By Anthony Diosdi
The 2017 Tax Cuts and Jobs Act (“TCJA”) enacted a new category of foreign source taxable income known as global intangible low-taxed income (“GILTI”). Similar to subpart F income, GILTI is an anti-deferral regime applicable to U.S. shareholders of controlled foreign corporations (“CFCs”). GILTI is the excess of a U.S. shareholder’s net CFC tested income for a taxable year over its net deemed tangible income return. Net CFC tested income is any excess of the U.S. shareholder’s pro rata share of share of the tested income of each CFC for which it is a U.S. shareholder over its pro rata share of each such CFC’s tested loss. A U.S. shareholder’s net deemed tangible income is 10 percent of the shareholder’s pro rata share of the CFC’s tax basis in tangible personal property used by its CFCs in the production of the tested income which is reduced by certain interest expense.
Congress intended to make GILTI income only applicable to foreign countries with a low tax rate. The GILTI taxing regime is extremely punitive. So, Congress created mechanisms to ensure that domestic C corporations would not suffer harsh tax consequences of the GILTI taxing regime. For example, a domestic C corporation is permitted to claim a 50 percent deduction of a GILTI inclusion under Internal Revenue Code Section 250. Domestic C corporations are also permitted to offset GILTI income with foreign tax credits that equal to 80 percent of the foreign taxes paid on GILTI income. With property planning domestic C corporations will pay little if any tax on GILTI income. Unfortunately, the same mechanisms created by Congress for domestic C corporations are not available to individual U.S. shareholders of a CFC or other entities. These taxpayers are subject to GILTI inclusions at a federal rate of up to 37 percent plus and Medicare tax of 3.8 percent. Individual U.S. shareholders also are not entitled to claim foreign tax credits paid on GILTI inclusions. Because the global tax liabilities are so excessive on GILTI income, individuals must plan accordingly. This article discusses GILTI planning options for individual CFC shareholders.
Computing the GILTI Tax
1. Determining a U.S. Shareholder’s GILTI Inclusion
A U.S. shareholder’s GILTI for a taxable year is the excess, if any, of the U.S. shareholder’s “net CFC tested income” for the taxable year over the shareholder’s “net deemed tangible income return” for the taxable year. Net CFC tested income with respect to any U.S. shareholder is the excess of the aggregate of the shareholder’s pro rata share of the “tested income” of each CFC with respect to which the shareholder is a U.S. shareholder for the taxable year over the aggregate of that shareholder’s pro rata share of the “tested loss” of each CFC with respect to which the shareholder is a U.S. shareholder for the taxable year of the U.S. shareholder. See IRC Section 951A(c). These amounts are determined for each taxable year of the CFC which ends in or with the taxable year of the U.S. shareholder. Expressed as a formula:
GILTI = Net CFC Tested Income – Net Deemed Tangible Income Return = [Tested Income – Tested Loss] – [10% of QBAI – Certain Interest Expense].
2. Computing the GILTI Tested Income
The tested income of a CFC is the excess of the gross income of the CFC determined without regard to certain items (stated below) over deductions properly allocable to that gross income. The items of income excluded from gross tested income include:
1) the CFC’s effectively connected income (“ECI”) under Section 952(b) of the Internal Revenue Code; 2) any gross income taken into account in determining the CFC’s subpart F income; 3) any gross income excluded from foreign base company income or insurance income by reason of the high-tax exception under Section 954(b)(4); 4) any dividend received by a CFC from a related person (as defined in Section 954(d)(3))); and 5) foreign oil and gas extraction income.
3. Computing the GILTI Tested Loss
A tested loss represents the excess of deductions (properly allocable gross income) over the applicable gross income. If a CFC has a “tested loss,” there is a reading that the amount of its QBAI (as defined below) may not be taken into account and aggregated with QBAI of other CFCs with tested income owned by the U.S. shareholder. A U.S. shareholder reduces the amount of its net CFC tested income by the shareholder’s net deemed tangible income return. Net deemed tangible income return is calculated as 10 percent of the U.S. shareholder’s aggregate qualified asset investment (“QBAI”) over the amount of certain interest expense.
