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March 8, 2018 - Haoshen Zhong

The GILTI Software Developer, Making a Corporate Rate Election

The GILTI software developer, electing corporate tax rules

If you were paying attention to the tax law rewrite last year, you may have heard the term “global intangible low-taxed income” (GILTI). It is supposed to establish a minimum tax on foreign source income for multinational corporations. It also affects US citizens and residents.

Two posts ago, we covered what happens under the default GILTI rules if a US citizen owns a software company abroad. In summary:

  • Almost all the profits of his company is taxed to him each year as GILTI regardless of whether the company distributes the profits.
  • The GILTI is taxed at ordinary income tax rates, overriding qualified dividend rules for companies in treaty countries.
  • When the company distributes profits, the profits previously taxed as GILTI is not included in income again.
  • There may be a mismatch in timing for foreign tax on the dividends and US tax on GILTI, resulting in the loss of foreign tax credits.

Today, we will check how the results can change if the US citizen elects to pay tax on GILTI at corporate rates.

Our assumptions

Let us revisit the example we used for the default rules, so we have continuity:

A US citizen moves to Israel and starts a software company.

The company develops its own software and licenses the software to unrelated enterprises. The licensing royalties are its only source of income. It qualifies for the 16% reduced corporate tax rate and the 20% reduced dividend tax rate in Israel because of Israeli incentives for tech companies.

Aside from the US citizen, the company has a 3 employees in Israel, none of whom is a US citizen or resident. The company rents an office. It owns $10,000 or so of furniture and computing equipment.

The company’s annual revenue is about $900,000, and its expense are about $400,000 (not including income tax).

The US citizen owns 60% of this company, and his employees own 40%.

A note of caution: One reader pointed out that for a controlling shareholder–that is, a person who owns at least 10% of the shares of the company–the Israeli tax on the dividends is 30% rather than the normal 20%. I believe the controlling shareholder rule is overridden for a preferred enterprise such as the software company in our hypothetical, but please let us know if you are certain of the answer.

Summary of the default results under GILTI

The Israeli company is a controlled foreign corporation, because it is organized in Israel, it provides limited liability to all shareholders, and a US person owns 60% of its shares. Reg. §§301.7701-5(a), -3(b)(2); IRC §957(a).

It has no subpart F income, because the software licensing royalties it receives are from software it developed and therefore fall under an active royalty exception to subpart F income. Reg. §1.954-2(d)(1)(i).

Instead, most of the profits are taxed to the US citizen as GILTI, because the software company has little tangible business assets with which the US citizen can reduce his GILTI. IRC §951A.

For more details, see our previous blog post.

The corporate rate election

There is an election a US citizen can make to be taxed at corporate tax rates on subpart F income and GILTI, and it works like this.

Corporate tax election allowed for 951(a) inclusion

The corporate rate election is found under section 962(a):

Under regulations prescribed by the Secretary, in the case of a United States shareholder who is an individual and who elects to have the provisions of this section apply for the taxable year–

(1) the tax imposed under this chapter on amounts which are included in his gross income under section 951(a) shall (in lieu of the tax determined under sections 1 and 55) be an amount equal to the tax which would be imposed under section 11 if such amounts were received by a domestic corporation, and

(2) for purposes of applying the provisions of section 960 (relating to foreign tax credit) such amounts shall be treated as if they were received by a domestic corporation. IRC §962(a).

The corporate rate election does 2 things:

  • It taxes income included under 951(a) under corporate tax rates and
  • It pretends that an individual who is subject to income inclusion is a corporation for the section 960 credit.

Let us now check how this applies to GILTI.

The election works for GILTI

GILTI is included in income under section 951A(a), not 951(a). But fortunately, there is a provision for this under section 951A(f)(1)(A), and it works like this:

Except as provided in subparagraph (B), any global intangible low-taxed income included in gross income under subsection (a) shall be treated in the same manner as an amount included under section 951(a)(1)(A) for purposes of applying sections 168(h)(2)(B), 535(b)(1), 851(b), 904(h)(1), 959, 961, 962, 993(a)(1)(E), 996(f)(1), 1248(b)(1), 1248(d)(1), 6501(e)(1)(C), 6654(d)(2)(D), and 6655(e)(4). IRC §951(A)(1)(1)(A).

For the corporate rate election, GILTI is treated as income included under section 951(a). Our US citizen is permitted to use the corporate rate election.

The individual gets a foreign tax credit for the foreign taxes the company paid

Aside from corporate tax rates, the election has a second effect: It pretends that the individual is a domestic corporation for section 960. This permits the individual to use some of the foreign tax the company paid as a foreign tax credit against GILTI. The formula is this (IRC §960(d)(1)):

Deemed paid credit = 0.8 x inclusion percentage x ∑tested foreign income taxes

What do these terms mean? Here is the inclusion percentage (IRC §960(d)(2)):

Inclusion percentage = GILTI / ∑tested income

GILTI is ∑tested income – ∑tested loss – 0.1 x tangible business assets. The GILTI formulas use sums, because a US shareholder gets to add the profits and losses of his pro-rata share from all CFCs in which he is a shareholder. In our scenario, we have only a single CFC, so we can ignore the sums.

