In response to the tax law changes enacted December of 2017, we converted our PFICs Only newsletter to cover more topics that arise when a business crosses the US border–when a US person owns part of a foreign business or when a foreign person starts a business in the US. This is the first blog post under the new subject.
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.
In fact, it affects US citizens and residents in addition to large multinationals like Google and Apple. Let us work through a simple example to see how the law might work.
A US citizen moves to Israel and starts a software company.
The company develops its own software and licenses the software to other 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).
Let us assume the US citizen owns 60% of this company, and his employees own 40%.
The Israeli company is a foreign business entity, because it is organized in Israeli. Reg. §301.7701-5(a).
It is a foreign corporation, because it is a foreign business entity that provides limited liability to all its shareholders. Reg. §301.7701-3(b)(2)(i)(B).
It is a controlled foreign corporation (CFC), because a US citizen owns 60% of its shares. IRC §957(a). It is this CFC classification that triggers GILTI and subpart F income.
Under the old rules, “United States shareholders” of a CFC must include in his share of the CFC’s subpart F income in his personal income. IRC §951(a) (2017).
“United States shareholder” is a defined term that meant a US person who owns at least 10% of the voting power of a foreign corporation. IRC §951(b) (2017).
Subpart F income includes foreign base company income. IRC §952(a)(2). Foreign base company income includes foreign personal holding company income. IRC §954(a)(1). Foreign personal holding company income includes income that we typically think of as income from passive investments, and it includes royalties. IRC §954(c)(1)(A).
This Israeli company collects royalties. At first glance, it appears to collect subpart F income.
Fortunately, there is an exception for active royalties. IRC §954(c)(2)(A). If the CFC uses its own employees to develop IP, and the IP produces royalties, then the royalties are active royalties and not subpart F income. Reg. §1.954-2(d)(1)(i). Our example’s CFC uses its own employees to develop software. The royalties fit under the active royalty exception. They are not subpart F income.
When the Israeli company pays a dividend, the dividend is qualified dividend because of the income tax treaty between the US and Israel. IRC §1(h)(11); IRS Pub. 550, 21. The dividends are taxed at a maximum income tax rate of 20% and are subject to the 3.8% net investment income tax.
For example, suppose after year 1, the Israeli company distributes all its profits. Its income is $900,000. It has $400,000 of expenses. It has $500,000 of income before tax. Israel imposes a corporate income tax of 16%, or $80,000. We are left with $420,000 of profits.
The US shareholder’s share of the profits is $252,000 (60%). Israel imposes a 20% tax on the dividends, or $50,400.
The US imposes a 20% income tax on the dividends but gives a foreign tax credit for the Israeli tax paid, leaving a $0 US income tax. Then, the US imposes a 3.8% net investment income tax, or $9,576.
Tax at the shareholder level: $59,976.
The new tax law did not eliminate inclusion of subpart F income, nor did it change the definition of active royalties. As a result, the Israeli company still does not have any subpart F income.
The new law introduced section 951A. Section 951A(a) says:
Each person who is a United States shareholder of any controlled foreign corporation for any taxable year of such United States shareholder shall include in gross income such shareholder’s global intangible low-taxed income for such taxable year. IRC §951A(a).
The new law updated the meaning of United States shareholder a bit: It includes US persons who own 10% of a foreign corporation by voting power or by value. IRC §951(b) (2018). The old law includes only those who own 10% by voting power. IRC §951(b) (2017).
What is global intangible low-taxed income (GILTI)? This is how section 951(b)(1) defines it:
The term “global intangible low-taxed income” means, with respect to any United States shareholder for any taxable year of such United States shareholder, the excess (if any) of—
(A) such shareholder’s net CFC tested income for such taxable year, over (B) such shareholder’s net deemed tangible income return for such taxable year.
The formula looks simple: “net CFC tested income” minus “net deemed tangible income return”. Except we need to know what these terms mean. I am going to stop quoting the Code, so this newsletter does not become too long.
The net CFC tested income is this:
∑share of tested income of CFCs – ∑share of tested loss of CFCs (IRC §951A(c)(1))
The net CFC tested income requires us to look at all CFCs in which the US person is a United States shareholder. In our example, the US citizen owns only 60% of 1 CFC: the Israeli company. Thus, we look at 60% of the Israeli company’s tested income and tested loss.
To find tested income, we start with gross income excluding the following items (IRC §951A(c)(2)(A)(i)):
The only exclusion that might apply is the 18.9% effective tax rate exclusion, because Israel has a corporate income tax. But Israeli imposes only a 16% corporate income tax on this company. Thus, none of these exclusions apply. We use the gross income of $900,000.