4. Determining a U.S. Shareholder’s Aggregate QBAI
A U.S. shareholder’s aggregate QBAI consists of its pro rata of the QBAI of each CFC in which it is a U.S. shareholder. A CFC’s QBAI consists of the average of such corporation’s aggregate adjusted bases as of the close of each quarter of such taxable year in specified tangible property used in a trade or business of the CFC and of a type with respect to which a deduction is allowable under Section 167. Specified tangible property does not include tangible property, inventory, receivables, or real property.
Section 959 Ordering Rules and GILTI PTEPs
The vast majority of CFCs generate GILTI annually. GILTI typically becomes reclassified as PTEP. The term PTEP refers to earnings and profits (“E&P”) of a foreign corporation attributable to amounts which are, or have been, included in the gross income of a U.S. shareholder (as defined under Section 951(b)) under Section 951(a) or under Section 1248(a). Under Section 959(a)(1), distributions of PTEP are excluded from the U.S. shareholder’s gross income, or the gross income of any other U.S. person who acquires the U.S. shareholder’s interest (or a portion thereof) in the foreign corporation. Section 959(a)(2) further excludes PTEP from a U.S. shareholder’s gross income if such E&P would be included in the gross income if such E&P would be included in the gross income of the U.S. shareholder or successor in interest under Section 951(a)(1)(B) as an amount determined under Section 956. Distributions of PTEP to a U.S. shareholder are not treated as dividends except that such distributions immediately reduce the E&P of the foreign corporation.
Section 959(c) ensures that distributions from a foreign corporation are first attributable to PTEP described in Section 959(c)(1)(Section 959(c) (1) PTEP) and then to PTEP described in Section 959(c)(2)(Section 959(c)(2) PTEP), and finally to non-previously taxed E&P (Section 959(c)(3) E&P). Finally, Section 959(f) ensures that, in determining the amount of any inclusion under Section 951(a)(1)(B) and 956 attributable to a foreign corporation, PTEP attributable to Section 951(a)(1)(A) inclusions remaining after any distributions during the year are taken into account before non-previously taxed E&P described in Section 959(c)(3).
The rules discussed above all matter because of two reasons. First, the 959 ordering rules prevent GILTI income from being double taxed. Second, the 959 ordering rules are used for purposes of determining available foreign tax credits. Depending on how the PTEP was generated, a GILTI PTEP must be allocated into one of four separate Section 904(d) categories, known as baskets. Any foreign taxes paid or accrued on GILTI income is allocated to a GILTI basket. These allocations become important to CFC shareholders making a so-called 962 election which will be discussed below.
GILTI Tax Planning
As discussed above, U.S. shareholders of CFC’s must include any 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. The first planning opportunity for CFC to mitigate the impacts of GILTI is to make a Section 962 election.
Making a 962 Election
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 the ability to offset their GILTI liability with foreign tax credits for taxes paid by the CFC. A 962 election also results in the individual CFC shareholder being taxed at corporate tax rates on GILTI income. (Corporate tax rates are taxed at a maximum rate of 21 percent compared to 37 percent for individuals). In addition, CFC shareholders that make a Section 962 election can make a Section 250 deduction equal to 50 percent of the GILTI inclusion. This deduction effectively reduces the current 21 percent federal corporate rate to 10.5 percent on GILTI inclusions.
However, there is a major drawback to making a Section 962 election. Section 962 requires that 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 951A (GILTI) 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%, but decreases to 37.5% but decreases to 37.5% 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 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.
|FC 1||FC 2|
|Pretax earnings and profits||$100,000||$100,000|
|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:
|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 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 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.
|FC 1||FC 2||Total|
|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|
|Tenative 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).
