The foreign-derived intangible income (“FDII”) and global intangible low-taxed income (“GILTI”) regimes are an attempt by Congress to use the Internal Revenue Code to encourage U.S. multinational corporations to increase investments in the United States. However FDII and GILTI are incredibly complicated tax regimes and it is not always clear which of these provisions is the hero or the villain in international tax planning. This article compares the FDII and GILTI tax rules.
What Exactly is the GILTI Tax Regime?
Whenever a U.S. person decides to establish a business abroad that will be conducted by a foreign corporation, the U.S. shareholders of controlled foreign corporations (“CFCs”) must plan for the Global Intangible Low-Taxed Income (“GILTI’) tax regime.
GILTI is a provision that can be found in Internal Revenue Code Section 951A. The Tax Cuts and Jobs Act requires a U.S. shareholder of a 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 offer little opportunity for planning, there are a number of ways to lower a GILTI liability.
What should be understood of the 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.
Who is Subject to GILTI?
GILTI is assessed on a “United States shareholder” of any CFC for any taxable year of such United States shareholder that receives intangible low-taxed income for such year. See IRC Section 951A(a). A CFC is defined as a foreign corporation in which 50 percent of: 1) the total combined voting power of all classes of stock of such corporation entitled to vote, or 2) the total value of the stock of such corporation is owned (within the meaning of Section 958(a), or is considered as owned by applying the rules of ownership of Section 958(b) during any day of the taxable year of such foreign corporation. See IRC Section 957(a).
A “United States shareholder” can be defined as a “U.S. person” (Section 7701(a)(1) of the Internal Revenue Code defines a “U.S. person” to include an individual, trust, estate, partnership, or corporation) who owns (within the meaning of Section 958(a)), or is considered as owning by applying the rules of ownership of Section 958(b), 10 percent or more of the total combined voting stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. See IRC Section 951(b).
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 pro rata 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 investment income must be determined. The net deemed tangible investment income is 10 percent of a shareholder’s pro rata share of the Qualified Business Asset Investment Income or (“QBAI”) for each CFC, less the amount of interest expense taken into consideration of the CFC tested income. The QBAI is the adjusted basis of a CFC’s depreciable assets used to generate GILTI. To determine QBAI, “specified tangible property” must be identified that produced the tested income of a CFC. These assets must be depreciable. See IRC Section 951A(d)(1)(B). The adjusted basis for each asset must be computed, quarterly and averaged annually. See IRC Section 951A(d)(1). Once the QBAI is determined, specified interest expenses are subtracted from QBAI. See Treas. Reg. Section 1.951A-1(c)(3)(ii).
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 that 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 (or an individual making a Section 962 election), 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 under Section 250 of the Internal Revenue Code. The special GILTI deduction allows a reduction in the sum equal to 50 percent. (This deduction will be reduced to 37.5 percent after December 31, 2025).
In almost every case, a GILTI inclusion to a non-corporate shareholder is taxed at a higher rate than to a corporate shareholder. This is because non-corporate shareholders are not permitted to claim indirect foreign tax credits and the 250 deduction to reduce the GILTI income tax inclusion. This article will discuss two options available to CFC shareholders to reduce their exposure to the GILTI tax. This article will compare and contrast each of these options.
Section 962 Election
Internal Revenue Code Section 962 allows an individual U.S. shareholder of a CFC to elect to be subject to corporate income tax rates on Subpart F inclusions and
GILTI. According to the legislative history of Section 962, “[t]he purpose of [Section 962] 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 or she does not receive. Section 962 gives such individuals assurance that their tax purposes, 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.” See S.Rep. No. 1881, 87th Cong. 2d Sess. 92 (1962).
Historically, because corporate and individual rates were both so high, Section 962 elections were economically disadvantageous and thus not used. The attractiveness of Section 962 elections changed drastically as of January 1, 2018. This is because corporate rates fell to 21 percent, and the effective tax rate that U.S. C corporations pay on their GILTI income is only 10.5 percent (after accounting for a 50 percent Section 250 deduction). Individuals, on the other hand, pay 37 percent on all their GILTI income, and are not permitted to take a 50 percent deduction under Internal Revenue Code Section 250. CFC shareholders making a 962 election are also permitted to offset some of their federal tax liability with foreign tax credits.
