Private Clients - 05 Mar 2019
American individuals who have significant (10% or greater) participation in controlled foreign corporations (CFC’s) have cause to celebrate after publication yesterday of proposed Treasury Regulations implementing a special deduction newly available under the “GILTI” provisions of the CFC rules. Prop. Regs. §1.962-1.
As part of the 2017 tax reform legislation (the TCJA) Congress introduced a “participation exemption” for dividends received by a domestic corporation from a 10% or greater-owned CFC, but at the same time broadened the income of a CFC attributed and taxed directly to such corporate shareholders to include “Global Intangible Low-Taxed Income” (GILTI), i.e. net income of the CFC in excess of a 10% notional rate of return on the CFC’s tangible assets. Tax on GILTI of a domestic corporate shareholder is imposed at a reduced rate of 50% of the normal corporation tax rate (currently 21%), i.e. 10.5%, achieved through allowing a deduction of 50% of the amount of the GILTI under Internal Revenue Code §250. 80% of the foreign tax paid by the CFC on its GILTI is allowable as a credit against the U.S. liability, so where foreign corporation tax is paid at an average rate of 13.125% or greater, U.S. liability is eliminated.
U.S. individual 10% or greater shareholders of CFC’s are not treated so favourably. While required to recognize GILTI inclusions to the same extent as domestic corporations, they are not eligible for either the §250 deduction or the indirect credit for foreign taxes paid by the CFC. Accordingly, for an individual, the GILTI inclusion is potentially taxable at 37% rather than 10.5% and without the possibility of a reduction for credits.
This brought into focus IRC §962, a somewhat obscure provision of the CFC rules which allowed an individual U.S. shareholder of a CFC to elect “in lieu of” the tax regime described above to be taxed on his CFC inclusions at the rate which would be applicable if a hypothetical domestic corporation owned his CFC shares, and also taking into account the indirect foreign tax credit that a domestic corporation could claim. The downside of a §962 election is that, consistent with the treatment of the CFC shares as being held by the electing individual through a notional domestic corporation, any distribution from the CFC will be treated similarly to a distribution from a domestic corporation, i.e. taxable as a dividend to the extent of the corporation’s current and accumulated earnings.
When §962 was enacted in 1962, the corporation tax rate of 35% compared favourably with individual rates of up to 70%, making the §962 election potentially attractive, but relatively soon after this, individual rates fell and the §962 election ceased to be an attractive option. However, with the dramatic cut in the corporation tax rate under the TCJA from 35% to 21%, as compared with a current top individual rate of 37%, §962 is back in the limelight.
The TCJA was silent about whether the notional corporation tax computation under §962 could consider the §250 deduction. This was of vital importance to individual CFC shareholders as it could spell the difference between no tax on GILTI inclusions (where foreign corporation tax of 13.125% or more was being paid) and a “dry” tax charge of 10% or more, with the prospect of further tax when distributions from the CFC were received. Failing a favourable outcome of the §250 issue, other options, frequently having an upfront tax cost, had to be explored, e.g. introducing an actual domestic corporation as a holding vehicle for the CFC participation, or making a transparency election for (and notionally liquidating) the CFC.
Following the enactment of the TCJA, the first commentators who weighed in on the subject, some of them very prestigious law firms and professional associations, were categoric in concluding that the §250 deduction could not be claimed. Nonetheless, we and other voices in the wilderness took an opposing view, and we submitted our analysis to the Treasury Department in a letter dated October 8, 2018
The proposed §250 regulations published yesterday by the Treasury Department are among the last of the major regulations implementing the TCJA’s foreign provisions. One look at the proposed regulations makes it clear why they were delayed—the §250 deduction is fundamental both to the GILTI rules and to the domestic tax relief given to “foreign-derived intangible income” (“FDII”) and are extremely detailed.
Insofar as the §962 election is concerned, the Treasury Department accepted the basic argument advanced by those (ourselves included) who supported the availability of the §250 deduction, namely that the 1962 legislative history of §962 indicated that Congress intended by the election to put individual shareholders of CFC’s on the same footing as those who invested in CFC’s through a domestic corporation. This could only be achieved by allowing the §250 deduction in the computation of the notional corporation tax liability.
We continue to await vital guidance on other issues under the TCJA affecting our clients but it is certainly a good sign that Treasury has shown some sympathy for individual taxpayers in this latest release.
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