Checked the Box? Feeling GILTI Now?
April 08, 2019
Once Upon A Time
I recently recalled a client that was referred to us a few years back, shortly before it was acquired by a larger company. The client was closely held by U.S. individuals and by an S corporation, and was organized as a Delaware LLC that was treated as a partnership for U.S. tax purposes.
Beginning in the early 2000’s, the LLC had formed or acquired several foreign corporate subsidiaries (the “Foreign Subs”). I remembered reviewing a few years’ worth of the LLC’s partnership tax returns (on IRS Form 1065)[i] and, based upon what I knew of the LLC’s business and that of the Foreign Subs, I did not expect to find any subpart F income on the returns – in other words, any foreign business income realized by the Foreign Subs would not have been subject to U.S. income tax in the hands of the LLC until such income was distributed as a dividend to the LLC.[ii] However, I noticed losses from foreign operations on Schedule K of the returns. When I asked about the source of the losses, I was told they were attributable to the Foreign Subs.
As I looked further into the subsidiaries, I learned that each of them was organized as a business entity with “limited liability” under the law of the jurisdiction in which it operated – meaning that no owner or member of the entity had personal liability for the entity’s obligations by reason of being a member.[iii] Thus, each Foreign Sub’s default classification for U.S. tax purposes was as an “association”; i.e., as an entity that was treated as a corporation.[iv] More relevant to the issue before me, each Foreign Sub was a “foreign eligible entity” that may have elected to change its classification for U.S. tax purposes.[v]
I asked to see the IRS Form 8832, Entity Classification Election,[vi] that I assumed must have been filed by each Foreign Sub to elect to be disregarded as an entity separate from the LLC – the so-called “check the box”.[vii] Such an election would have caused each subsidiary to be treated as a branch of the LLC, with the branch losses treated as having been realized directly by the LLC.[viii]
As it turned out, no such elections had been made. When I asked what the client intended when it acquired or organized the Foreign Subs, I was informed that they were to be treated as branches, which was consistent with the LLC’s tax returns as filed (as reflected on the Schedule K).
In order to redress the situation, we requested, and obtained, a ruling from the IRS that allowed the Foreign Subs to file late entity classification elections.
All’s well that ends well. Right?
The End of Tax Deferral
Fast forward. The LLC is no longer a client. The Tax Cuts and Jobs Act is enacted.[ix] Every U.S. person that owns a controlled foreign subsidiary that is treated as a corporation (or association) for U.S. tax purposes (a “CFC”) is scrambling to understand the new anti-deferral rules,[x] and to develop a plan for managing their impact.
In particular, tax advisers are discovering the benefits under the Act of being a direct C corporation parent of a CFC, or – in the case of an individual U.S. shareholder who owns stock of a CFC either directly, or indirectly through a partnership or an S corporation – the benefit of electing under Section 962 of the Code to be treated as a C corporation shareholder of the CFC.[xi]
In order to limit a U.S. person’s ability to defer the U.S. taxation of a CFC’s non-subpart F, foreign-source income, the Act introduced a new class of income – “global intangible low-taxed income” (“GILTI”) – that must be included in income by a U.S. shareholder of a CFC.
This provision generally requires the current inclusion in income by a U.S. shareholder of (i) their share of a CFC’s non-subpart F income, (ii) less an amount equal to their share of 10 percent of the adjusted basis of the CFC’s tangible property used in its trade or business of a type with respect to which a depreciation deduction is generally allowable – the difference being the U.S. shareholder’s GILTI.
This income inclusion rule applies to both individual and corporate U.S. shareholders.
In the case of an individual shareholder, the maximum federal income tax rate applicable to GILTI is 37 percent. This is the rate that will apply, for example, to a U.S. individual who directly owns at least 10 percent of the stock of a CFC, or to one who indirectly owns such CFC stock through an S-corporation or partnership.
More forgiving rules apply in the case of a U.S. shareholder that is a domestic C corporation. Such a corporation is generally allowed a deduction of an amount equal to 50 percent of its GILTI (the “50-percent deduction”) for purposes of determining its taxable income;[xii] thus, the effective federal corporate tax rate for GILTI is actually 10.5 percent.[xiii]
In addition, for any amount of GILTI included in the gross income of a domestic corporation, the corporation is allowed a deemed-paid credit equal to 80 percent of the foreign taxes paid or accrued by the CFC with respect to such GILTI (the “80-percent FTC”).[xiv]
Based on the interaction of the 50-percent deduction and the 80-percent FTC, the U.S. tax rate on GILTI that is included in the income of a domestic C corporation will be zero (0) where the foreign tax rate on such income is at least 13.125 percent.[xv]
Of course, not all foreign subsidiaries of a U.S. person are treated as corporations for U.S. tax purposes. As in the case of the Foreign Subs, described above, a foreign subsidiary may be treated as a branch of its U.S. owner for tax purposes.