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 C corporation. Third, when the CFC makes an actual distribution of earnings that has already been included in gross income by the shareholder under the Subpart F or 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 when the 962 election was made. 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 for GILTI inclusions. A Section 250 deduction allows U.S. shareholders to deduct (currently 50 percent of a GILTI inclusion (including any corresponding Section 78 gross-up). The Section 250 deduction decreases to 37.5 percent after December 31, 2025.
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.
Illustration 1.
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
Assuming that Tom did not make a Section 962 election, federal tax liability on the GILTI
Inclusion will be as follows:
FC 1 $100,000
FC 2 $100,000
Total federal tax liability $200,000 x 37% = $74,000
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 (“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.
Illustration 2.
Assume the same facts in Illustration 1. However, in this case, Tom made a 962 election.
FC 1 FC 2 Total
GILTI inclusion $81,000 $81,000 $162,000
Section 78 gross up $19,000 $19,000 $38,000
(A Section 78 gross-up amount equal to the deemed-paid credit paid by the foreign corporation is added to Tom’s income)
Tentative income $100,000 $100,000 $200,000
Section 250 deduction -$50,000 -$50,000 $100,000
Net Income $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 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.
FC1 FC2 Total
GILTI Inclusion $81,000 $81,000 $162,000
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, 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 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 Internal Revenue Service or (“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. 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.
We will now discuss the pros and cons of making a Section 962 election.
Pros to Making a Section 962 Election
The benefits of making a 962 election is that it provides the CFC shareholder with an opportunity to be taxed for federal income tax purposes at 10.5 percent on GILTI inclusions. It also allows the CFC shareholder the opportunity to claim 80 percent of foreign tax credits. When a 962 election is made, GILTI and subpart F income of the CFC is treated as PTEP which is classified as with “Excludable Section 962 E&P” to the extent of the income paid by the U.S. shareholder, or “Taxable Section 962 E&P” to the extent of the excess of Section 962 E&P over Excludable Section 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 compromises Taxable 962 E&P is subject to a second layer shareholder level tax.
A 962 election provides simplicity in that a CFC shareholder can potentially obtain more favorable rates without the cost of restructuring a CFC. In addition, a 962 election provides flexibility. It can be made annually.
Cons to Making a Section 962 Election
Although a 962 election is less complicated than restructuring a CFC to obtain beneficial tax rates and allows a deferral of some foreign source income from taxation, its calculations can be tedious and thus there typically is an added compliance cost. A 962 election also subjects the CFC shareholder to a second layer of tax. This may result in the CFC paying more federal tax than doing nothing in the long run. Furthermore, this second layer of tax may or may not qualify for reduced corporate dividend rates under a tax treaty.
For example, the Section 962 regulations adopt the general Section 962 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 are PTEP under 959(c)(1) (i.e., 956 inclusions) are distributed first, E&P that is PTEP under Section 959(c)(2) (e.g. GILTI and Subpart F inclusions) is distributed second, and all other E&P under Section 959(c)(3) (i.e. E&P related to the net deemed tangible return amount, high-taxed exception) 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 is PTEP under Section 959(c)(1) (e.g. Section 956 inclusions) are made, distributions of E&P come from Non-962 E&P. The distributions of E&P that is PTEP under Section 959(c)(1) then comprise Excludable 962 E&P, and finally Taxable 962 E&P. The same ordering rule applies to distributions of E&P that is PTEP under Section 959(c)(2) (e.g. GILTI and Subpart F inclusions). That is, distributions that are PTEP under Section 959(c)(2) come first from Non-962 E&P, then Excludable 962 E&P, and finally 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.
As indicated above, the tax accounting associated with a 962 election can be extremely complicated and costly.
The Section 954 High-Tax Exception
For many years, CFC shareholders and U.S. multinational corporations were able to utilize a high-tax election to defer Subpart F income. However, when the GILTI taxing regime was announced in late 2017, a corresponding high-tax election was not available. Shortly after the enactment of the GILTI taxing regime, CFC shareholders, U.S. multinational corporations and their advisors began lobbying the Department of Treasury (“Treasury”) and the IRS to issue regulations to permit the use of a high-tax election for GILTI income. On July 20, 2020, the Treasury promulgated final regulations which permit a high-tax election for GILTI. This was welcome news to many CFC shareholders and their advisors. In general, the Final Regulations enable CFC shareholders to exclude amounts that would otherwise be tested income from its GILTI computation if the foreign effective tax rate on such amounts exceeds 90 percent of the top U.S. corporate tax rate (currently 18.9 percent based on the current 21 percent corporate tax rate).
