result in a net benefit to the taxpayer. Now, in this case, it might make more sense to forego the Section 962 election in lieu of interposing an actual UFC corporation which would feature the same mechanical benefits of the Section 962 election, but it would also open the door to taking advantage of the dividends received deduction on distributions from the CFC. Alternatively, the taxpayer might consider setting up a flow-through structure, and that would also permit the use of foreign tax credits to offset the GILTI inclusions, although the GILTI inclusions would generally be subject to the higher individual tax rate.
PAUL D’ ALESSANDRO
So those are some great points you made, Megan, and I’ll just piggyback off a few of them before we wrap up here. Section 962, I think you’re going to want to look at whether your CFC is in a treaty jurisdiction versus a non-treaty jurisdiction, as Megan said. The 962 election is more beneficial when you’re in a treaty jurisdiction because you can take advantage of the lower qualified dividend income rates of 23.8%. Like anything else in tax planning, I think you have to do a little bit of modeling when you’re looking at 962, and by that I mean you have to see if you’re in a situation where your client is going to be looking to pull dividends out of his CFC on a regular to semi-regular basis, or whether the income realization event is really going to be had upon exit when an individual is going to sell shares in a CFC. In that case, 962 is going to provide some benefit there simply by providing deferral in the years where you’re not taking distributions. And I think a final point worth noting, and Megan touched on this; there’s been a lot of talk about simply having an individual drop their CFC shares into a parent USC corporation to achieve a lot of these results that we’ve been talking about. That sounds great in theory, but it cannot always be done tax-free in the foreign country where the CFC is located. Many times, contributing those shares to a U.S. corporation is a taxable event in that foreign country, and it could even result in that foreign country’s own CFC laws now applying to the U.S. parent corporation. So 962, in that case, could also serve a tremendous benefit by avoiding all those foreign taxes and local taxes that would otherwise be triggered by dropping shares into an actual U.S. parent C corporation. And with that, I think we’ve concluded our first podcast. I hope you all enjoyed it and found it useful. We‘re going to be looking to bring everybody more timely tax topics and hopefully more useful planning tips over the next few months and in the next year. Megan, is there anything you want to say before we sign off?
MEGAN FERRIS
Thanks, Paul. I think you made some great points just to wrap up there. And again, yeah, I hope everybody enjoyed this. I hope they can take some of these points and integrate them into their practices, and I hope you continue to tune in and listen to us as we bring you more current tax topics that might apply to your own practice.
PAUL D’ ALESSANDRO
Okay. Very good. And with that, we’re signing off. Happy holidays and a happy new year to everyone, and we’ll see you next time.
