For a corporate taxpayer, the combination of a reduced corporate rate, a special deduction, and access to indirect FTCs largely mitigates the impact of GILTI and section 965 –Individuals and pass-through entities have no such benefits.
Consider an individual who owns, directly or through a pass-through entity, 100 percent of a German services company which pays a 30 percent rate of local income tax. If the German company generates $1,000 U.S. dollars of income, that income is first subject to $300 U.S. dollars of German taxes, then potentially the entire $700 remainder could be currently taxed as GILTI and subject to an additional 37 percent U.S. individual tax rate in the year incurred (note that GILTI inclusions are not eligible for the new section 199A business income deduction). The outcome: a current effective tax rate of over 55 percent, regardless of whether the individual owner draws a dividend or reinvests the business’ earnings.
Enter section 962 which allows an individual (or trust or estate) U.S. shareholder of a CFC to elect to be subject to corporate income tax rates (under Sections 11 and 55) on amounts that are included in his or her gross income.
The keys to the effectiveness of the election to minimize U.S. tax on anti-deferral income are:
1. The use of the 21% corporate tax rate to determine the baseline U.S. tax liability.
2. Access to the 50% Section 250 deduction against GILTI (although such offset is not available against income included under the historic anti-deferral rules).
3. The availability of the foreign tax credit mechanism to offset the calculated U.S. tax with foreign taxes on the included income (subject to the GILTI haircut of foreign taxes).
4. A special rule that prevents the spillover of personal or business deductions that could otherwise impair the use of foreign tax credits or subject the 50% deduction to a taxable income limitation.
Returning to the facts of the prior example, if the individual makes a section 962 election for the year, the German earnings are now subject to GILTI tax at the deemed-corporate level instead of the individual level. Applying GILTI’s rules for corporate indirect foreign tax credits and section 250 deductions, the $1,000 of pre-tax income is eligible for a 50 percent deduction ($500 U.S. dollars) and the net income of $500 U.S. dollars is subject to a 21 percent U.S. corporate rate. A FTC is available of up to 80 percent of the German taxes, or $240 U.S. dollars. The FTC offsets the full $105 U.S. dollars of corporate-level tax and, assuming the German earnings are not distributed to the shareholder, there is zero residual U.S. tax in the current year.
The §962 election is made on a year-by-year basis with the tax return filed for that year. As a result, US individual shareholders facing a significant tax on GILTI may wish to consider making this election to lower the taxes due. However, an individual making this election will also be subject to US tax when it receives a dividend from the CFC. Dividends from a foreign corporation are generally taxed at regular tax rates unless the dividend is from a “qualified foreign corporation” which is taxed at the long term capital gains tax rate of 20%. A qualified dividend is a dividend from a foreign corporation that is eligible for benefits under an income tax treaty between the US and their home country. The US has income tax treaties with many nations (e.g., England, France, Germany), but not with all nations.
Section 962 election may be a valuable tool in softening or deferring the double-tax blow of being a U.S. shareholder in a foreign business – but careful consideration should be used before making the election. Depending on the specific circumstances, using section 962 could result in an individual paying a greater effective rate of tax on their foreign earnings once they have been repatriated (distributed).