In order to make a GILTI high-tax foreign exclusion, the shareholder must be subject to an effective foreign tax rate of 18.9 percent. This is calculated by dividing the U.S. dollar amount of foreign income taxes paid or accrued by the U.S. dollar amount of the tentative tested income item increased by the U.S. dollar amount of the relevant foreign income tax. This requires determining the tentative gross tested income and the tentative tested income.
Pros to Making a Section 954 Election
The regulations promulgated by the IRS and Treasury allows a CFC shareholder to make a high tax exception to Subpart F income or GILTI inclusions. This exception applies to the extent the foreign income from the CFC exceeds 90 percent of the U.S. federal corporate tax rate. Consequently, if the effective foreign tax rate exceeds 18.9 percent, the CFC shareholder can elect to utilize the high tax exception. This option is far more simple than the 962 election. Thus, the compliance cost should be less than a 962 election. When a high tax exception is used, the CFC retains undistributed profits as E&P. If the CFC is incorporated in a country that has entered into a double tax treaty with the United States, it is possible that the dividend may result in a reduced qualified dividend rate. Making a Section 954 election also eliminates the second layer of tax associated with making a 962 election.
Cons to Making a Section 954 Election
The high tax exception results in the CFC retaining undistributed profits as E&P.
This classification difference makes a big difference for cross-border tax planning. In addition, foreign tax credits may be lost through the use of a 954 election. Finally, a 954 election must be made with respect to all CFC’s controlled by the CFC. The election cannot be made on a CFC basis. This may result in the loss of cross-crediting of high-taxed CFC’s foreign taxes.
Contributing CFC Shares to a Domestic C Corporation
In order to reduce the sting of a GILTI inclusion, an individual CFC shareholder may contribute his or her shares to C corporation. This would result in the C corporation becoming a U.S. shareholder of the CFC. The short-term benefits of this strategy are clear. The contribution, when structured properly, should qualify as a tax-free Section 351 contribution. (Shareholders in an incorporation transaction will not recognize any gain or loss on the exchange if they satisfy three requirements of Internal Revenue Code Section 351(a)). First, there must be a contribution of property. Second, the contribution must be solely in exchange for stock and, third, the contributors must control the corporation immediately after the exchange).
GILTI earned by a domestic C corporation should receive the benefits of the Section 250 deduction and flow-through of foreign tax credits. In addition, a distribution of the CFC’s PTEP should not be subject to further U.S. federal tax. Moreover, if the CFC has any E&P (that is not otherwise PTEP) a distribution of such an amount from the CFC to a domestic corporation may qualify for the Section 245A participation exemption. Internal Revenue Code Section 245A allows an exemption for certain foreign income of a domestic C corporation that is a U.S. shareholder by means of a 100 percent dividends received deduction for the foreign-source portion of the dividends. Proper planning may also result in dividend distributions from the C corporate holding company qualifying for reduced qualified dividend rate of 20 percent (plus medicare, state, and local taxes).
However, anyone considering transferring CFC shares into a domestic C corporate holding company must understand there are significant long term costs. First, typically, if an individual were to sell CFC shares, the gain on such sale would likely be classified as long-term capital gain for federal tax purposes. Long-term capital gains are subject to federal income tax at a preferential 20 percent rate. To the extent that the CFC has E&P, then some or all of this gain may be recharacterized as a dividend under Section 1248. Under Section 1248(a) of the Internal Revenue Code, gain recognized on a U.S. shareholder’s disposition of stock in a CFC is treated as dividends to the extent of relevant E&P accumulated while the person held the stock. With respect to individual U.S. shareholders who sell shares of a C corporation holding CFC shares, recharacterization is significant due to the rate differential between long-term capital gains, (maximum 20 percent) and ordinary income (maximum 37 percent).