Because these foreign subsidiaries are not treated as corporations for U.S. tax purposes, they are not CFCs. Therefore, neither the GILTI nor the subpart F anti-deferral rules apply to them.
Rather, the income generated by a branch of a U.S. person (including income that would have been treated as GILTI in the case of a CFC) is treated as having been earned directly by the U.S. person, and is included in such U.S. person’s gross income on a current basis, without any deferral whatsoever.[xvi]
In the case of a U.S. individual owner of the branch – whether directly or through a partnership or S corporation – the foreign branch income will be subject to federal income tax at a maximum rate of 37 percent. In the case of an owner that is a C corporation, the foreign branch income will be subject to federal tax at the flat 21 percent rate applicable to corporations.
Because the branch is not a CFC for U.S. tax purposes, neither the 50-percent deduction nor the 80-percent FTC, that are available for GILTI, may be used to reduce or even eliminate the U.S. income tax on the branch income.[xvii] That being said, the U.S. owner of the branch generally may still claim a tax credit for the foreign taxes paid by the branch, thereby reducing their U.S. income tax liability attributable to the branch income.[xviii]
Incorporate the Branch?
Under these circumstances, would it make sense for the U.S. owner of the branch to incorporate the branch, and thereby convert it into a CFC, the income of which may be eligible for the reduced tax rates on GILTI described above?
Such an incorporation may be effectuated by contributing the assets comprising the branch (and subject to its liabilities) to a foreign corporation in exchange for all of its stock.
Alternatively, where the branch is held through a foreign eligible entity – a corporation, for all intents and purposes, under local law – that has elected (“checked the box”) to be treated as a disregarded entity for U.S. tax purposes (as in the case of the LLC’s Foreign Subs, described above), the U.S. owner may consider having the foreign entity elect to be treated, instead, as an association that is taxable as a corporation for U.S. tax purposes.[xix]
Either of these options may seem like a good idea – but not necessarily.
In general, a U.S. person will not recognize gain if they transfer property to a corporation solely in exchange for stock in such corporation and, immediately after the exchange, the transferor is in control of the corporation.[xx]
However, in order to prevent a U.S. person from placing certain assets beyond the reach of the U.S. income tax by transferring them to a foreign corporation on a tax-favored basis (as described immediately above), the Code provides that if a U.S. person transfers property to a foreign corporation in exchange for stock in the foreign corporation, the transfer by the U.S. person becomes taxable.[xxi]
Prior to the Act, the Code provided an exception to this recognition rule; specifically, the transfer of property[xxii] by a U.S. person to a foreign corporation in exchange for its stock would not be treated as a taxable exchange where the property was to be used by the foreign corporation in the active conduct of a trade or business outside of the U.S.[xxiii]
The Act repealed this nonrecognition rule for exchanges after December 31, 2017. Thus, a transfer of property used in the active conduct of a trade or business outside the U.S. – a foreign branch – by a U.S. person to a foreign corporation no longer qualifies for non-recognition of gain.
What’s more, the Act also added a new rule which provides that, if a U.S. corporation transfers substantially all of the assets of a foreign branch to a foreign corporation with respect to which it owns at least 10 percent of the total voting power or total value after the transfer, the U.S. corporation will include in its gross income an amount equal to the “transferred loss amount” of the branch.[xxiv]
In general, the transferred loss amount is equal to the losses incurred by the foreign branch after December 31, 2017, and before the transfer, for which a deduction was allowed to the U.S. corporation. The amount is reduced by certain taxable income earned, and gain recognized, by the foreign branch, including the amount of gain recognized by the U.S. corporation on account of the transfer of the branch assets.
What’s a Taxpayer to Do?
It appears that there aren’t many options available to a U.S. person with a foreign branch.
The U.S. person may continue to operate through the branch; it will not be subject to the GILTI rules; it will be subject to current U.S. income tax on all of its branch-derived income at its ordinary federal income tax rate; it will be entitled to a credit against its U.S. tax for any foreign income tax paid by the branch; the remittance by the branch of its earnings to the U.S. person will not be subject to U.S. tax, though the foreign jurisdiction of the branch may impose a withholding tax on such a distribution, for which a credit should be available to the U.S. person.
