GILTI and the 962 election
A new tax law called “GILTI” (Global Intangible Low Taxed Income) was introduced into the US tax code for the tax year 2018 and on. It is important to note that in concept, GILTI is similar to the “Repatriation Tax” that applied to the 2017 tax year which required US citizens who owned foreign corporations to pick up the retained earnings of their foreign corporation for many back years as personal income on their personal 2017 US tax returns.
What is Gilti
When I start explaining what this means to most of my clients verbally in a meeting, their immediate reaction is to have a feeling of “guilt” for owning a foreign corporation. I am not kidding here by the way. They feel it’s enough that the US requires its citizens to report their worldwide income and highest account balances to the US tax authorities and the United States Treasury which almost no other country in the world requires……. now they have to make us feel guilty for owning a foreign corporation as well?!
In simple English, what this new law means is that a US citizen who owns a foreign corporation is now required as of 2018 and on to report the current annual net profit of the foreign company as taxable income on their personal US tax returns. One may think initially that this is not necessarily such a big deal since we all know that there is the foreign tax credit system in place that allows one to utilize the foreign taxes that they pay to offset the US tax otherwise owing on the same income. In most countries the corporate tax rate is usually quite high and this tax should cover any resulting US income tax on this income, right? So what’s the big deal and hype with this new GILTI law?
The answer is that although you are generally correct in how the foreign tax credit system works, it is important to realize that it is a foreign corporation that has paid this foreign tax and not you as an individual. The GILTI laws require you as an individual to pick up these corporate earnings on your PERSONAL tax return as personal income. There are very specific rules in the US foreign tax credit system and only foreign taxes paid “on the same basket of income” can be utilized to offset US taxes on income that is in the same basket. Since it was the foreign corporation that paid the taxes, and you are an individual, you are not permitted to use any of this corporate tax paid to your country to alleviate the double tax burden in this situation.
Once you come to this sad realization, it quickly becomes apparent that the GILTI laws do not seem very fair for the US individual who owns a foreign corporation.
The 962 Election
Initially, accountants and tax attorneys racked their brains to come up with a solution that they were hoping would get around this problem. By making a “section 962 election”, one effectively can elect to treat this GILTI income reported on their personal tax returns as if they themselves were a US corporation instead of an individual. This effectively gets around the problem of the “different baskets” since it is now a “US corporation” picking up foreign corporate income as US corporate income which is the same basket.
There was a major problem encountered though with this approach in the early stages. The way the rules work is that a proper US corporation with foreign corporate earnings would be required to pick up 100% of the foreign corporate earnings on the current annual US corporate tax return, get a 50% deduction automatically off of this income amount, and then can only utilize 80% of the foreign corporate taxes paid. The way the numbers played out is that this “50% deduction” was really needed in order to achieve an end result of no US income taxes owing on this income. The problem was that the 50% deduction provision was only specified for a real US corporation. There was no mention as to whether the 50% deduction would also apply to an individual making the 962 election or not. Without the 50% deduction, additional taxes would be owing even with the 962 election.
After much heartache, the IRS announced that at the end of the day, the 50% would indeed be granted to US individuals making the 962 election. This was the first major breakthrough and full-proof solution to the GILTI problem that we had on our hands for Israeli corporations.
The High Tax Exception
In June of 2019, another major breakthrough happened which is extremely exciting and actually a bit shocking that the IRS only announced this news so late in the game.
The IRS published a proposed regulation that expands the “High Tax Exception” to include regular foreign corporate earnings. You are probably wondering what this means and why I sound so excited about it! The answer is that it provides a simpler and easy to implement solution to eliminate any additional taxes owing due to GILTI. In simple English, it states that as long as 90% of the current US corporate tax rate, which is 21%, is paid in foreign corporate taxes, all of these foreign corporate earnings can be excluded and not required to be reported as taxable income on the personal US income tax return. This comes out to 18.9%. If your country’s corporate tax rate is currently higher than this then generally speaking, all your corporate earnings will be eligible for this “High Tax Exception” and will not be subject to additional US taxes.
There is a caveat here that will likely apply to some situations where your corporation may have large current annual net earnings and will not pay the full corporate tax. Why would that be? Well, if your corporation has carryover losses from prior years, they can be utilized in a current year to offset the current earnings. As a result, much less than 18% and in some cases even no Israeli corporate taxes will be paid on the current annual earnings. The GILTI inclusion is really only on the current net profit of the foreign company and does not address how prior year losses come into the picture. The question that then arises is how this will play itself out with both the High Tax Exception and also when making the 962 election.