In addition, on the sale of the CFC stock by a domestic C corporation, the shareholder of the domestic C corporation is subject to two layers of tax. First, the sale of CFC stock by the domestic C corporation would be subject to 21 percent federal corporate tax rate. A second layer of tax is assessed when the C corporation makes a distribution of the CFC gains to its shareholders. Planning opportunities may be used to reduce or even eliminate the 21 percent corporate rate on the sale of CFC shares. This could be done by making an election under Section 338(g) of the Internal Revenue Code. When a Section 338(g) election is made, the target CFC is deemed to sell its assets and must recognize any gain resulting from the deemed asset sale. If the seller is a domestic C corporation, the CFC target’s gain on non-trade or business assets typically is classified as Subpart F income, and the remaining gain (with respect to trade or business assets) instead is classified as tested income for GILTI purposes. The CFC’s tax year closes, and its Subpart F income and GILTI through the date of sale are included in the gross income of the domestic C corporate seller.
With a Section 338(g) election, the domestic seller also will be taxed on the gain from the sale of the CFC stock, with the basis of such stock being increased to account for any inclusions under Subpart F or GILTI for the year (including the Subpart F and GILTI income generated by the deemed asset sale). Subject to holding period requirements, the stock gain will be recharacterized as a dividend under Section 1248 and generally will be deductible under Section 245A to the extent of the CFC’s prior year untaxed earnings and profits and current year earnings that are not Subpart F income or tested income, as well as earnings arising from gain on deemed sale of assets that are not subject to Subpart F or GILTI. Because of the dividends received under Section 245A, there may be a preference for C corporate sellers toward dividend characterization under Section 1248 (i.e., a stock sale), which may be exempt from U.S. tax under Section 245A, as compared to gain that may be classified as GILTI income (i.e., an asset sale), which would trigger a 10.5 percent corporate tax. However, if sufficient E&P exists, corporate sellers will likely prefer stock sales over asset sales. In this case, utilizing a Section 338(g) election will convert gains to GILTI tax which will be taxed 10.5 percent.
The liquidation or distribution of the sale proceeds of CFC would be subject to an additional tax at the shareholder level. As discussed above, this may be reduced to 20 percent for federal income tax purposes. A word of caution when using C corporate structure to hold CFC shares. Some holding corporations are developed to avoid shareholder level tax by simply failing to make corporate distributions. In these cases, the IRS may assess penalty taxes under the provisions of the accumulated earnings tax and the personal holdings company tax.
The accumulated earnings penalty tax is imposed upon corporations “availed of for the purpose of avoiding the income tax with respect to its shareholders…by permitting earnings and profits to accumulate instead of being divided or distributed.” See IRC Section 532(a). Once the IRS determines that a corporation is subject to the accumulated earnings penalty tax, a tax imposed upon “accumulated taxable income” at the 37 percent top marginal tax rate imposed on individuals. See IRC Sections 532, 535. Under the personal holding company tax provisions of the Internal Revenue Code, a penalty tax is imposed upon undistributed personal holding company at the top individual marginal tax rate of 37 percent. See IRC Section 541.
Contributing CFC Shares to a Partnership or S Corporation
CFC shareholders may also contribute CFC shares to flow-through structures such as partnerships or S corporations through tax-free transactions. Compared to utilizing a C corporate corporation, placing CFC shares through flow-through structure does not result in a second layer of tax. Individuals that place CFC shares into flow-through structures may also be able to foreign tax credits without an 80 percent limitation. However, flow-through structures are not likely eligible to utilize the Section 250 deduction. Thus, a flow-through structure may not be an optimal structure if the CFC is operating in a zero or low tax country. There still remains some uncertainty regarding S corporations holding CFC shares with accumulated E&P and PTEPs. As a result, the IRS intends to issue regulations addressing these issues in the near future.
What Exactly is the FDII Tax Regime?
The FDII deduction was enacted as part of the 2017 Tax Cuts and Jobs Act. Under this tax regime, a U.S. C corporation may claim a deduction of up to 37.5 percent on a portion of the corporation’s FDII income. Because the current U.S. federal corporate income tax rate is 21 percent, a FDII deduction can result in an effective tax rate of only 13.125 percent (21% – 37.5% = 13.125%).
A FDII deduction can be extremely beneficial to U.S. exporters of goods, services, and intellectual property such as the sale of software or apps, and the streaming of audio or video. A FDII deduction is not available for income received from financial services, any domestic oil and gas extraction, activities performed through a branch, and certain passive income. The FDII 13.125 percent federal tax rate is not only available to domestic exporters of goods and services, with proper planning, even U.S.-exporters of goods and services can take advantage of FDII’s favorable rates.