After finding gross income and excluding these items, we then subtract deductions properly allocable to gross income excluding the above items. IRC §951A(c)(2)(A)(ii). In our situation, the Israeli company did not exclude any items from gross income, so it uses all deductions: $400,000 of expenses. But the corporation also paid $80,000 of Israeli corporate tax. The sum of of expenses and Israeli corporate tax is $480,000.
We take the difference between gross include (after exclusions) and expenses (including foreign taxes paid): This CFC’s tested income is $420,000. Our US citizen’s share is $252,000.
Tested loss is essentially the same formula, except it is used when deductions are higher than gross income. IRC §951A(c)(2)(B). In our situation, there is no tested loss, because our US citizen is a United States shareholder of only 1 CFC, and that CFC made a profit.
Our US citizen’s net CFC tested income is $252,000.
Net deemed tangible income return is defined as follows (IRC §951A(b)(2)):
0.1 x ∑share of qualified business asset investment – ∑interest expense used in determining net CFC tested income to the extent the interest income attributed to the expense is not used to determine net CFC tested income
We assumed there was no interest income or expense, so we need only be concerned with qualified business asset investment.
Qualified business asset investment is the quarterly average adjusted bases of “specified tangible property” used in a trade or business and for which a depreciation deduction is allowed. IRC §951A(d)(1). Specified tangible property is any tangible property used to produce tested income. IRC §951A(d)(2).
This is more or less tangible business property. In our scenario, that is $10,000 of furniture and computing equipment. Our US citizen’s pro-rata share is $6,000. We multiply his share by 0.1 to get a net deemed tangible income return of $600.
GILTI is net CFC tested income minus net deemed tangible income return.
We calculated net CFC tested income to be $252,000. We calculated net deemed tangible income return to be $600.
Our US citizen’s GILTI is $252,000 – $600, or $251,400. This GILTI is included in his personal income each year, regardless of whether the company paid any dividends.
Section 951A does not say how dividends affect GILTI or vice versa, but we can make some inferences–and these inferences are bad for the taxpayer.
Looking at how we calculate GILTI–corporation’s gross income, expenses, and tangible business assets–, we see that there is nothing about reducing GILTI by distributing dividends.
We treat GILTI as subpart F income for section 959. IRC §951A(f)(1)(A). Section 959 provides that profits previously taxed to US shareholders as subpart F income are not included in income again when distributed. IRC §959(a).
If we put these provisions together, GILTI should function like subpart F income: First, GILTI is included in the US shareholder’s income as ordinary income. Then, if the CFC distributes a dividend, the dividend is not subject to the normal income tax.
Under the old law, the US shareholder would have received qualified dividends taxed at capital gain rates of 20%. Under the new law, the US shareholder instead has GILTI taxed at ordinary income rates of 37%.
This is how the math works when the corporation distributes $252,000 of profits to the US citizen shareholder:
Israel imposes a tax on the dividends of 20%, or $50,400.
The US imposes a tax of 37% on $251,400 of GILTI, or $93,018. This amount is not included in income again when distributed.
But there was $252,000 of dividends paid from profits. The remaining $600 that was not taxed as GILTI is taxed as qualified dividends. The tax rate is 20%. The tax is $120.
The total income tax is $93,138, but the US gives a foreign tax credit for the Israeli tax paid, leaving a balance of $42,738.
Then the US imposes a 3.8% net investment income tax on the distribution: $9,576.
Total tax on the shareholder: $102,714
Compare to the tax under $59,974, there is an increase in tax of $42,740.
Permit me to observe that his $43,000 or so increase in tax is not because the US citizen has been doing anything nefarious to avoid tax.
He is living in a treaty country with its own corporate tax and individual income tax. He incorporated his business in the country in which he lives. He is in software development, and he takes dividends each year. These appear to be normal and expected activities.
US shareholders of a CFC may elect to pay tax on subpart F income and GILTI at corporate tax rates. IRC §§962, 951A(f)(1)(A). This has some advantages, but it came with additional tax reporting complexities.
Under the old law, where the corporate tax rate was 35%, the additional complexities may not have been worth it. It definitely was not worth it if the CFC had little subpart F income.
Under the new law, with the introduction of GILTI, the corporate tax rate election looks much more attractive. Our next blog post in this series will describe how the taxes will change if this US citizen makes a corporate rate election.