In the last several months much has been written about the implications of P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA). (1) For owners of flowthrough entities (including sole proprietorships, partnerships, and S corporations), most of the commentary has focused on the new 20% deduction available for qualified business income (Sec. 199 A). (2) Of course, the reductions in the corporate and noncorporate tax rates also have received ample attention. (3) Collectively, these new provisions raise questions about whether it remains more beneficial to own domestic businesses in a flowthrough structure rather than a corporate structure. In the international context, however, ownership of a foreign corporation by a U.S. flowthrough taxpayer may produce unwelcome results under the TCJA. (4)
In general, the TCJA shifts the U.S. corporate taxation of foreign earnings to a "quasi-territorial" system, which, for corporate taxpayers, may result in no U.S. tax with respect to income of a controlled foreign corporation (CFC) (even upon repatriation). (5) Aspects of the TCJA aimed at transitioning taxpayers to the new system, however, as well as the system itself, treat flowthrough taxpayers that own CFCs considerably differently than corporate shareholders. This article explores two areas of concern for U.S. flowthrough taxpayers that own an interest in one or more CFCs: the new tax imposed on "global intangible low-taxed income" (GILTI) and the new "deemed repatriation" tax imposed on certain previously untaxed income generated by CFCs. (6)
The new tax on GILTI
Under pre-TCJA law, U.S. shareholders (whether corporations or individuals) that owned 10% or more of the voting stock in a foreign corporation classified as a CFC generally were taxed on the CFC's earnings only upon receipt of a dividend. (7) The primary exception historically has been a series of rules generally referred to as the "Subpart F rules," which require the inclusion of certain types of income earned by a CFC on a current basis, regardless of whether a distribution is received. (8) Thus, a U.S. taxpayer that structured its operations in a manner that was mindful of the Subpart F rules generally was able to defer U.S. tax on income earned by a CFC until the U.S. taxpayer received a dividend (the amount of which could then be used to fund the payment of the associated U.S. tax liability).
Under the TCJA, Congress has implemented GILTI as a new anti-deferral tax on certain earnings of a CFC, effective starting with the first tax year of the CFC beginning after Dec. 31, 2017. (9) Similar to the taxation of Subpart F income, a 10% U.S. shareholder of one or more CFCs will be required to include its GILTI currently as taxable income (in addition to any Subpart F income), regardless of whether any amount is distributed to the U.S. shareholder. The tax on GILTI essentially serves to tax the U.S. shareholder currently on its allocable share of CFC earnings for a tax year to the extent such earnings exceed a 10% return on the shareholder's allocable share of tangible assets held by CFCs. The tax on GILTI applies equally to U.S. shareholders that are corporations or flowthrough taxpayers.
Specifically, a U.S. shareholder's GILTI is calculated as the shareholder's "net CFC tested income" less "net deemed tangible income return" determined for the tax year. (10) Net CFC tested income is calculated by determining the U.S. shareholder's pro rata share of tested income or tested loss of each CFC held by the U.S. shareholder, and aggregating those amounts. (11) Tested income or loss generally is calculated as a CFC's gross income after excluding items of high-taxed foreign base company income, Subpart F income, related-party dividends, certain foreign oil and gas extraction income, and income of the CFC taxable in the United States as effectively connected income, less deductions allocable to tested income. (12) Thus, in the simple case where a single shareholder owns 100% of a CFC with none of the categories of excluded income, net CFC tested income will equal the CFC's net income.
The exclusion for high-taxed income found in Sec. 951A(c)(2)(A)(i)(III) appears to only exclude high-taxed income that is considered foreign base company income (i.e., income of a CFC that potentially gives rise to a Subpart F inclusion). Thus, high-taxed income that is not foreign base company income is included as tested income under the statute. For passthrough taxpayers who do not benefit from foreign tax credits on GILTI (discussed below), this limiting of the exclusion does not make sense--high-taxed potential Subpart F income is excluded, but similarly high-taxed income that is not subject to Subpart F is not. One would expect Sec. 951A to provide an exclusion for income that "would be subject to the high-tax exception if such income were foreign base company income."
Once the net CFC tested income is determined, it is reduced by the shareholder's "net deemed tangible income return" to arrive at the shareholder's GILTI. This amount generally is calculated as the excess of: (1) a U.S. shareholder's allocable share of the U.S. tax basis of depreciable tangible assets used in the production of tested income held by each CFC owned by the U.S. shareholder, multiplied by 10% (subject to certain adjustments); less (2) the amount of interest expense taken into account under Sec. 951A(c)(2)(A)(ii) in determining the shareholder's net CFC tested income for the tax year to the extent the interest income attributable to such expense is not taken into account in determining the shareholder's net CFC tested income. (13) For this purpose, Sec. 951A(d)(3) provides that tax basis is determined by applying depreciation on a straight-line basis. (14)
Where the U.S. shareholder holds multiple CFCs, GILTI is effectively determined on an aggregate basis.
Example 1: As of Dec. 31, 2018, a U.S. shareholder owns 50% of CFC1 and 100% of CFC2. CFC1 has $50,000 of tested income and a tax basis in its tangible assets of f 500,000. CFC2 has $80,000 of tested income and a tax basis in its tangible assets of $200,000. The U.S. shareholder will have net CFC tested income of $105,000 (50% x $50,000 + 100% x $80,000). The U.S. shareholder will have a net deemed tangible income return of $45,000 (10% x [50% x $500,000 + $200,000]). The U.S. shareholder's 2018 GILTI will be equal to $60,000 ($105,000 - $45,000). Once the amount of GILTI has been determined, a U.S. corporate taxpayer may claim a deduction, subject to certain limitations, equivalent to 50% of its GILTI (reduced to 37.5% for tax years starting after 2025). (15) Prior to the consideration of U.S. foreign tax credits, this results in a 10.5% minimum tax on a corporate US. shareholder's GILTI (50% x 21%). In addition to this "GILTI deduction," a foreign tax credit may be claimed by a corporate taxpayer for 80% of the foreign income taxes paid by a CFC attributable to the shareholder's tested income multiplied by the corporation's inclusion percentage. (16) The inclusion percentage is the corporation's GILTI divided by the aggregate amount of the corporation's pro rata share of the tested income of each CFC of which the corporation is a shareholder. Application of the deduction and the tax credit eliminates the U.S. tax owed on the U.S. corporate shareholder's GILTI if the tested income is subject to an effective foreign income tax rate above 13.125%, for tax years before 2026, and 16.406% thereafter. (17) From an after-tax cash perspective, the TCJA likely will result in corporate taxpayers' having significantly more cash from foreign operations to deploy in the United States and abroad.
Considerations for flowthrough taxpayers
Though the amount of a U.S. shareholder's GILTI is calculated the same for corporate and flowthrough taxpayers, only corporate taxpayers are entitled to the GILTI deduction and related indirect foreign tax credits. Thus, a flowthrough taxpayer subject to tax on GILTI is...