Making a 962 Election on a Tax Return
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. However, the individual making a 962 election requires filing the federal tax return with an attachment. According to the 962 regulations, the attachment making the 962 election must contain the following information:
1. Names, address, and taxable year of each CFC to which the taxpayer is a U.S. shareholder.
2. Any foreign entity through which the taxpayer is an indirect owner of a CFC under Section 958(a).
3. The Section 951(a) income included in the Section 962 election on a CFC by CFC basis.
4. Taxpayer’s pro-rata share of E&P and taxes paid for each applicable CFC.
5. Distributions actually received by the taxpayer during the year on a CFC by CFC basis with details on the amounts that relate to 1) excludable Section 962 E&P; 2) taxable Section 962 E&P and 3) E&P other than 962.
Special Rules for Distributions of PTEP for Section 962 Shareholders
The treasury regulations under Section 962 provide a unique set of ordering rules with respect to distributions and current year earnings, which modify the traditional PTP rules. When a CFC makes an actual distribution of E&P, the regulations distinguish between E&P earned during a tax year in which the U.S. shareholder has made an election under Section 962 (962 E&P) and other, non-Section 962 E&P (Non-962 E&P). Section 962 E&P is further classified between (1) “Excluble 962 E&P,” which represents an amount of 962 E&P equal to the amount of U.S. federal corporate tax paid on 962 E&P, and (2) “Taxable 962 E&P,” which is the excess of 962 E&P over Excludable 962 E&P.
Generally, a distribution of E&P that the U.S. shareholder has already included in his or her income is tax-free to the U.S. shareholder. However, when a CFC distributes 962 E&P, the portion of the earnings that comprises Taxable 962 E&P is subject to a second layer shareholder level tax. If no Section 962 election had been made, then the distribution of all of the PTP would have been tax-free to the recipient shareholder. Thus, a Section 962 results in the imposition of an additional layer of tax on the 962 E&P that is considered Taxable 962 E&P. This second layer of tax is consistent with treating the U.S. individual shareholder in the same manner as if he or she invested in the CFC through a domestic corporation.
The Section 962 regulations adopt the general Section 959 ordering rules with respect to a CFC’s distribution of E&P, but modify them by providing a priority between 962 E&P and non-962 E&P. First, distributions of E&P that is PTEP under Section 959(c)(1) are distributed first, E&P that is PTEP under Section 959(c)(2) (e.g., Section 951A(a) inclusions) is distributed second, and all other E&P under Section 959(c)(3) (i.e., E&P relating to the net deemed tangible return amount) is distributed last. This is the case irrespective of the year in which the E&P is earned. Second, when distributions of E&P that are PTEP under Section 959(c)(1) are made, distributions of E&P come first from Non-962 E&P. The distributions of the E&P that is PTEP under Section 959(c)(1) then compromise Excludable 962 E&P. The distributions of the E&P that is PTEP under Section 959(c)(1) then compromise Excludable 962 E&P, and finally Taxable 962 E&P. The same ordering rules applies to distributions of E&P that are PTEP under Section 959(c)(2) (e.g., Section 951A(a) inclusions). That is, distributions of E&P that are PTEP under Section 959(c)(2) come first from Non-962 E&P, then Excludable 962 E&P, and finally Taxable 962 E&P. Finally, within each subset of PTEP (e.g., Sections 959(c)(1) and 959(c)(2)), the ordering rule is LIFO, meaning that E&P from the current year is distributed first, then the E&P from the prior year, and then E&P from all other prior years in descending order.
