Symmetrical Treatment of U.s. Individual Shareholders Investing in Controlled Foreign Corporations: Proposed Amendment to Irc § 962(d)

• Publication year: 2022
• Author: Written by William K. Norman

SYMMETRICAL TREATMENT OF U.S. INDIVIDUAL SHAREHOLDERS INVESTING IN CONTROLLED FOREIGN CORPORATIONS: PROPOSED AMENDMENT TO IRC § 962(D)

Written by William K. Norman¹

EXECUTIVE SUMMARY²

A United States shareholder of a controlled foreign corporation (CFC) may be subject to an inclusion in gross income of subpart F income or global intangible low-taxed income (GILTI) of all or a portion of the earnings of the CFC regardless of whether the earnings are currently distributed. A U.S. shareholder of the CFC which is a domestic C corporation will be able to claim a deemed paid foreign tax credit against its Federal corporation income tax with respect to the inclusions. If the domestic corporation onward distributes earnings and profits representing an inclusion to an individual who is a United States person, the individual shareholder will be eligible for the preferred tax rate as the recipient of "qualified dividend income" provided the CFC is a "qualified foreign corporation".

If the U.S. shareholder of the CFC is an individual, she may elect to be taxed as if she were a domestic C corporation on the undistributed gross income attributed to and included in her gross income as subpart F income or GILTI. However, if the CFC actually distributes the earnings and profits representing the inclusion, the inclusion amount less any Federal income taxes previously paid with respect to the inclusion of the individual U.S. shareholder is not eligible to be treated as a "qualified dividend" eligible for a preferred tax rate unless the CFC is a "qualified foreign corporation," essentially a foreign corporation eligible for benefits of a comprehensive income tax treaty with the United States.

Consequently, U.S. individuals investing directly (or through a domestic passthrough entity) in a CFC who are not eligible for benefits of a U.S. income tax treaty are effectively incentivized to

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invest in the foreign corporation through a domestic C corporation. Only by investing in a CFC not eligible for treaty benefits through a domestic corporation will an individual U.S. shareholder be subject to the lowest effective tax burden on the initial Subpart F and GILTI inclusions and the subsequent distributions of the previously taxed earnings of the CFC. The amendment to Code section 962(d) proposed in this paper would provide symmetrical and equitable tax treatment for "U.S. shareholders" of CFCs which are domestic C corporations and who are U.S. residents or citizen individuals with respect to both any initial inclusions under Subpart F and GILTI and any subsequent distributions of the previously taxed earnings of a CFC. The symmetrical treatment under the proposed amendment in Code section 962 is available as an election to an individual U.S. shareholder regardless of whether the foreign corporation is eligible for benefits under a comprehensive U.S. income tax treaty without undermining U.S. income tax treaty policy.

CURRENT LAW

BACKGROUND

The provisions of subpart F of the Internal Revenue Code (the "Code") were enacted as part of the Revenue Act of 1962 ("the 1962 Act").³ With exceptions and relief provisions, subpart F as enacted provided, in essence, for the current inclusion in gross income of a United States shareholder of a CFC ("CFC") the subpart F income and investment in United States property of the CFC.⁴

If the U.S. shareholder of a CFC were a domestic C corporation, the domestic corporation would be entitled to claim a deemed paid foreign tax credit for foreign income taxes of the CFC attributed to the inclusion subject to limitations.⁵ However, if the U.S. shareholder of the CFC were an individual, no deemed paid foreign tax credit is available except under a special election.

At the time of enactment of the 1962 Act, the highest marginal individual tax rate was then 91 percent⁶ as compared to the highest marginal corporate rate of 52 percent.⁷ Apparently because of the differential in Federal income tax rates applicable to individuals and corporations, a relief provision in the form of Code section 962 was made available as part of the 1962 Act for an individual who is a U.S. shareholder subject to inclusions under subpart F. The Conference Report to the 1962 Act explains the rationale for the relief provision as follows:

The purpose of this provision is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. This provision gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.⁸

The subpart F provisions, current Code sections 951 through 965, reflect numerous amendments made since the enactment of the 1962 Act. Code section 962 has been subject to several amendments but only to reflect changes in the calculation of the corporate tax rate. The most recent amendment to Code section 962 was made to reflect the corporate tax rate determinations under the Tax Cuts and Jobs Act 2017 ("TCJA").⁹

The importance of Code section 962 has increased since the date of its enactment in 1962 because of the enactment of TCJA as evidenced by numerous articles on the subject.¹⁰ Under the Code as amended by TCJA, a U.S. shareholder may be required to report inclusions not only for subpart F income and investments in U.S. property but also for global intangible low-taxed income ("GILTI") and, in limited circumstances, for "accumulated post-1986 deferred foreign income" or "transition tax".¹¹ The availability of an election under Code section 962 for individuals with respect to the transition tax is noted in the Conference Report to TCJA at page 491 and in footnote 1513.¹² The Code provision dealing with GILTI itself allows for the use of Code section 962 election.¹³

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OPERATION OF SECTION 962 UNDER CURRENT LAW

Under Code section 962, an individual who is a United States shareholder (U.S. Shareholder) as specially defined in Code section 951(b) may elect to report the inclusion of subpart F income (including transition tax inclusions under Code section 965), subpart F inclusion under Code section 951(a) and GILTI inclusion under Code section 951A as if the inclusion amounts were received by a domestic C corporation for tax rate purposes under Code section 11.¹⁴ Further, the U.S. Shareholder is eligible to claim a deemed paid credit for foreign income taxes attributable to the inclusions.¹⁵

More specifically the amount included as taxable income of the electing U.S. shareholder for the taxable year under Code section 962 is

A) the sum of:

1. all amounts required to be included in gross income under Code section 951(a) with respect to the CFC (including any transition tax inclusions under Code section 965);
2. GILTI inclusions amount under Code section 951A(a) with respect to the CFC;
3. All gross up amount inclusions under Code section 78 as if the shareholder were a domestic corporation;

Less B) the sum of the following deductions:

1. Deductions under Code section 965(c) that would have been allowed to a domestic corporation to reflect the 8 percent rate equivalent percentage and
2. Deductions under Code section 250 that would have been allowed to a domestic corporation with respect to GILTI inclusion and gross up amounts.^{16 17}

The individual U.S. shareholder makes the election annually by means of a statement attached to her individual tax return.¹⁸ Under the Treasury Regulations, the election once made by a U.S. shareholder for a given taxable year is irrevocable unless revocation is approved by the IRS.¹⁹ If the earnings and profits of the CFC are subsequently distributed, the amounts attributed to a previous inclusion with respect to which an election had been made are "included in gross income" of the U.S. shareholder.²⁰ Any foreign withholding tax imposed on the subsequent distribution of previously taxed income may be eligible for a direct foreign tax credit subject to a special ambulatory limitation.²¹

The character of the inclusion as a dividend is not specified in Code section...