For example, let’s assume a Japanese multinational corporation manufactures automobile parts. Let’s also assume that the Japanese multinational establishes a U.S. corporate subsidiary in Las Vegas, Nevada as the exclusive distributor of the automotive parts throughout Europe.The U.S. corporation negotiates sales of its goods to unrelated retailers in Europe. These sales would be subject to a federal tax rate of up to 13.125 percent. Any dividends paid from the U.S. corporate subsidiary out of its E&P will not be subject to additional U.S. tax as a result of the United States-Japan tax treaty.
Overview of U.S. Taxation of Exported Goods, Services, and Outbound Licenses of IP
For U.S. C corporations that sell goods and/or provide services to foreign countries, there is a deduction pursuant to Internal Revenue Code Section 250 that reduces the effective tax rate on qualifying income to 13.125 percent. This includes U.S. corporate subsidiaries of foreign-based multinationals.
The determination of the FDII deduction is a mechanical calculation that rewards a corporation that has minimal investment in tangible assets such as machinery and buildings. Specifically, FDII was designed to provide a tax benefit to income that is deemed to be generated from the exploitation of intangibles. The mechanical computation assumes that investments in tangible assets should generate a return on investment no greater than 10 percent. Thus, a corporation’s income that is eligible for the FDII deduction is reduced by an amount that equals 10 percent of the corporation’s average tax basis in its tangible assets, an amount that is known as Qualified business asset investment or “QBAI.”
The FDII deduction is determined based on the following multi-step calculation.
DEI
The FDII calculation starts with the computing of a U.S. corporation’s deduction eligible income (“DEI”). DEI is a corporation’s gross income which is adjusted to take into consideration certain items and is reduced by certain deductions allocable to gross income. DEI adjusts gross income to exclude certain types of income such as subpart F income, dividends received from foreign controlled corporations, income from foreign branches, and the GILTI.
FDDEI
The next step in calculating FDII is to determine a U.S. corporation’s FDDEI. FDDEI is DEI that is 1) derived in connection with property sold (including property leased, licensed, or exchanged) by a U.S. corporation to a foreign person for foreign use or 2) services provided to any foreign person. FDDEI can be broken down into the following categories: sales of general property, intangibles, and services.
FDDEI Sales- General Property
This includes any income derived from the sale of property to any foreign person for a foreign use. The term “sale” is specifically defined for this purpose to include any lease, license, exchange, or disposition which is not within the United States.” The sale of the property must only be for foreign use. The question is what is foreign use? Under the proposed regulations for the FDII tax regime, sales of property were considered to be foreign use if either the property was not subject to domestic use within three years, or the property was subject to manufacturer, assembly, or other processing outside the United States before any domestic use of the property. These rules also provided that general property was subject to manufacturing, assembly or other processing only if it meets one of two tests. The final regulations did away with the two part test and adopted a more flexible approach. The final regulations provide that the sale of property is for foreign use if the property is subject to manufacturing, assembly or other processing outside the United States, or if delivered to an end-user outside the United States.
The final FDII regulations also provide an additional rule for the sale of general property that includes digital content. The term digital contest is defined in the final regulations as a computer program or any other content in digital form. The final regulations go on to provide that a sale of general property that primarily contains digital content that is transferred electronically rather than in a physical medium is for a foreign use if the end-user downloads, installs, receives, or accesses the purchased digital content on the end-user’s device is downloaded, installed, received, or accessed (such as the device’s IP address) is unavailable, and the aggregate gross receipts from all sales with respect to the end user are far less than $50,000, the final regulations provide that a sale of general property is for foreign use if the end-user that has a billing address located outside the United States.
FDDEI Sales- Services
Qualifying foreign income also includes income derived in connection with services provided to any person not located within the United States, or with respect to property that is not located in the United States. The services may be performed within or outside the United States (but not in a foreign branch of the domestic corporation), which limits the extent of permissible qualifying activity outside the United States. The gross foreign sales and services income is reduced by expenses properly allocated to such income. The sum of these two amounts yields foreign-derived deductible eligible income.
