By Anthony Diosdi
U.S. shareholders of a controlled foreign corporation (“CFC”) must include any subpart F income or global low-taxed income (“GILTI”) as ordinary income on their taxable income. The current highest federal tax rate applicable to individual CFC shareholders is 37 percent. Individuals receiving GILTI inclusions may also be subject to an additional Medicare tax of 3.8 percent. To make matters worse, individual CFC shareholders cannot offset their federal income tax liability with foreign tax credits paid by their CFCs. Under these circumstances, it is not too difficult to imagine scenarios where a CFC shareholder pays more in federal, state, and foreign taxes than the actual distributions they receive from the CFC. On the other hand, for federal tax purposes, domestic C corporations that are shareholders of CFCs are taxed on subpart F and GILTI inclusions at a rate of only 21 percent.
Because of the differences in these tax rates and because CFC shareholders are not permitted to offset their federal tax liability with foreign tax credits paid by the foreign corporation, many CFC shareholders are making so-called 962 elections. A Section 962 election permits individual CFC shareholders to pay a maximum of 21 percent on subpart F inclusions. It also allows individual CFC shareholders the ability to offset their subpart F liability with foreign tax credits for taxes paid by the CFC. A 962 election can also reduce the income tax consequence of a GILTI inclusion to only 10.5 percent. With that said, Section 962 requires that subpart F and GILTI inclusions be included in the individual CFC shareholder income again to the extent that it exceeds the amount of the U.S. income tax paid at the time of the Section 962 election. In other words, depending on the CFC’s E&P, a 962 election generates a second layer of tax as if the CFC shareholder received a dividend from a C corporation. Whether or not a 962 election will leave the U.S. shareholder in a “better place” in the long run depends on a number of factors.
The Mechanics of a 962 Election
The U.S. federal income tax consequences of a U.S. individual making a Section 962 election are as follows. First, the individual is taxed on amounts in his gross income under corporate tax rates. Second, the individual is entitled to a deemed-paid foreign tax credit under Section 960 as if the individual were a domestic corporation. Third, when the CFC makes an actual distribution of earnings that has already been included in gross income by the shareholder under Section 951(a) or Section 951A requires that the earnings be included in the gross income of the shareholder again to the extent they exceed the amount of U.S. income tax paid at the time of the Section 962 election. To implement this rule, the regulations describe two categories of Section 962 E&P. The first category is excludable Section 962 E&P (Section 962 E&P equal to the amount of U.S. tax previously paid on amounts that the individual included in gross income under Section 951(a)). The second is taxable Section 962 E&P (the amount of Section 962 E&P that exceeds excludable Section 962 E&P).
Individuals making a 962 election will be permitted to claim a Section 250 deduction. A Section 250 deduction allows U.S. shareholders to deduct (currently 50 percent, but decreases to 37.5 percent for taxable years beginning after December 31, 2025) of the corporation’s GILTI inclusion (including any corresponding Section 78 gross-up).
Examples of 962 Computations
When a CFC shareholder does not make a Section 962 election, he or she is taxed at ordinary individual income tax rates and the CFC shareholder cannot claim a foreign tax credit for foreign taxes paid by the CFC.
Below please see Illustration 1 which demonstrates the typical federal tax consequence to a CFC shareholder who did not make a Section 962 election.
Tom is a U.S. person taxed at the highest marginal tax rates for federal income tax purposes. Tom wholly owns 100 percent of FC 1 and FC 2. FC 1 and FC 2 are South Korean corporations in the business of providing personal services throughout Asia. FC 1 and FC 2 are CFCs. FC 1 and FC 2 do not own any assets. Tom received pre-tax income of $100,000 FC 1 and $100,000 of pre-tax income from FC 2. Tom paid 19 percent corporate taxes to the South Korea government. For purposes of this example, Tom did not receive any distributions from either FC 1 or FC 2 during the tax year.