The GILTI High-Tax Exception
Another GILTI tax planning tool is making a high-tax exception election under Section 954 of the Internal Revenue Code. On July 23, 2020, the Internal Revenue Service (“IRS”) and the Department of Treasury (“Treasury”) finalized regulations for the GILTI high-tax exception. This exception applies to the extent that the net tested income from a CFC exceeds 90 percent of the U.S. federal corporate income tax rate. Consequently, if the effective foreign tax rate of the CFC exceeds 18.9 percent, an individual CFC shareholder can elect to make a high tax exception. As with a Section 962 election, a CFC shareholder making a Section 954 election, must make an election on his or her tax return.
A Section 954 election allows CFC shareholders to defer the recognition of undistributed GILTI income as E&P. The GILTI high-tax exception applies on an elective basis, and a U.S. shareholder generally must elect (or not elect) the application of the GILTI high-tax exception with respect to all of its CFCs (i.e., no CFC-by-CFC elections). At the level of a CFC, effective foreign tax rates are determined separately with respect to the income of the various branches, disregarded entities, and other “tested units” of the CFC. In other words, certain portions of a CFC’s income may qualify for the GILTI high-tax exception while others portions may not.
A Section 954 election will likely result in a CFC shareholder’s foreign corporation consisting of retained earnings. When a CFC consists in whole or in part of retained earnings, special rules under Section 959 will apply to determine the eventual taxation of the deferred E&P. For purposes of Section 959, any undistributed profits of E&P as the result of claiming the high-tax exception should be classified as accumulated E&P under Section 959(c)(3). Once the undistributed E&P is distributed to the individual CFC shareholder, the accumulated earnings will be reclassified to Section 959(c)(2) PTEP or Section 959(c)(1) PTEP.
U.S. Individual Contributes CFC to a U.S. C Corporation
Besides making a Section 962 or Section 954 election, CFC shareholders can contribute their CFC shares to a domestic C corporation. The contribution usually can be made as a tax-free exchange under Internal Revenue Code Section 351. The benefit of contributing CFC shares to a domestic C corporate structure is clear. Any GILTI earned by a domestic C corporation will be taxed at favorable corporate rates and should qualify to receive a 50 percent deduction under Section 250. In addition, domestic C corporations can claim deductions for foreign tax credits. On the other hand, a contribution of CFC shares to a domestic C corporation has significant long-term costs that must be considered. That is, if an individual were to sell his or her CFC shares held by a domestic C corporation, any gains would likely be subject to two layers of federal tax. However, sometimes, an election under Section 338(g) of the Internal Revenue Code may reduce the sting of the double tax associated with the sale of CFC stock held by a domestic C corporation. There may also be negative tax consequences to domestic C corporations making a 954 election. Such a structure may be subject to the accumulated earnings tax and the personal holding company tax.
Utilizing the Check-the-Box Rules for Avoiding GILTI Utilizing Disregarded Entity
Finally, some CFC holders can eliminate the GILTI tax. This can be done by liquidating the CFC and treating the CFC as a disregarded entity through the checking-the-box rules. Such a transaction can typically be done as a tax-free liquidation or reorganization. For example, a U.S. shareholder might be able to contribute the CFC to an U.S. S corporation, and then have the CFC make a check-the-box election. Reclassifying a CFC to a disregarded entity may result in a U.S. individual being subject to federal tax on foreign source income at progressive rates (currently up to 37 percent) and the ability of the U.S. individual being entitled to claim foreign tax credits to reduce overall U.S. federal income tax liability. Such a strategy may be beneficial if the CFC operates in a high-tax foreign country. With that said, if the foreign entity is on the “per se” list published by the IRS, it might be difficult and expensive to utilize check-the-box planning.
Because the liabilities associated with the GILTI tax regime are so excessive, individual CFC shareholders must plan accordingly. Through proper planning and techniques, it is possible to significantly reduce one’s exposure to the GILTI tax regime. We have extensive experience advising multinational corporations and CFC shareholders to reduce their tax liabilities associated with GILTI.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As an international tax attorney, Anthony Diosdi has substantial experience advising U.S. multinational corporations and other international tax practitioners plan for and calculate GILTI inclusions.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at
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.