Notable Provisions Affecting International Tax
The Tax Cut and Jobs Act of 2017 (“TCJA”) continued to have a profound impact in the international tax arena in 2019. The year brought forth IRS notices and regulations (both final and proposed), that expanded on the TCJA and provided much needed clarity on various topics.
Two of the major provisions of the TCJA as they relate to international taxation are the Global Intangible Low- Taxed Income (GILTI) and Foreign-Derived Intangible Income (FDII) regimes. Following is a brief discussion of these provisions, as well as planning points taxpayers should consider for 2019 and future years.
GLOBAL INTANGIBLE LOW-TAXED INCOME (“GILTI”)
Originally introduced under TCJA, the IRS has since enacted a host of additional regulations concerning Global Intangible Low- Taxed Income (“GILTI”), in hopes of providing clarity to those U.S. taxpayers that fall under the ambit of the TCJA’s revamped multinational tax regime.
Designed to deter the offshoring of IP intellectual property (IP) and other intangibles, GILTI effectively functions as a current income inclusion on undistributed foreign earned income, equal to the income earned by certain foreign corporations with U.S. shareholders that exceeds 10% of that foreign corporation’s depreciable tangible property. Currently, domestic corporations are generally allowed a deduction of 50 percent of their GILTI inclusion, under Internal Revenue Code (“IRC”) §250, and can additionally claim a foreign tax credit of up to 80 percent of foreign income taxes paid or accrued on GILTI inclusions.
Note: A GILTI high -tax exception was proposed in June of 2019 and, if finalized, may provide relief to taxpayers conducting business in foreign high-tax jurisdictions in future tax years. Under this proposed exception, income subject to tax in a foreign country at a rate greater than 18.9 percent would not be included in GILTI, at the election of the taxpayer.
Notably, however, many of the aforementioned means by which taxpayers can minimize the effect of the GILTI inclusion (i.e., application of foreign tax credits or the §250 deduction) are generally only available to domestic C corporations. For individual taxpayers, who would otherwise be subject to ordinary tax rates on their GILTI inclusions, §962 provides an avenue through which they might not only mitigate the effect of their GILTI inclusion, but also lower their effective tax rate on the whole.
Often overlooked historically, §962 has recently risen to prominence with the advent of the TCJA. Section 962 allows certain U.S. individuals to elect to be treated as a domestic C corporation for federal income tax purposes with respect to GILTI income. In the context of GILTI, treatment as a domestic C corporation through a §962 election allows U.S. individual shareholders to be taxed at corporate rates on their GILTI inclusions, and to take advantage of §250’s 50% GILTI deduction, while granting the ability to utilize foreign tax credits. The election can mitigate the U.S. tax on GILTI inclusions if the foreign income tax rate on such income is at least 13.125%. This result can be achieved by election, without the need to interpose a corporation in the structure.
Certain individual shareholders, particularly those U.S. shareholders owning shares of foreign entities operating in non-treaty countries, may find that interposing a domestic C corporation to own their foreign entities may provide a more appealing tax-planning alternative than the §962 election. While both the §962 election and use of a C corporation intermediary grant taxpayers the ability to mitigate the effect of GILTI inclusions, utilization of an actual C corporation provides taxpayers with an important benefit that the §962 election cannot provide: the ability to be taxed at qualified dividend rates (capped at 20%) on dividend distributions from foreign non -treaty entities. Without use of a domestic corporation intermediary, dividend distributions from non-treaty corporations will be taxed at ordinary income tax rates.
Under the TCJA, domestic C corporation shareholders are entitled to a ‘”dividends received deduction'” under §245A for dividends received from foreign corporations that are greater than 10% owned and for which certain holding period requirements are met. U.S. taxpayers utilizing a domestic corporation in the ownership chain can have such corporation receive dividends from its foreign subsidiary without U.S. tax by virtue of the dividends received deduction. Moreover, once income is distributed from the corporation to its shareholders, such income will be taxed to the U.S. individuals at qualified dividend rates, thereby potentially reducing the income tax rate imposed on foreign subsidiary income from ordinary tax rates to a maximum rate of 20%.
Careful planning and a detailed financial analysis should be undertaken to determine the feasibility of this alternative, particularly as the use of a domestic holding corporation may implicate various state corporate taxation issues, and a change in structure may have foreign tax consequences.
FOREIGN-DERIVED INTANGIBLE INCOME (“FDII”)
Also introduced under the TCJA, §250 provides a U.S. C corporation that provides services and makes sales to foreign customers located outside of the U.S. the ability to take a deduction on its foreign-derived intangible income (“FDII”). FDII was intended to discourage offshoring by providing an incentive for U.S. entities to develop their intangibles inside the U.S. rather than in foreign localities. While mechanically the FDII deduction can be quite complex, the §250 framework for calculating the deduction amount generally works as follows: FDII-eligible income constitutes net income earned by domestic C corporations from the sale of property or provision of services to foreign persons or entities over a certain threshold. The threshold is 10% of the corporation’s depreciable tangible property. The excess income over the threshold is multiplied by the applicable current year rate of 37.5%, and the result is the corporation’s FDII deduction.
The FDII deduction can effectively reduce the corporate tax rate on applicable earnings from 21% to 13.125%. Notably, this deduction is available only to domestic entities taxed as C corporations, and is effective for tax years beginning on or after January 1, 2018 (and the effective rate will change to from 13.125% to 16.4% in 2026).
It is worth noting that the European Commission has indicated that it may issue a World Trade Organization (“WTO”) challenge to the FDII deduction on the grounds that it constitutes an unfair subsidy favoring U.S. C corporations, and that implementation of the FDII regime violates international trade law. We will continue to monitor this issue as it unfolds.
The upcoming year will likely provide more guidance on, and clarifications with respect to, the TCJA. We at Marcum will continue to provide proactive advice and tax savings opportunities for our clients as well as assist in navigating additional complexities that will undoubtedly arise.