In our last post, we described the basics of how GILTI works in the context of a software company. Many questions we received through email related to a “high tax exception” to GILTI. Today’s post discusses what the high tax exception is and why this high tax exception appears to not exempt shareholders of corporations in high tax countries from GILTI.
Let us work with a set of assumptions to see how limited the high tax exception is:
A US citizen lives in the UK and owns a fairly successful retail business. It is run through a UK limited company.
The annual gross profits are about £600,000. It has expenses of about £400,000, including UK income tax. It does not have any other source of income.
The company has about £200,000 of basis in equipment, furniture, and similar tangible assets used in its business. It leases its warehouse and retail outlets, so it does not own any real estate.
GILTI stands for global intangible low-taxed income. It was added to the Internal Revenue Code in December of 2017, amidst the flurry of changes to cut taxes for corporations. It is Code section 951A.
“United States shareholders” of a controlled foreign corporation (CFC) are subject to GILTI rules. IRC §951A. “United States shareholder” means a US person who owns at least 10% of the shares of a foreign corporation by voting power or share value. IRC §951(b). A foreign corporation is a CFC if United States shareholders own more than 50% of the shares by voting power or by value.
In our scenario, the UK company’s sole shareholder is a US citizen, so it is a CFC, and the US citizen is a United States shareholder.
Our last post described the basics of calculating GILTI. Here is the abridged version:
The result is GILTI, at least if we are dealing with a US person who owns 1 CFC that makes a profit. The calculation differs if more than 1 CFC is involved.
The 5 items excluded from gross income for calculating GILTI are the following, quoted from IRC §951A(c)(2)(A)(i):
(I) any item of income described in section 952(b), (II) any gross income taken into account in determining the subpart F income of such corporation, (III) any gross income excluded from the foreign base company income (as defined in section 954) and the insurance income (as defined in section 953) of such corporation by reason of section 954(b)(4), (IV) any dividend received from a related person (as defined in section 954(d)(3)), and (V) any foreign oil and gas extraction income (as defined in section 907(c)(1)) of such corporation
The one we care about is item (III), because section 954(b)(4) gives us the high tax exception:
Foreign base income and insurance income shall not include any item of income received by a controlled foreign corporation if the taxpayer establishes to the satisfaction of the Secretary that such income was subject to an effective tax rate of income imposed by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11.
The tax rate in section 11 is 21%. IRC §11(b). To use this high tax exception, the foreign country must impose an effective tax rate of more than 18.9%. The UK tax on the limited company is 20%, for small corporations whose profits are under £300,000. That is above 18.9%, so solely by tax rate, the income of the UK company should be excluded from GILTI.
But there is more to the high tax exception than just the high tax rate. The income we want to exclude from GILTI must be “excluded from the foreign base company income […] and the insurance income […] of such corporation by reason of [high foreign tax]”. IRC §951A(c)(2)(A)(i)(IIII).
If the income is excluded from foreign base company income and foreign insurance income, because the income was not foreign base company income or foreign insurance income to begin with, then this exception does not apply.
We are not dealing with insurance income, so we can ignore that category.
Foreign base company income is a type of subpart F income. IRC §952(a). It is included in the income of United States shareholders of CFCs annually, regardless of distributions. IRC §951(a). This annual inclusion existed long before 2017.
Here are the types of foreign base company income (IRC §954(a)):
To get the high tax exception, we must show that the income subject to high tax in a foreign country falls into 1 of these categories.
Foreign personal holding company income refers to types of income we typically think of as passive, such as dividends, interest, rents, royalties, gains from selling property, commodities trading, etc. IRC §954(c). It does not include retail income.
Foreign base company sales income requires a transaction between the CFC and a related party. For example, the CFC buys goods from a related person and sells the goods; the CFC sells goods on behalf of a related person, and the like. IRC §954(d)(1).
Foreign base company sales income exists to prevent companies from shifting profits to low-tax jurisdictions. For example, suppose a US citizen incorporates a company in Cayman and a second company in the UK. The Cayman company buys goods for $100 from the US, then sells it to the UK company for $200. The goods never touch the Cayman Islands. The UK company then sells the goods to customers for $210.
The Cayman company has a profit of $100, which is not taxed, because Cayman does not impose a corporate income tax when the goods do not touch Cayman. The UK company has a profit of $10 taxed in the UK. Although the US citizen’s companies made $110 of profits, only $10 of profits is taxed. The Cayman company’s profits are foreign base company sales income. It is included in the shareholder’s income as subpart F income each year.
Here, the UK limited company sells goods for its own account. There is no transaction with a related person. The retail income is not foreign base company income.
Foreign base company services income is very similar to foreign base company sales income, except it deals with providing services using related persons. IRC §954(e). It does apply here, because our UK company only has retail sale income.
Our UK company’s retail income is not foreign base company income. Therefore, it is not excluded from foreign base company income “by reason of” section 954(b)(4). To use the high tax exception, the income must be excluded “by reason of” section 954(b)(4). The retail income is not excluded from GILTI.
The company has £600,000 of gross profits and £400,000 of expenses, including UK income tax. It has £200,000 of depreciable tangible business assets. The US citizen’s GILTI is
£600,000 – £400,000-0.1 x £200,000= £180,000
Suppose we have a wealthy US citizen living in the UK. He incorporates a UK limited company, and the UK limited company invests in real estate. The company outsources management of the real estate to a professional firm.
This type of income is foreign personal holding company income. IRC §954(c)(1)(A). It is taxed at 20% in the UK, so more than 90% of the US tax rate of 21%. It is excluded from foreign base company income under Section 954(b)(4) as highly-taxed income. Therefore, it is excluded from GILTI.
We have a bizarre situation where a US citizen can have a holding company in a high tax country and defer US tax on income, while a US citizen who has an active business in the same country cannot defer income from GILTI. The result is perverse enough that we should suspect a drafting oversight, but that is what the text of the statute seems to say.
This is the type of problem that Congress might fix with a technical correction, or the IRS might use its regulatory authority to fix. But at least by the text of the statute, it seems active business income subject to high tax in a foreign jurisdiction is included in GILTI.