The Section 965 Transition Tax and Global Intangible Low Taxed Income regimes
On December 22nd 2017, the Tax Cuts and Jobs Act made many changes to the taxation of corporations and individuals. Most of the changes relating to individuals involved changes of tax rates, thresholds and allowable deductions. However, there were some major changes to the taxation of foreign corporations which are also impacting those corporations owned by US individuals which are considered Controlled Foreign Corporations (CFCs). A CFC is a foreign corporation owned more than 50% by US persons (who at least own 10% each); a UK limited company owned more than 50% by any US citizen individual is considered a CFC.
Before 2018 the overall system of taxation of US corporations and their foreign subsidiaries was the highest-rate in the OECD. This incentivised US corporations with foreign subsidiaries to leave the retained earnings and profits (“E & P”) of their foreign subsidiaries within the foreign entities rather than bringing the profits into the US parent company and investing the money in the US. To eliminate this disincentive there is a new system of taxation which essentially does not tax the repatriation of earnings from foreign subsidiaries. To enable the transition to this new corporate taxation system there is a one-off “Transition Tax” so that future distributions can be repatriated US-tax free. Thereafter, the new Global Intangible Low Taxed Income regime applies to certain income earned by CFCs to ensure the income does not escape taxation completely.
The Section 965 Transition Tax
The Section 965 Tax is a one-off tax applied to CFCs which taxes the entire retained earnings of the foreign corporations for the last “tax year” of the foreign corporation that begins before 1st January 2018, based on the amounts as of November 2nd and December 31st 2017. Retained earnings are generally the “Profit and Loss” account on a company’s balance sheet. It represents the amount of profit made by the business that has not yet been paid out to shareholders as dividend. There is a “deemed repatriation” of the foreign earnings i.e. the shareholder is considered to have received a distribution of all the foreign earnings even if none was actually made.
The headline 965 Tax rates are 15.5% on earnings held as cash or equivalent and 8% for earnings that have been invested into long term assets. However, because of the way the mechanics of the 965 Tax work, the treatment can result in a situation where an individual shareholder is taxed at rates that exceed the prescribed 15.5% and 8% tax rates (see below). This will be the case where the deemed repatriated E & P are large enough to push the ordinary marginal tax rate on the taxpayer’s return to above the corporate tax rate (35% in TY 2017 and 21% in TY 2018). Furthermore, an individual US taxpayer living abroad, will be subject to the US tax in one of these years but will then be subject to tax by foreign country when distributions of the profits are actually made. This creates the possibility of being substantially “double-taxed” on the same profits.
However, for many taxpayers this is not actually a calamitous situation—it could even be a bonus for some. Fortunately, the potential transition tax is eligible (based on our current understanding) to be offset using the right type of foreign tax credits held and claimed by the taxpayer. Many taxpayers will have or have had ample credits and most clients that we have reported the “income inclusion” for have not owed US tax on it.
Global Intangible Low Taxed Income
After the 965 Transition Tax, the new GILTI regime will apply to CFCs going forward. This regime forces the “intangible” income earned by a CFC to be taxed directly to the US shareholders as it arises, even if no distributions of profits are made to the shareholder.
Income is considered “intangible” if it is more than a ten percent return (the “net Deemed Intangible Income Return”) on the company’s qualifying tangible/fixed assets e.g. plant, machinery, buildings etc., also known as the Qualified Business Asset Investment. In today’s economy this represents a substantial proportion of economic activity. Essentially, if your business relies on humans or other intangible assets to provide services and earn income for your business, it is likely going to be mostly intangible income and subject to GILTI.
The default treatment of GILTI is that the individual taxpayer must include the full amount of GILTI income in their taxable income, and does not have any foreign tax credits available to offset the potential tax. This is because the GILTI regime has created a new “basket” of foreign tax credits specifically for that income. So without doing anything an individual taxpayer may incur a significant amount of tax from GILTI.
Potential strategies to mitigate the potential GILTI tax include:
If you have questions about handling the Section 965 Tax, GILTI, CFCs or your Form 5471 filing requirements in general please get in contact with us and we would be happy to see if we can help you.
Before 2018 the overall system of taxation of US corporations and their foreign subsidiaries was the highest-rate in the OECD. This incentivised US corporations with foreign subsidiaries to leave the retained earnings and profits (“E & P”) of their foreign subsidiaries within the foreign entities rather than bringing the profits into the US parent company and investing the money in the US. To eliminate this disincentive there is a new system of taxation which essentially does not tax the repatriation of earnings from foreign subsidiaries. To enable the transition to this new corporate taxation system there is a one-off “Transition Tax” so that future distributions can be repatriated US-tax free. Thereafter, the new Global Intangible Low Taxed Income regime applies to certain income earned by CFCs to ensure the income does not escape taxation completely.
