On March 4, 2019, the Internal Revenue Service (IRS) and the Treasury Department issued proposed regulations that provide guidance to determine the amount of the deduction for foreign-derived intangible income and global intangible low-taxed income (GILTI). For purposes of determining US tax liability under the GILTI regime, Section 250 provides that a domestic corporation is generally allowed a deduction equal to 50 percent, or 37.5 percent for taxable years beginning after December 31, 2025, of the sum of its GILTI plus associated foreign taxes.
The proposed regulations would extend the benefit of the Section 250 deduction to individual US shareholders who make a Section 962 election to be taxed as a domestic corporation with respect to their controlled foreign corporation (CFC) inclusions. A Section 962 election causes the GILTI income to be taxed at the US corporate tax rate and allows for an 80 percent foreign tax credit (FTC) as though the CFC stock was held through a hypothetical domestic corporation. The application of Section 250 to taxpayers making a Section 962 election is consistent with Section 962’s purpose of ensuring that an electing individual’s tax burden with respect to its CFC’s undistributed foreign earnings is not greater than if the individual owned such CFC through a domestic corporation. In adopting the guidance, the IRS and Treasury Department sought to eliminate the need for costly restructuring for individuals who might otherwise transfer their CFC stock to a new US corporation in order to obtain the benefit of the Section 250 deduction.
Scope of Section 250 deduction for GILTI
Under the proposed regulations, the Section 250 deduction for GILTI is available to (i) domestic corporations (but not including real estate investment trusts (REITs), regulated investment companies (RICs) or S corporations) and (ii) individuals (including individual partners in a partnership and individual shareholders in an S corporation) that make an election under Section 962 (“applicable taxpayers”).
For purposes of determining the amount of the GILTI deduction, the proposed regulations define “GILTI,” with respect to an applicable taxpayer for a taxable year, as the sum of the taxpayer’s (i) GILTI and (ii) distributive share of GILTI of a domestic partnership that is a US shareholder (as defined in Section 951(b)) (“US shareholder partnership”) of one or more CFCs (“partnership CFCs”) with respect to which the taxpayer partner is not also a US shareholder.
Thus, for example, applicable taxpayers that are partners in a private investment fund, taxed as a domestic partnership, which acquires 10 percent or more of the stock of one or more CFCs, can take into account the Section 250 deduction as an offset to their respective share of the fund’s GILTI, even if such taxpayers are not also US shareholders of the partnership CFCs. Such taxpayers should be aware, however, that they generally would not be entitled to indirect FTCs for the partnership CFCs’ foreign taxes attributable to the fund’s GILTI, according to proposed FTC regulations issued by the Treasury Department and IRS in December 2018, if the applicable taxpayer is not also a US shareholder of the partnership CFC.
Section 962 election mechanics
A Section 962 election may be made only by an individual who is a US shareholder, including an individual who is a US shareholder because he/she is considered to own stock of a foreign corporation owned by a domestic partnership or S corporation. After the Tax Cuts and Jobs Act, a “US shareholder” includes an individual who directly, indirectly or constructively owns at least 10% of the stock of a foreign corporation by vote or value.
An individual US shareholder makes an election under Section 962 by filing a statement with his/her return for the taxable year for which the election is made.
A Section 962 election applies only to the taxable year for which it is made, but is applicable to all CFCs with respect to which the electing US shareholder has a GILTI or Subpart F inclusion for that year.
An election under Section 962 cannot be revoked without IRS approval, which will not be granted unless a material and substantial change in circumstances occurs which could not have been anticipated when the election was made.
Transfer CFC stock to new US corporation?
Notwithstanding the favorable guidance for individuals contained in the proposed Section 250 regulations, there still may be situations in which an individual may consider transferring directly or indirectly held CFC stock to a new US corporation for tax reasons. For example, an individual partner in a US shareholder partnership who is not eligible to make a Section 962 election (e.g., because he/she is not a US shareholder of a CFC) may consider transferring his/her partnership interests to a new US corporation in order to obtain the benefit of the Section 250 deduction with respect to his/her distributive share of the partnership’s GILTI.
In addition, an individual US shareholder of a CFC that is not a qualified foreign corporation under Section 1(h)(11)(C), such as a CFC organized in a non-treaty jurisdiction may transfer his/her CFC stock to a new US corporation in order to obtain the benefit of the lower qualified dividend income (QDI) tax rates with respect to repatriated foreign earnings of the CFC. If properly structured, (i) CFC distributions to the new US corporation should not be subject to additional US tax under the previously taxed income rules of Section 959 or the participation exemption system established by the Tax Cuts and Jobs Act, and (ii) distributions by the new US corporation to the shareholder should qualify for the preferential QDI tax rates. Factors such as the CFC’s country of residence, withholding taxes on distributions and local country corporate income tax rates should all be considered.
The rule which allows an individual making a Section 962 election to obtain the benefit of the Section 250 deduction for GILTI is proposed to apply to taxable years of a foreign corporation ending on or after March 4, 2019, and the taxable year of a US person in which or with which such taxable year ends. However, the guidance provides that taxpayers may rely on such rule for the 2018 taxable year. The Treasury Department and IRS invite taxpayers to submit comments on the proposed regulations on or before May 6, 2019.