FDDEI Related Party Rules
The general rule is that a U.S. corporation’s sales or services provided to foreign related parties are not for foreign use and, therefore, are not treated as FDDEI for purposes of the FDII deduction. Under the FDII rules, parties are generally considered to be related if they are members of an affiliated group of companies connected by more than 50 percent ownership. In certain cases, sales and services to related parties may qualify for the FDII deduction if the transaction satisfies certain additional requirements. Where a sale of property is made to a foreign related party, the outcome depends on whether: 1) the property is resold to an unrelated party or parties; or 2) the property is used in the process of providing property or services to unrelated parties.
In the second case, the FDII benefit may be claimed if the seller in the related party sale reasonably expects that more than 80 percent of the revenue earned from the use of the property received in the related party transaction will be derived from unrelated party sales or services transactions that meet the substantive FDII requirements. For example, assume from the example above, the Japanese subsidiary sells manufactured automotive equipment to its Japanese parent and the parts are used to produce other inventory sold worldwide. The requirement is met if the foreign affiliate has a reasonable expectation that more than 80 percent of the revenue from that inventory will be from sales to foreign unrelated persons for foreign use.
A related party services transaction may qualify for the FDII deduction if the services rendered are not considered to be “substantially similar” to the services provided by the related party services recipient to the person or persons located in the U.S. Under the FDII rules, the services provided by the related party service recipient are considered to be substantially similar services if: 1) 60 percent or more of the benefits conferred by the related party service ultimately accrue to persons located in the U.S.; or 2) 60 percent or more of the price paid by the persons located in the U.S. is attributable to the related party services.
A related party service provided to a foreign related party is considered to be substantially similar to the services that the foreign related party provides to U.S. persons if 1) the related party services are used by the foreign related party to serve a U.S. person and 2) the services fall within the Benefit Test or Price Test. If the related service does fall within the Benefit Test or the Price Test then the U.S. corporation has established that the service is not substantially similar to the services that the foreign related party providers to U.S. persons.
The Benefit Test deems a related party service to be substantially similar to services that the foreign related party provides to U.S. persons if at least 60 percent of the benefits conferred to the related party are used to confer benefits to a U.S. person. As a simplified example of the Benefit Test, assume that a domestic corporation (DC) is hired by a foreign related party (FC) to create architectural plans for FC’s U.S. customer R who only operates in the U.S. Since all of the benefits that DC confers to FC are directly used in the provision of FC’s services to R, a U.S. person, the Benefit Test would deem the service provided by DC to FC substantially similar to the service that FC provides to R. Therefore, DC’s creation of the architectural plans would not be treated as FDDEI services income. See FDII for All: Practical Strategies for U.S. and non-U.S. Business for a Reduced Tax Rate under the FDII Regime (2020) Steve Hadjiogiou.
The Price Test deems a related service to be substantially similar to the services that a foreign related party provides to U.S. persons if at least 60% of the price paid by the U.S. person for the foreign related party service is attributable to the related party service. As a simplified example, the Price Test, assumes that a domestic corporation (DC) is hired by a foreign related party corporation (FC) to create architectural plans for FC’s customer R. In this example, R is a multinational corporation whose operations are 90% foreign and 10% U.S. FC pays DC $75 for the architectural service which DC includes in its gross income and FC charges R $100 for the total services.
Applying the Price Test, the first step is to determine the price paid by persons located in the U.S. As applied to the facts, the price paid by R to FC ($100) is allocated proportionally based on the locations in which R benefits from the service. Accordingly, $10 of R’s benefit is allocated to the U.S. ($100 10% of R’s operations). The next step is to determine the amount attributable to the related party services. FC paid DC $75 of which $7.5 ($75 10% of R’s U.S. operations) is treated as attributable to related party services provided in the U.S. Applying the Price Test, more than 60% of the price paid to FC is attributable to DC’s related party service 75% (7.5 / 10), and thus the services provided by DC to FC is substantially similar to the service that FC provided to R. There, only $67.5 ($75 – $7.5) of DC’s gross income can be treated as FDDEI services. See FDII for All: Practical Strategies for U.S. and non-U.S. Business for a Reduced Tax Rate under the FDII Regime (2020) Steve Hadjiogiou.