The Section 965 Transition Tax
The Section 965 Tax is a one-off tax applied to CFCs which taxes the entire retained earnings of the foreign corporations for the last “tax year” of the foreign corporation that begins before 1st January 2018, based on the amounts as of November 2nd and December 31st 2017. Retained earnings are generally the “Profit and Loss” account on a company’s balance sheet. It represents the amount of profit made by the business that has not yet been paid out to shareholders as dividend. There is a “deemed repatriation” of the foreign earnings i.e. the shareholder is considered to have received a distribution of all the foreign earnings even if none was actually made.
The headline 965 Tax rates are 15.5% on earnings held as cash or equivalent and 8% for earnings that have been invested into long term assets. However, because of the way the mechanics of the 965 Tax work, the treatment can result in a situation where an individual shareholder is taxed at rates that exceed the prescribed 15.5% and 8% tax rates (see below). This will be the case where the deemed repatriated E & P are large enough to push the ordinary marginal tax rate on the taxpayer’s return to above the corporate tax rate (35% in TY 2017 and 21% in TY 2018). Furthermore, an individual US taxpayer living abroad, will be subject to the US tax in one of these years but will then be subject to tax by foreign country when distributions of the profits are actually made. This creates the possibility of being substantially “double-taxed” on the same profits.
However, for many taxpayers this is not actually a calamitous situation—it could even be a bonus for some. Fortunately, the potential transition tax is eligible (based on our current understanding) to be offset using the right type of foreign tax credits held and claimed by the taxpayer. Many taxpayers will have or have had ample credits and most clients that we have reported the “income inclusion” for have not owed US tax on it.
Global Intangible Low Taxed Income
After the 965 Transition Tax, the new GILTI regime will apply to CFCs going forward. This regime forces the “intangible” income earned by a CFC to be taxed directly to the US shareholders as it arises, even if no distributions of profits are made to the shareholder.
Income is considered “intangible” if it is more than a ten percent return (the “net Deemed Intangible Income Return”) on the company’s qualifying tangible/fixed assets e.g. plant, machinery, buildings etc., also known as the Qualified Business Asset Investment. In today’s economy this represents a substantial proportion of economic activity. Essentially, if your business relies on humans or other intangible assets to provide services and earn income for your business, it is likely going to be mostly intangible income and subject to GILTI.
The default treatment of GILTI is that the individual taxpayer must include the full amount of GILTI income in their taxable income, and does not have any foreign tax credits available to offset the potential tax. This is because the GILTI regime has created a new “basket” of foreign tax credits specifically for that income. So without doing anything an individual taxpayer may incur a significant amount of tax from GILTI.
Potential strategies to mitigate the potential GILTI tax include:
- Making a Section 962 election: this allows the individual to be taxed on their GILTI inclusion at corporate tax rates and enables them to claim a deemed foreign tax credit for (80% of) the foreign corporation tax already paid. It also allows a 50% reduction in the amount of GILTI inclusion. Since the US domestic corporation tax rate is now 21% this means that as long as the CFC has paid more than 13.125% (21% x 50% divided by 80%) rate of corporation tax, the shareholder should not incur any tax on their GILTI inclusion.
- High-taxed personal service contract income: if the contract between the company and the client specifies that the US shareholder is to personally perform the services then this income is generally considered a type of “Subpart F” income, which is exempt from the definition of GILTI. If the Subpart F income is taxed at more than 90% of the federal corporate tax rate then the income is also exempt from being Subpart F income; which results in no current income inclusion.
- General high-taxed exception: In July 2020 the IRS and Treasury issued final regulations that say that any GILTI income that is already subject to a foreign tax rate of more than 90% of the US corporate tax rate is exempt from being included as GILTI (i.e. 18.9%). With the current UK corporation tax rate of 19% this means that most UK corporations would be eligible for the exception. The exception is applied based on “tested units” to avoid mixing high and low taxed income; and must be applied for all of a group and not individual CFCs. The election can be made annually.
- Foreign disregarded entity: you may want to make a “check-the-box” election which turns the company into a “disregarded” entity which is no longer taxed as a corporation. This means that all the income of the corporation is deemed earned by the shareholders. This sounds similar to GILTI but the difference is that there are significantly fewer restrictions on the ability to claim foreign tax credits against the income so in most cases it should be possible to eliminate the tax.
If you have questions about handling the Section 965 Tax, GILTI, CFCs or your Form 5471 filing requirements in general please get in contact with us and we would be happy to see if we can help you.
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