Tested income of a CFC is gross income (with some exclusions that do not apply to our hypothetical) minus deductions attributed to the gross income, if the company made a profit. Tested loss is deductions minus gross income, if the company made a loss.

We have GILTI = tested income – 0.1 x tangible business assets, because we are dealing with a single CFC that made a profit.

The tested foreign income taxes are the foreign taxes paid on tested income. IRC §954(d)(3).

Does this sound confusing? We will work with concrete numbers below.

Profits are taxed as dividends when distributed

There is a catch for using the corporate tax rates and taking the deemed paid credit, and it is found in section 962(d):

The earnings and profits of a foreign corporation attributable to amounts which were included in the gross income of a United States shareholder under section 951(a) and with respect to which an election under this section applied shall, when such earnings and profits are distributed, notwithstanding the provisions of section 959(a)(1) , be included in gross income to the extent that such earnings and profits so distributed exceed the amount of tax paid under this chapter on the amounts to which such election applied. IRC §962(d).

What does this mean? Section 959(a)(1) says that when the profits of a CFC are taxed as GILTI or subpart F income, then the profits create a post-tax earnings and profits pool. When dividends are paid from the post-tax earnings and profits pool, the dividends are not included in the US shareholder’s income. IRC §959(a)(1). This rule exists to prevent the US from taxing the shareholder twice: once as GILTI as once as dividends.

Section 962(d) says that if you use the corporate rate election, then the dividends will be included in gross income when distributed. This is the price the shareholder pays for using the corporate rates and deemed paid foreign tax credit.

Calculating the tax

The corporate rate election is surprisingly straightforward: Subpart F income and GILTI are taxed as if the taxpayer had a separate income and foreign tax credit pool. Reg. §1.962-1(c). It does not affect the taxpayer’s normal income brackets. For our calculations, we do not even need to assume the taxpayer has no other source of income–they do not affect tax on GILTI, and GILTI does not affect tax on them.

Here is how the rules apply to our example.

Our assumptions

To recap our assumptions:

  • Annual revenue of $900,000
  • Business expenses of $400,000
  • Israeli corporate tax of $80,000 (16% of $500,000)
  • Tangible business assets of $10,000
  • The US citizen owns 60% of the company

Let us see how much tax the US citizen pays.

The US tax on GILTI

Here is how we calculate the GILTI inclusion and US tax on the GILTI:

  • Tested income before gross up = 0.6 x (900,000 – 400,000 -80,000) = 252,000
  • Gross up for foreign taxes paid: 252,000/ (900,000 – 400,000 – 80,000) x 80,000 = 48,000
  • Tested income = 252,000 + 48,000 = 300,000
  • GILTI = 300,000 – 0.1 x 0.6 x 10,000 = 299,400
  • US tax on GILTI = 0.21 x 299,400 = 62,874

And here is the foreign tax credit:

  • Inclusion percentage = 299,400 / 300,000
  • Tested foreign income taxes = 0.6 x 80,000 = 48,000
  • Foreign tax credit = 0.8 x 2,994 / 3,000 x 48,000 = 38,323

US tax = 62,874 – 38,323 = $24,551

The US tax on dividends

This is the income tax on the dividends, when they are actually distributed:

  • Non-section 962 E&P: 0.6 x (900,000 – 400,000 – 80,000) = 252,000
  • Excludible section 962 E&P: 24,551
  • Dividends included in income: 252,000 – 24,551 = 227,449
  • Tax on dividends: 0.2 x 227,449 = 45,490
  • Israeli tax on dividends: 0.2 * 252,000 = 50,400
  • US tax after foreign tax credit: $0
  • $4,910 of unused foreign tax credit carry forward.

Net investment income tax = 0.038 x 252,000 = 9,576

The total US tax

The total US tax on the shareholder is $34,127. This is considerably lower than the $52,314 of taxes under the default rules, and there is $4,910 of Israeli tax that can be carried forward as a credit.

Here, we used Israeli taxes as a foreign tax credit. What happens if our US citizen lives in a country that does not impose any income taxes and runs his company from there? For one thing, the US likely does not have an income tax treaty with that country, so the dividends are ordinary dividends taxed at 37%.

Default rules: 0.37 x 251,400 of GILTI + 0.038 x 252,000 = 102,714 Corporate rate election: 0.21 x 251,400 + 0.37 x 252,000 + 0.038 x 252,000 = 155,610

Using the corporate rate election increases overall tax by about $53,000, so the US citizen is paying significantly more taxes. But the tax on GILTI is only $52,794. The remaining $103,000 or so of taxes are paid when he takes a distribution. Basically, he is electing to pay about $50,000 more in taxes in the long run for $50,000 of tax deferral now. Is the deferral worth it? It will differ from person to person.

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