Deemed Tangible Income
Finally, a domestic corporation’s deemed intangible income is determined. The excess (if any) of the corporation’s deduction eligible income over 10 percent of its qualified business asset investment (“QBAI”). A domestic corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases are determined using straight line depreciation. A domestic corporation’s QBAI does not include land, intangible property or any assets that do not produce the deductible eligible income.
The FDII calculation is expressed by the following formula:
FDII = Deemed Intangible Income x Foreign-Derived Deduction Eligible Income
Deduction Eligible Income
The FDII computation is apparently a single calculation performed on a consolidated group A basis. Domestic corporation’s FDII is 37.5 percent deductible in determining its taxable income (subject to a taxable income limitation), which yields a 13.125 percent effective tax rate.
Cross-Border Tax Considerations
Because FDII involves cross-border transactions which are subject foreign taxes such as value added tax (“VAT”), income tax, and customs tax, foreign taxes must be considered. If the foreign tax component is significant on the cross-border transaction, any FDII planning may quickly become irrelevant. Consequently, foreign taxes should be considered before any FDII planning begins.
Repatriating Income from a US Subsidiary
Multinationals operating a U.S. subsidiary may be subject to a 30-percent withholdings on any dividend distributions. However, tax treaties generally provide for a reduction or elimination of this withholding tax. However, if the parent corporation is a member of a country that has entered into a tax treaty with the U.S. such withholding may be reduced or eliminated. Because each treaty results from separate bilateral negotiations, the extent to which the withholding on dividends varies substantially among the treaties currently in force between the U.S. and other countries. The withholding tax on dividends is reduced generally to 15 percent. If the foreign shareholder is a corporation that owns at least ten percent of the U.S. corporation, however, the withholding could be as low as five percent. See U.S. Model Treaty, Art. 10. In some treaties, certain dividend payments have been exempted from the withholding tax. See e.g., United States-Japan Treaty, Art. 10(3); Protocol to United States-Netherlands Treaty, which amends Art. 10 of the treaty.
Is FDII Truly the Carrot it Has Been Advertised as?
Everyone in the international tax community was told that GILTI was designed to be a “stick” to FDII’s “carrot” for outbound international tax purposes. For the unprepared and ill-informed CFC shareholder, GILTI is definitely punitive and can be characterized as a stick. At the same time, the international tax bar was advised that FDII was supposed to be beneficial or a “carrot.” Let’s take a closer look at FDII to see if this is true. Like GILTI, the benefits of FDII are designed for C corporations. Therefore, CFCs that are held directly by individuals or through entities other than C corporations are not eligible to claim the benefits of FDII.
For C corporate shareholders of CFCs that sell and/or provide services to customers located in foreign countries, a deduction is available pursuant to Internal Revenue Code Section 250. This provision of the Code reduces the overall effective tax rate on qualifying income to 13.125 percent. The FDII benefit is determined by performing a calculation. Like GILTI, FDII involves a multi-step calculation. FDII begins with taking into consideration the CFC’s corporate holder’s gross income. The gross income is calculated and then reduced by certain items of income. The items that reduce the income include Subpart F income, dividends received from CFCs and income earned in foreign branches. This amount is further reduced by deductions which include taxes. At the conclusion of these reductions an amount is determined. This amount is known as the “yielding deduction eligible income.”
The second step of the FDII formula is to determine the foreign amounts of the domestic corporation which holds the CFCs. This amount includes any income that is derived from the “sale” of property to any foreign person for a “foreign use.” The terms “sale” and “foreign use” are defined by FDII. For purposes of FDII, the term “sale” includes any lease, license, exchange or other disposition. The term “Foreign use” is defined by the Code to mean “any use, consumption, or disposition which is not within the United States.” FDII has also defined the term “qualifying foreign.” Qualifying foreign includes income derived in connection with services provided to any person not located within the United States, or with respect to property that is not located in the United States. Qualifying foreign does not just apply to goods. It also applies to services. For FDII purposes, services may be performed within or outside the United States. However, services may not be performed in a foreign branch of a domestic corporation. The gross foreign sales and services income is reduced by expenses properly allocated to such income. The sum amounts of the first and second part of the formula yields FDII eligible income.
Finally, a domestic corporation’s “deemed intangible income” must be determined. “Deemed intangible income” is the excess (if any) of the corporation’s deductible eligible income over 10 percent of its QBAI. QBAI (for the purposes of FDII) is the average of the CFC’s adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases are determined using straight line depreciation. The QBAI does not include land, intangible property or any assets that do not produce the deductible eligible income.