Pretax earnings and profits
|Foreign Income taxes||$19,000||$19,000|
|Earnings and profits||$81,000||$81,000|
|Taxable GILTI Inclusion||$81,000||$81,000|
Assuming that Tom did not make a Section 962 election, federal tax liability on the GILTI
Inclusion will be as follows:
FC 1 $81,000
FC 2 $81,000
Total federal tax liability $162,000 x 37% = $59,994
Since Tom did not make a Section 962 election, for U.S. federal income tax purposes, he cannot receive a deduction for the foreign income taxes paid by his CFC.
As discussed above, CFC shareholders making a Section 962 election are taxed at favorable corporate rates on subpart F and GILTI inclusions. CFC shareholders can also claim foreign tax credits for the foreign taxes paid by the CFC. However, when an actual distribution is made from income previously taxed or PTEP, the distribution less any federal taxes actually paid under the 962 election will be taxed again.
Below, please see Illustration 2 which discusses the potential federal tax consequences associated with a Section 962 election if an individual was the sole shareholder of two CFCs.
Assume the same facts in Illustration 1. However, in this case, Tom made a 962 election.
|Section 78 gross up||$19,000||$19,000||$38,000|
|Section 250 deduction||$50,000||$50,000||$100,000|
|Corporate tax 21%||$21,000|
|Foreign tax credit||-$38,000|
|962 tax liability||0|
When the $162,000 E&P is distributed in a future year to Tom, the distribution will be subject to federal income tax. In this case, the distribution will be taxed at a favorable rate. This is because South Korea is a country that has entered into a bilateral tax treaty with the United States. Under the tax treaty, the $162,000 distribution will be eligible for a preferential 20 percent qualified dividend rate. Thus, in this case, Tom’s federal tax liability associated with FC 1 and FC 2 (excluding Medicare tax) is only $32,400. ($162,000 x 20% = $32,400). By making a 962 election, Tom saved $27,594 ($59,994 – $32,400 = $27,594) in federal income taxes.
However, making a Section 962 election does not always result in tax savings. Depending on the facts and circumstances of the case, sometimes making a 962 election can result in a CFC shareholder paying more federal income taxes in the long term.
Below, please see Illustration 3 which provides an example when a 962 election resulted in an increased tax liability in the long run.
For Illustration 3, let’s assume that Tom is the sole shareholder of FC 1 and FC 2.
Only this time, FC 1 and FC 2 are incorporated in the British Virgin Islands. FC 1 and FC 2 are both CFCs. Assume that the foreign earnings of FC 1 and FC 2 are the same as in Illustration 1. Let’s also assume that FC 1 and FC 2 did not pay any foreign taxes.
|Section 78 gross up||0||0||0|
|Tentative taxable income||$81,000||$81,000||$162,000|
|Section 250 deduction||$40,500||$40,500||-$81,000|
|Net income after deduction||$40,500||$40,500||$81,000|
|21% corporate tax rate||$17,010|
|Foreign tax credit||0|
|First layer 962 tax||$17,010|
At the time of the 962 election, Tom will pay $17,010 in taxes (excluding Medicare tax).
However, in the future, when Tom must pay a second tax once the E&P from FC 1 and FC 2 associated with the 962 PTEP is distributed to him. In this case, Tom will owe an additional $59,994 (assuming federal tax from the first layer of 962 tax cannot be used to offset the second layer of 962 tax) in federal income tax (excluding Medicare tax). Tom’s total federal tax liability associated with the 962 election will be $77,004. In this example, by making the 962 election, Tom increased his tax liability by $17,010 ($77,004 – $59,994 = $17,010). But, Tom has had the benefit of deferring his tax liability.
Translation of Foreign Currency Issues
Anyone considering making a 962 election must understand there will likely be foreign conversion issues. A CFC will probably use a foreign currency as its functional currency. Anytime a 962 election is made for a CFC which has a functional currency that is not the dollar, the rules stated in Section 986 and Section 986 of the Internal Revenue Code must be used to translate the foreign taxes and E&P of the CFC. Section 986 uses the average exchange rate of the year when translating foreign taxes. The average exchange rate of the year is also used for purposes of 951 inclusions on subpart F income and GILTI. In the case of distributions of the CFC, the amount of deemed distributions and the earnings and profits out of which the deemed distribution is made are translated at the average exchange rate for the tax year. See IRC Section 986(b); 989(b)(3).
