Strategies to Recharacterize Gain From Certain Stock Sales With Untaxed Foreign Earnings

This article discusses the relevant rules governing untaxed foreign earnings and the basics of Section 1248 and Section 245A of the Internal Revenue Code. The first half of this article provides an overview of the U.S. tax system after the enactment of the 2017 Tax Cuts and Jobs Act. The second half of this article discusses how untaxed E&P of foreign controlled corporations that may result as a result of the various tax provisions of the Tax Cuts and Jobs Act are taxed under Section 1248 and Section 245A.

The Taxation of Foreign Corporations Post 2017 Tax Cuts Jobs Act

Definition of a Controlled Foreign Corporation

Sections 1248 and 245A apply to Controlled Foreign Corporations (“CFCs”) and U.S. shareholders of CFCs. Since Section 1248 and Section 245A apply to CFC and CFC shareholders, we will begin this article by defining these terms. Section 957(a) defines a CFC as a foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned, directly, indirectly or constructively under the Section 958 ownership rules, by “U.S. shareholders” on any day during the foreign corporation’s tax year. Section 951(b) defines a “U.S. shareholder” as a U.S. citizen, resident alien, corporation, partnership, trust or estate, owning directly, indirectly or constructively under the ownership rules of Section 958, ten percent or more of the total combined voting power of all classes of stock of a foreign corporation by vote or value. Thus, only those U.S. shareholders owning ten percent or more by vote or value are taken into account in determining whether a foreign corporation is a CFC.

The Subpart F Income Tax Regime

U.S. shareholders of a CFC must include in income a pro-rata share of CFC Subpart F income for the tax year, this includes the pro-rata share of certain amounts withdrawn by the CFC from favored investments and the earnings of the CFC invested in U.S. property (Sections 951(a)(1)(B) and 956). A Subpart F inclusion only applies if the foreign corporation is treated as a CFC. If this test is met, every person who is a U.S. shareholder of the corporation (as defined in Section 951(b)) and who owns stock of a foreign corporation that is a CFC must include its pro rata share of the corporation’s Subpart F income in gross income for the tax year in which or with which the tax year of the corporation ends.

A U.S. shareholder’s pro rata share is determined by going through a hypothetical dividend distribution of the CFC Subpart F income on the last day of its tax year on which it meets the CFC definition. Specifically, a U.S. shareholder’s pro rata share of Subpart F income is the amount of the distribution that the U.S. shareholder would have received with respect to the stock owned in the CFC if, on the last day of its tax year on which it was a foreign corporation if, the corporation had distributed pro rata to all of its shareholders a dividend in an amount equal to the Subpart F income for the year.

Under the rules for determining a U.S. Shareholder’s pro rata share, Subpart F income of a lower-tier CFC owned only indirectly by the U.S. shareholder may be includible in the shareholder’s income. In this situation, the Subpart F income of the lower-tier CFC is treated as if it were received directly by the U.S. Shareholder rather than as if it flowed up through the intervening entities and was homogenized or blended with their earnings. This method of taxation is often referred to as the “hop-scotch” method because the Subpart F income of the lower-tier CFC hop-scotches over the intervening foreign corporations directly to the U.S. Shareholder.

The Subpart F tax regime is dramatically different to a U.S. shareholder that isa domestic corporation compared to a U.S. shareholder that is an individual. Individuals are subject to Subpart F tax at federal rates of up to 37 percent. Absent planning, no indirect foreign tax credit is available to offset the income tax liability imposed. A Section 962 election allows an individual U.S. shareholder who actually owns at least ten percent of a CFC stock to be taxed at U.S. corporate rates on income taxed under Subpart F and to obtain the benefit of the Section 960 indirect credit.

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 included in his or her gross income under Section 951 at corporate rates. Second, the individual is entitled to a deemed-paid tax credit under Section 960 as if the individual were a domestic corporation. Third, when the CFC makes an actual distribution of earnings that has already been included in gross income by the shareholder under Section 951(a), Section 962 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). See Treas. Reg. Section 1.962-3(b)(1).

