Controlled Foreign Corporations and the impact of GILTI

Elections

Check-The-Box (CTB) election

A CTB election disregards the limited company as a separate entity from the shareholders. A US shareholder’s share of the underlying profits will be taxed as either self-employment income in the case of a single shareholder company or as partnership income if there are multiple shareholders. If a CTB election is made, the US shareholder can claim a credit for both the foreign taxes paid on dividend income distributed from a CFC and the foreign corporation taxes paid against the US Federal tax. Once made, a CTB election cannot be varied for five years.

S.962 election

If a US shareholder makes a S.962 election, the underlying profits of the company are taxed at the US corporate tax rate of 21%, rather than the individual’s rate. It is also possible to claim a 50% IRC S.250 deduction resulting in a potential effective US tax rate of 10.5%. 

To the extent that a CFC is paying foreign taxes, it is possible to claim a credit for 80% of these against the US tax. The current UK corporate tax rate is 19%. Therefore, for the majority of UK based CFCs, a foreign tax credit can be claimed and will reduce the US Federal tax to nil.

There are additional compliance burdens associated with making a S.962 election due to having to run both a corporate and individual tax calculations within an individual tax return.

Proposed regulations – high-tax exception election

While the 2017 US Tax Reform Act was passed into law on 22 December 2017, many of the regulations surrounding GILTI were not finalised until the Summer of 2019. At the same time, the IRS issued further proposed GILTI regulations, which we anticipate will be finalised in Summer 2020.

The proposed regulations provide for a GILTI high-tax exception. If enacted, this will allow US shareholders to exclude GILTI that is subject to foreign tax of at least 90% of the US corporate tax rate (i.e. 18.9%). This exemption would therefore apply to UK limited companies, which are taxed at 19%.

The proposed regulations state that if enacted, the GILTI high-tax exception will only apply to tax years that begin after the date the final regulations are published. Therefore, the earliest year that this will apply is likely to be for 2021 US tax returns.

Tax compliance

US shareholders who own, acquire or dispose of stock in a CFC can create a one off or ongoing Form 5471 filing requirement. Form 5471 is submitted with an individual’s US Federal income tax return. The level of reporting required will depend on the US shareholder’s ownership but normally consists of basic company information as well as a profit and loss statement, balance sheet and tracking of retained earnings.

US shareholders of a CFC will also likely have a Form 8858 filing requirement, which is also submitted with an individual’s US Federal income tax return. This form reports similar information to the Form 5471.

For US tax purposes, any accounts have to be reported on a calendar year basis for individuals regardless of the CFC’s foreign accounting period.

Other considerations

Subpart F income and Passive Foreign Investment Companies (PFICs)

As well as GILTI, US shareholders of foreign companies need to be aware of the Subpart F income rules and PFIC rules. 

If a US shareholder owns more than 50% of a CFC, consideration needs to be given to non-trading income or personal service contracts. Such income would be taxed on the US shareholder as it arises under Subpart F rules as a separate category of income to GILTI.

Similarly, if a US shareholder owns less than 50% of a foreign company, which is not a CFC, and the foreign company generates 75% or more of its income from passive sources or 50% of its assets produce either passive or no income (such as cash), PFIC rules will apply. Owners of PFIC stock are subject to punitive tax treatment on distributions and capital gains realised on sale.

Case study

James, a US shareholder who is a top rate taxpayer in the US (37%) and UK (45%), owns outright a UK limited company, which provides consultancy services and generates a $100,000 net profit before tax with no depreciable assets. He wishes to withdraw all of his profits by way of dividend distributions. James’ colleague Barbara recommended Buzzacott for expat tax advice, as she had previously worked with the team on her US and UK personal tax filings and repatriation advice. 

When James approached Buzzacott, he was aware of the new GILTI tax, but unsure of what elections were available to him. The team were able to advise James on what the financial outcomes would be for the different elections, in order for James to select the most tax efficient option. 

For UK tax purposes:

• UK corporate tax: $19,000 ($100,000 @ 19%)
• Personal tax: $30,861 ($81,000 @ 38.1%) 

For US tax purposes:

No election

• Federal income tax on GILTI: $29,970 ($81,000 @ 37%)
• Federal income tax on dividends: $0 (US tax of 20% covered by UK personal tax)*
• Net Investment Income Tax: $3,078 ($81,000 @ 3.8%)
• Effective worldwide tax rate: 83%

CTB election

• Federal income tax: $0 (US tax of 37% covered by UK tax on dividends and UK corporate tax)*
• Effective worldwide tax rate: 50%

S.962 election

• Federal income tax: $0 (US corporate tax of 10.5% covered by UK corporate tax, US federal tax of 20% covered by UK tax on dividends)*
• Net Investment Income Tax: $3,078 ($81,000 @ 3.8%)
• Effective worldwide tax rate: 53%

*Typically, foreign taxes must be paid in the same calendar year that the income arises in order to claim a foreign tax credit.

Our advice for James

The Check-The-Box (CTB) election was the appropriate choice for James because this meant that he could potentially retain the benefit of the Entrepreneurs’ Relief when he sold his business in future. This is the reduced Capital Gains Tax rate of 10%, which would normally be irrelevant given the US long-term Capital Gains Tax rate of 20% and the additional 3.8% Net Investment Income Tax (NIIT) due. However, the check-the box strategy could potentially result in no US Capital Gains tax due, therefore retaining the benefit of a 10% tax rate on the disposal of the business. 

How we can help

Although CTB was the right option for James, there is no one size fits all solution and the correct course of action will ultimately depend on each individual’s circumstances. For example, if James’ business fell into the personal service contract company rules orJames wanted to extract the majority of his profits from the business each year, a different election would be more suitable.