The Election Statement that Must be Filed with a Tax Return to Make a 962 Election
The IRS must be notified of the Section 962 election on the tax return. There are no special forms that need to be attached to a tax return. The individual making a 962 election must file the federal tax return with an election statement. See Treas. Reg. Section 1.962-2. According to the 962 regulations, the election statement must contain the following information:
1. The election statement should explicitly say you are making an election under Internal Revenue Code Section 962.
2. Treasury Regulation Section 1.962-2 states the election statement shall include the following: a) The name address, and, an taxable year of each controlled foreign corporation with respect to which the electing shareholder is a U.S. shareholder and of all other corporations, partnerships, trusts, or estates in any applicable chain of ownership described in Section 958(a) of the Internal Revenue Code; b) The amounts, on a corporation-by-corporation basis, which are included in such shareholder’s gross income for his or her taxable year under Section 951(a); c) Such shareholder’s pro rata share of earnings and profits (determined under Section 1.964-1) of such controlled foreign corporation with respect to which such shareholder includes any amount in gross income for his taxable year under Section 951a (or 951A) and the foreign income, war profits, excess profits, and similar taxes paid on or with respect to such earnings and profits; d) The amount of distributions received by such shareholder during his or her taxable year from each controlled foreign corporation and e) such further information as the Commissioner of the IRS may prescribe by forms and accompanying instructions. Anyone making a 962 election should identify each requirement stated in Treasury Regulation Section 1.962-2(b)(1) and the election statement should respond to each element of the regulation.
3. As stated above in Treasury Regulation 1.962-2, when a CFC shareholder is making a 962 election must state the amount of distributions received by such shareholder. The treasury regulations provide a set of ordering rules previously taxed income or PTEPs for current year earnings. When a foreign corporation makes an actual distribution of earnings and profits, the regulations distinguish between the earnings and profits during the current year in which the CFC shareholder has made an election under Section 962 and other non-Section 962 earnings and profits. Section 962 earnings and profits is further classified between excludable 962 earnings and profits, which represents an amount of 962 earnings and profits equal to the amount of U.S. federal corporate tax paid on 962 earnings and profits and taxable 962 earnings and profits which is the excess of 962 earnings and profits over excludable earnings and profits.
The Section 962 regulations adopt 959 ordering rules in regards to a foreign corporation’s distribution of earnings and profits. However, the regulations modify the 959 regulations by providing a priority between Section 962 earnings and profits and non-Section 962 earnings and profits. Under these modified rules, distributions of earnings and profits that are PTEP under Section 959(c)(1) (Section 956 inclusions) are distributed first. Earnings and profits that are PTEP under Section 959(c)(2) (Subpart F or GILTI inclusions) are distributed next. Then all other earnings and profits under Section 959(c)(3) are distributed. When distributions of earnings and profits that are PTEP under Section 959(c)(1) are made, distributions of earnings and profits come first from non-962 earnings and profits. The distributions of earnings and profits that are PTEP under Section 959(c)(1) then compromise excludable Section 962 earnings and profits, and finally taxable Section 962 earnings and profits. The same ordering rules apply to distributions of earnings and profits under Section 959(c)(2). Finally, within each PTEP group, the ordering rule is last in first out of LIFO.
Taking into consideration the 962 regulations, when stating the distribution on the election statement should state the total distribution from the CFC. The distribution should be broken down by the amount which is excludable earnings and profits from taxation and the amount that is currently taxable earnings and profits.
Anyone considering making a 962 election should have hypothetical computations of federal tax liabilities with and without the Section 962 election prepared before the election is actually made. Only through a hypothetical computation can a CFC shareholder know if he or she can potentially reduce his or her federal tax liability through a 962 election. In some cases a 962 election will result in a CFC shareholder paying more taxes in the long term. However, a CFC shareholder may be more interested in deferring his or her tax liability than obtaining tax savings. In this case a 962 election may be optimal. In these situations, the deferral of tax should be weighed against a potential increase in tax liability as a result of a 962 election. Anyone considering making a 962 election should also consider the “high-tax exception” under Section 954.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.