The U.S. person may incorporate the branch, as described above, and pay the resulting U.S. income tax liability – of course, the liability should be quantified before any change in form is effectuated; the GILTI and the CFC subpart F rules would then become applicable; with that, the recognition of a limited amount of foreign-sourced income may be deferred; in addition, the U.S. person – whether a C corporation or an individual who elects under Section 962 of the Code (including one who holds the foreign corporation stock through a partnership or an S corporation) – will be able to achieve the reduced U.S. income tax rate resulting from the application of the reduced 21 percent corporate rate, the 50-percent deduction, and the 80-percent FTC.
The U.S. taxpayer may eliminate the branch entirely – which may be impractical from a business perspective – in which case its foreign-sourced income will continue to be subject to U.S. income tax, though the taxpayer may be able to avoid paying any foreign taxes,[xxv] not to mention the U.S. reporting requirements that are attendant on the ownership and operation of a foreign business entity.
The decision will ultimately depend upon each taxpayer’s unique facts and circumstances, including the business reasons that caused the U.S. person to operate overseas to begin with.
[ii] In other words, recognition of the subsidiaries’ income would have been deferred.
[iii] In general, this determination is based solely on the law pursuant to which the entity is organized. A member has personal liability, for this purpose, if the creditors of the entity may seek satisfaction of all or any portion of the debts or claims against the entity from the member as such. Reg. Sec. 301.7701-3.
[iv] I had already determined that none of the foreign subsidiaries was described in Reg. sec. 301.7701-2 as a “per se corporation.”
[v] Reg. Sec. 7701-3(a) and 301.7701-3(b)(2).
[vii] A deemed liquidation of the association. Reg. Sec. 301.7701-3(g).
[viii] A controlled foreign corporation’s losses for a taxable year do not flow through to its U.S. shareholders; rather, they reduce the CFC’s earnings and profits for the year. According to Sec. 952 of the Code, a CFC’s subpart F income for a taxable year cannot exceed its earnings and profits for that year. In addition, the amount of subpart F income included in a U.S. shareholder’s gross income for a taxable year may generally be reduced by the shareholder’s share of a deficit in the CFC’s earnings and profits from an earlier taxable year that is attributable to an active trade or business of the CFC.
[ix] December 22, 2017. P.L. 115-97; the “Act.”
[x] IRC Sec. 951A, effective for taxable years of foreign corporations beginning after December 31, 2017, and to taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.
[xii] IRC Sec. 250.
[xiii] The 21 percent flat rate multiplied by 50 percent.
[xiv] IRC Sec. 960(d). This is to be compared with the foreign tax credit available to a domestic corporation that includes subpart F income in its gross income; in that case, under IRC Sec. 960(a), the domestic corporation is deemed to have paid so much of the CFC’s foreign income taxes as are properly attributable to such subpart F income.
[xv] 13.125 percent multiplied by 80 percent equals 10.5 percent.
[xvi] Including the limited deferral that is still available under the GILTI rules.
[xvii] The Section 962 election is only available with respect to a CFC.
[xviii] The Act added a new rule that limits the ability of a U.S. taxpayer to use the “excess” foreign tax credits attributable to a branch – the amount of foreign tax paid by the branch in excess of the U.S. income tax that would otherwise be imposed on the income of the branch – to reduce the taxpayer’s U.S. income tax on its other foreign-source income.
[xix] The owner of the eligible entity would be treated as having contributed all of the assets and liabilities of the entity to the association in exchange for stock of the association. Reg. Sec. 301.7701-3(g).It should be noted that, in general, an entity that has already elected to change its tax classification cannot make a second election during the 60-month period following the effective date of the first election.
[xx] IRC Sec. 351.
[xxi] IRC Sec. 367(a). This is accomplished by providing that the foreign corporation shall not be considered a corporation for purposes of Section 351 of the Code.
[xxii] Certain assets were excluded from this rule; for example, inventory and certain intangibles.
[xxiii] The “active trade or business” exception to gain recognition under Section 367(a) of the Code. Reg. Sec. 1.367(a)-2.
[xxiv] IRC Sec. 91.
[xxv] It may not be treated as “doing business” in the foreign jurisdiction. In the case of a treaty country, the U.S. taxpayer may be treated as not having a permanent establishment in the foreign country.