Introduction to GILTI
For years, tax planning for international outbound taxation remained the same, mitigation of Subpart F income, maximization of foreign tax credits, and transfer pricing. The 2017 Tax Cuts and Jobs Act has broken the monotony associated with international tax planning for outbound transactions and added a new category for tax planning. In addition to the anti-deferral regime built into Subpart F, the Tax Cuts and Jobs Act has introduced a new anti-deferral category known as the Global Intangible Low-Taxed Income (“GILTI”).
GILTI is now a provision that can found in Internal Revenue Code Section 951A. The Tax Cuts and Jobs Act requires a U.S. shareholder of a controlled foreign corporation (“CFC”) to include in income its global intangible low-taxed income or GILTI. The GILTI tax is meant to discourage businesses from avoiding federal taxes by holding intangible assets such as software patents or other intellectual property outside the United States in tax haven countries. GILTI creates no additional marginal tax rates. Instead, GILTI expands the definition of what items of offshore income are taxable. Think about it like this, Subpart F of the Internal Revenue Code subjects passive income earned outside the United States to taxation. The new GILTI provisions do the same. However, instead of taxing foreign passive income, GILTI subjects certain items of income known as “intangible income” to tax. However, unlike the Subpart F provisions of the Internal Revenue Code which assess a very punitive tax rate and offers little opportunity for planning, there are a number of ways to lower a GILTI liability.
What should be understood of the new GILTI regime is that it ends the tax deferral treatment of “intangible income” and subjects “U.S. shareholders” of CFCs, defined as U.S. persons owning at least 10 percent of the vote or value of a specific foreign corporation. 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. Because of the way GILTI is computed, it will likely hit tech companies and service providers the hardest. That’s because these types of businesses have the most intangible income producing assets and have benefited the most from creative international tax planning in the past. Many companies in these industries successfully transferred offshore “intangible property” to tax haven countries for tax planning purposes. A number of these tax haven countries completely exempted corporate income tax royalties derived from patents on inventions, regardless of where the patent was patented or where the underlying research and development was carried out. GILTI is designed to curb the tax benefits of transferring “intangible property” offshore. Even though GILTI was designed to only tax “intangible income,” the way GILTI is computed, it has a much broader reach. The broad reach of GILTI is demonstrated in the example discussed below.
Calculating the GILTI Taxable Amount
So how is GILTI computed? As a general rule, GILTI is determined by first calculating a deemed return on the CFC’s tangible assets. The first part of the GILTI formula is a calculation called the net CFC tested income. The net CFC tested income is the excess of the aggregate of a tested income of each CFC held by a U.S. shareholder (The tested gross income of a CFC excludes Subpart F income, effectively connected income, income excluded from foreign base company income or insurance income by reason of high-tax exception, dividends received from a related person, and foreign gas and oil income less deductions allocable to such gross income). This amount is taken over the aggregate of the shareholder’s prorata share of a tested loss of each CFC (The tested loss is the excess of deductions allocable to the CFCs’ disregarding tested income exceptions over the amount of gross income).
Next, the net deemed tangible income must be determined. The net deemed tangible income is 10 percent of a shareholder’s pro rata share of the QBAI for each CFC, less the amount of interest expense taken into consideration of the CFC tested income. The QBAI is the average of the corporation’s aggregate adjusted bases as of the close of each quarter of the year in specific tangible property used in a trade or business of the corporation and which is allowed a deduction under Internal Revenue Code Section 167.
Below, please find an Illustration as to how GILTI is computed.
The first part of the formula is to determine the tested income. In order to determine how the tested income is computed, let’s assume hypothetical U.S. C-corporation solely holds CFC 1 and CFC 2. These CFCs have annual gross income of $5,000,000 and $4,250,000. The CFCs have deductions of $3,000,000 and $5,000,000 each. The income and expenses of the CFCs result in net tested income of $1,250,000 ($5,000,000 – $3,000,000 plus $4,250,000 – $5,000,000).
The second part of determining GILTI is to calculate the net deemed tangible income. In our hypothetical, CFC 1 and CFC 2 had a quarterly average specific tangible property of $5,000,000 and $6,000,000 respectively. Applying the 10 percent QBAI test, 10 percent of $5,000,000 and $6,000,000 would be $500,000 and $600,000 (10% of $5,000,000 = $500,000 and 10% of $6,000,000 = $600,000). This results in a net deemed tangible income return of $1,100,000 ($500,000 + $600,000 = $1,100,000).
Applying part one and part two of the GILTI formula determines the GILTI income. In this case, the net CFC tested income exceeds the deemed tangible income return by $150,000 ($1,250,000 – $1,100,000 = $150,000). Therefore, the GILTI income in our hypothetical is $150,000. (It should be noted the GILTI computation in this hypothetical is relatively simple. It is easy to envision significantly more complex scenarios).
How the $150,000 GILTI income is taxed depends on the classification of the U.S. shareholder. If the U.S. shareholder is an individual taxpayer or S-corporation, the $150,000 of GILTI income would be taxed at the shareholder’s (after the applicable flow-through for subchapter S purposes) marginal tax rates. On the other hand, if the shareholder is taxed as a C-corporation the $150,000 GILTI income is taxed at the corporation’s marginal tax rate. However, the impact of the GILTI income can be reduced by foreign tax credits (up to 80 percent of foreign taxes paid) and special GILTI deduction. The special GILTI deduction allows a reduction in the sum equal to 50 percent of the corporate tax as the result of GILTI. (This deduction will be reduced to 37.5 percent after December 31, 2025). In essence, this special deduction reduces the new federal corporate tax rate from 21 percent to 10.5 percent on GILTI income.
The new GILTI regime will result in an unpleasant surprise to many CFC shareholders. If you are a CFC shareholder now is the time to consider if setting up a blocker corporation may reduce your exposure to GILTI. In addition, it is imperative that you retain a tax professional well versed in the GILTI provisions to guide you through this extremely difficult computation.
Anthony Diosdi is one of the founding partners of Diosdi Ching & Liu, LLP, a law firm with offices located in San Francisco, California; Pleasanton, California; and Fort Lauderdale, Florida. Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – 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.