OBBBA Changes to 962 Election for GILTI Inclusions

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).

One Big Beautiful Bill Act (“OBBBA”) made a number of changes to global intangible low-taxed income or (“GILTI”). For starters, OBBBA changed the term “GILTI” to “net CFC tested income.”  Beginning after December 31, 2025, the following changes will take place in regards to how net CFC tested income is taxed:

1. As discussed above, GILTI currently permits a deduction equal to 10% of QBAI. Beginning on January 1, 2026, the QBAI deduction will no longer be available to reduce GILTI inclusions. The OBBBA changes to Section 951A will likely increase the net CFC tested income base.
2. Section 250 deductions against GILTI will be reduced from 50% to 40%. This will result in an increase in the elective tax rate of CFC tested income from 10.5% to 12.6% beginning on January 1, 2026.
3. The OBBBA added Section 904(b)(5) to the Internal Revenue Code. Section 904 no longer specifically allocates interest and research and development (“R&D”) expenses to foreign Section 951A income. This change to the foreign tax credit rules will permit some multinational corporations the ability to allocate additional deductions to U.S.-source income. The impact of this change to Section 951A will vary based on the U.S. taxpayer.
4. The deemed credit for foreign taxes attributable to “net CFC tested income” increased from 80% to 90%.

This article discusses how the OBBBA changes the 962 calculation associated with GILTI inclusions. By the way of background, 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. As discussed above, after the enactment of the OBBBA the GILTI rates changed slightly.

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 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. After December 31, 2025, a Section 250 deduction allows U.S. shareholders to deduct 40 percent of a GILTI inclusion (including any corresponding Section 78 gross-up). In addition, individuals making a 962 election are permitted a deduction of 90% of foreign taxes paid on net tested income.

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.

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 in this case would be approximately $200,000  x 37% = $74,000 (Assuming that Tome is in the highest marginal tax bracket). Tom may also be subject 3.8% Medicare taxes on the GILTI inc

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 GILTI inclusions. CFC shareholders making a 962 election can also claim a Section 250 deduction in the amount of 40% of the net tested income and potentially foreign tax credits for 90% of the deemed paid. 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.

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. Assuming that the entire $162,000 of E&P is treated as a PTEP and is subject to a second layer of tax, 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.

At the time of the 962 election, Tom will pay an additional $39,953 in taxes (excluding Medicare tax). However, in the future, Tom will pay $59,940 ($162,000 x 37% = $59,940) – $20,041 (U.S. federal taxes already paid) = $39,899

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 $39,899. Tom’s total federal tax liability associated with the 962 election will be $59,940. In this example, by making the 962 election, Tom increased his tax liability by $39,899 ($59,940 – $20,041 = $39,899). 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.

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 adiosdi@sftaxcounsel.com.

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.