Many of us are suffering from overexposure to Tax Cuts and Jobs Act, the truth is, however, that the impact of the Global Intangible Low Taxed Income (GILTI) provisions cannot be overstated and deserves all the press time it has been getting.
After more than half a century on the books, the Section 962 election seems to finally have its moment in the spotlight. This provision has been part of the Internal Revenue Code since 1962, but was never very popular due to the way it taxes distributions of what would otherwise be Previously Taxed Income (PTI).
Section 962 is a provision which allows individuals to be taxed as a corporation on certain income from Controlled Foreign Corporations (CFCs), specifically Subpart F and now GILTI. Historically the benefit of this election has been the ability of the individual making this election to claim a foreign tax credit with respect to the corporate level taxes paid by the CFC. In the absence of this election, the individual would not be allowed this so-called “indirect credit.”
In a post-Tax Cuts and Jobs Act era, the Section 962 election is even more attractive because the Corporate income tax rate has gone from 35% to 21%. Allowing taxpayers to potentially pay a lower tax and claim an indirect foreign tax credit.
In addition, C Corporations are allowed a 50% dividend received a deduction on their GILTI, which may result in the added benefit of the 50% dividend received a deduction for individuals making a Section 962 election.
When an individual taxpayer makes a Section 962 election they elect to be taxed as a C Corporation for all subpart F and GILTI income earned in a given year. This allows the individual to take a foreign tax credit for the local country taxes paid by the CFC. A credit for foreign taxes that would otherwise not be available to them.
Take John who owns 100% of a CFC located in Israel. Assume the CFC had $100,000 of income all of which is GILTI. The Israeli corporate income tax on this would be 23,000. The remaining E&P considered GILTI would be $77,000. In the absence of a Section 962 election, John would pay a 37% U.S. tax of $28,490 without a foreign tax credit for the $23,000 Israeli corporate tax paid.
The Section 962 election would allow John to claim a foreign tax credit for the $23,000 Israeli taxes paid. Consequently, John’s tax in the year of the GILTI inclusion would be the $23,000 Israeli tax plus $2,600 of incremental U.S. tax on the GILTI. The U.S. tax computed as follows $100,000 of income at the 21% corporate tax rate, a tax of $21,000 less a foreign tax credit that equals 80% of the Israeli tax paid $18,400 for a residual tax of $2,600.
The Section 962 election may be even more beneficial if individuals making the Section 962 election would be allowed the 50% dividend received deduction allowed to C Corporations on their GILTI inclusions.
A strict interpretation of Tax Cuts and Jobs Act precludes this application of the dividend received a deduction. However, the legislative history of Section 962 indicates its purpose is to put individual taxpayers and C Corporations on equal footing. It would seem to allow individuals the 50% dividend received deduction would be necessary to put individuals and corporations on equal footing in accordance with the intent of Section 962.
While we await guidance on this matter, let’s assume individuals are allowed the dividends received deduction and John makes the Section 962 election. John’s tax expense for the year of inclusion would be as follows: $23,000 Israeli corporate taxes and $0 U.S. incremental tax. This would be computed by allowing a $50,000 dividend received deduction and 21% tax on the remaining income would be $10,500 with an $18,400 foreign tax credit, resulting in $0 incremental inclusion.
|John with the Israeli CFC||John with Israeli CFC and Section §962 election|
|IN YEAR OF GILTI INCLUSION|
|Local Country Corporate Income Tax Paid||23,000||23,000|
|U.S. Tax @ 37%/21%||28,490||21,000|
|Residual U.S. tax on GILTI||28,490||2,600|
|IN SUBSEQUENT YEAR OF DISTRIBUTION|
|Israeli withholding tax on this income 25%||19,250||19,250|
|U.S. Tax on this income 20% as qualified dividend||14,880|
|Direct Foreign Tax Credit allowed||19,250|
|Residual U.S. Tax on actual inclusion||–|
|Total Tax paid on this income||70,740||44,850|
|Effective Tax Rate||70.74%||44.85%|
Taxpayers considering a Section 962 election should take caution and consider the impact the election will have on the taxation of actual cash distributions from the CFC.
Take our example with John, in the absence of the Section 962 election, upon a subsequent distribution of cash from the CFC, the distribution would be considered Previously Taxed Income (PTI) and not subject to further U.S. tax.1 Note however the income will be subject to 25% Israeli withholding tax of $19,250
With a Section 962 election in place, distributions of cash from the CFC will not be considered PTI and the full amount of the distribution less any U.S. tax previously paid on the related earnings will be subject to U.S. tax. When John receives the cash distribution of $77,000 the full amount less the $2,600 in U.S. tax paid in the year of inclusion will be treated as a qualified dividend in the U.S. and subject to a 20% qualified dividends tax or $14,880. The distribution will also be subject to Israeli withholding taxes of 25% or $19,250 which will be credible. The credit of $19,250 should full offset the qualified dividend tax of $14,880.
For John, the Section 962 election taxation of cash distributions becomes irrelevant because the distributions are considered qualified dividend and the relatively high withholding taxes on the distributions out of Israel. However, if John’s CFC was located in Hong Kong the distributions would not be qualified dividends and therefore taxed at 37% in the U.S. In addition, Hong Kong does not have a withholding tax on dividends so there would not be any foreign tax credit benefit.
|John with the HK CFC||John with HK CFC and Section §962 election|
|IN YEAR OF GILTI INCLUSION|
|Local Country Corporate Income Tax Paid||16,500||16,500|
|U.S. Tax @ 37%/21%||30,895||21,000|
|Residual U.S. tax on GILTI||30,895||7,800|
|IN SUBSEQUENT YEAR OF DISTRIBUTION|
|Israeli withholding tax on this income 25%||–||–|
|U.S. Tax on this income 20% as qualified dividend||28,009|
|Direct Foreign Tax Credit allowed||–|
|Residual U.S. Tax on actual inclusion||28,009|
|Total Tax paid on this income||47,395||52,309|
|Effective Tax Rate||47.40%||52.31%|
For individual taxpayers with a possible GILTI inclusion anticipate for 2018, a Section 962 election should definitely be considered. Factors such as the CFC’s country of residence, withholding taxes on distributions and local country corporate income tax rates should all be considered. We will find some scenarios where the individual should be making a Section 962 election and others where the Section 962 election is not the best planning option.
For additional information on Section 962, please contact a member of Withum’s International Services Group by filling out the form below.