The FDII Computation is a single calculation performed on a consolidated group of CFCs. A domestic corporation’s FDII is 37.5 percent deductible in determining its taxable income (subject to a taxable income limitation), which yields a 13.125 percent effective tax rate. U.S. tax on FDII may be reduced with foreign tax credits to the extent the FDII is foreign source income. Foreign source FDII generally should fall within the general foreign tax credit limitation category, and therefore foreign taxes paid on other active foreign source income earned directly by the U.S. corporation should be available as a credit.
Unfortunately, FDII only provides favorable treatment to property sold or services designed on foreign land for foreign use. Any CFC shareholder seeking to take advantage of FDII must understand the limitations of this rule. For example, property sold to a foreign person or foreign corporation is not treated as FDII income if it is manufactured or modified within the United States. This is the case even if the property is subsequently used outside the United States. Likewise with services, if services are provided to a foreign person or business located within the United States, the services are not treated as “foreign use” for FDII purposes. This is even the case if the foreign person or business uses those services outside the United States. It is interesting to note that FDII was supposed to boost the U.S. economy by producing domestic jobs. Instead, FDII may actually discourage U.S. companies from manufacturing goods for export or provide services domestically for outside the U.S.
Who’s the Hero and Who’s the Villain?
One of the significant goals of the 2017 Tax and Jobs Act was to increase domestic jobs. Both GILTI and FDII are taxed at preferential rates (with proper planning). However, GILTI was intended to be punitive and FDII was supposed to be beneficial. However, with GILTI apparently being taxed at 10.5 percent and FDII being taxed at 13.125 percent, how is GILTI punitive and FDII beneficial? To make matters even more confusing, FDII can only be utilized in very limited circumstances. FDII simply does not live up to the hype and its benefits are not as wide-ranging as previously suggested. On the other hand, GILTI never pretended to be beneficial. Everyone in the international tax community knew GILTI was going to result in a punitive tax structure and prepared accordingly. Under these circumstances, it is hard not to imagine FDII being the villain.
And The Winner is…………
The winner is….tax and entity planning! For outbound investors, the starting place, analytically, should be to analyze how their CFCs are being held. Foreign investors holding CFCs must understand that GILTI will be a tax on their CFC’s income. In general, the tax can be considered to be net income tax for income exceeding an 80 percent tax credit that can offset the otherwise applicable 10.5 U.S. income on GILTI. As a result, foreign investors using CFCs will have an incentive to reduce their CFC effective tax rate to 13.125 percent. This means that CFCs will want to direct interest and royalty deductible payments to favorable low tax countries (for example, Ireland which has a tax rate of 12.5 percent). However, care needs to be taken with regards to the jurisdiction chosen for the CFC. Countries such as Singapore, Hong Kong, and Bermuda will not work well for GILTI planning because of these jurisdictions’ low tax rates and the absence of U.S. tax treaties. All this means is that shifting intellectual property offshore is still a very viable outbound tax planning strategy, as long as care is taken in selecting a proper jurisdiction.
It should be noted that under the current law, the GILTI lower tax rate is based upon a 50 percent tax reduction that only applies to Subchapter C corporations. Individual holders of CFCs may want to contribute their CFC share to a Subchapter C corporation. This corporate structure may dramatically reduce a CFC shareholder’s tax liability associated with GILTI. Another possible plan option for CFC shareholders is to make a Section 962 election. A Section 962 election may allow a noncorporate U.S. shareholder of a CFC to be treated as if it were a C corporation for purposes of determining its CFC foreign tax liability.
Another option for noncorporate U.S. shareholders could be to elect to treat their CFCs as pass through entities for tax purposes (e.g., through “check the box” elections). By properly making an election to treat a CFC as a flow-through entity, the CFC shareholders may be permitted to fully claim the foreign taxes paid as a credit against their U.S. tax liability.
The FDII is another 13.125 percent tax that can apply to exports of CFCs. In general, foreign sales that utilize significant foreign assets may obtain more preferential tax treatment.
Obviously, this is a very complex area of tax law. No CFC shareholder should face the battle with the new GILTI or FDII provisions without the benefit of a skilled international tax attorney on their side.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or [email protected].
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.
Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