In addition to Section 962, Section 954 of the Internal Revenue Code provides an exception to the recognition of Subpart F income. An item of income of a CFC that would otherwise be tainted Subpart F income will not be tainted if it was subject to an effective foreign tax rate greater than 90 percent of the maximum U.S. corporate tax rate specified in Section 11 of the Internal Revenue Code. Thus, as of the 2026 calendar year, if the item of income of a CFC is subject to a foreign tax of more than 18.9 percent (i.e. 90 percent of 21 percent), it will not be Subpart F income. See IRC Section 954(b)(4). This exception applies after reducing the income by deductions (including taxes) that are allocable to the income under Section 954(b)(5).

What is Subpart F Income

Subpart F income is assessed on a “United States shareholder” of any CFC for any taxable year of such United States shareholder that receives Subpart F income. 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).

Subpart F income includes the following categories of foreign source income.

Insurance Income

Premiums and other income from insurance activities represent the type of portable income that can be readily shifted to a foreign corporation in order to avoid U.S. taxation. Prior to the enactment of Subpart F, a domestic corporation could exploit the portability of insurance income by establishing an offshore insurance company. For example, a U.S. insurance company that had issued policies insuring U.S. risks might form a subsidiary in a low-tax jurisdiction and reinsure that U.S. risk with that foreign subsidiary. Assuming there was a bona fide shifting and distribution of risks, the U.S. parent could deduct the premiums paid to the subsidiary against U.S. taxable income. In addition, assuming the foreign subsidiary had no office or other taxable presence in the United States, the premium income was not subject to U.S. taxation. The net effect was the avoidance of U.S. taxes on the premium income routed through the foreign subsidiary.

To negate the tax benefits of such arrangements, Subpart F income includes any income attributable to issuing or reinsuring any insurance or annuity contract in connection with a risk located outside the CFC’s country of incorporation.

Definition of Foreign Base Company Income

1. Foreign Personal Holding Company Income

Foreign personal holding company income primarily includes:

1. Dividends, interest, royalties, rents, and annuities;
2. Net gains from the disposition of property that produces, dividend, interest, rent, and royalty income (except for net gains from certain dealer sales and inventory sales), and
3. Net gains from commodity and foreign currency transactions (excluding net gains from active business and hedging transactions).

However, foreign personal holding company income does not include (1) rents and royalties which are derived from the active conduct of a trade or business and which are received from unrelated persons, (2) export financing interest derived from the conduct of a banking business, (3) dividends and interest received from related parties incorporated in the same country as the CFC, and (4) rents and royalties received from related parties for the use of property in the CFC’s country of incorporation.

A “related person” is defined in Section 954(d)(3). For purposes of this definition, an individual, partnership, trust or estate that controls or is controlled by a CFC is a “related person” with respect to the CFC. In addition, a corporation, partnership, trust or estate that is controlled by the same persons or persons that control a CFC is a “related person” with respect to the CFC. See IRC Section 954(d)(3)(B). The definition of control means, in the case of a corporation, direct or indirect ownership of more than 50 percent of the total voting power or value of the stock of the corporation. In the case of a partnership, trust or estate, control means direct or indirect ownership of more than 50 percent (by value) of the beneficial interests in the partnership, trust or estate.

Foreign personal holding company income can also include related person factoring income, income from foreign currency gains, income from commodity transactions, gains from the sale of property producing passive income, income from notional principal contracts, payments in lieu of dividends, and certain personal services contract income.

2. Foreign Base Company Sales Income

Foreign base company sales income includes any gross profit, commission, fees, or other income derived from the sale of personal property which meets the following requirements:

1. The CFC buys goods from or sells them to a related person,
2. The property is manufactured, produced, grown, or disposed of outside the CFC’s country of incorporation.

Therefore, if a good is neither manufactured nor sold for use in the CFC’s country of incorporation, then it is assumed that the CFC is not a bona fide foreign manufacturing or marketing subsidiary, but rather a base company organized to avoid tax. A CFC is considered to have manufactured a good if it substantially transforms the good. See IRC Section 954(d)(1)(A).

S. Rep. No. 1881, 87th Cong., 2nd Sess. 84 (1962), explained the two requirements of foreign base company sales income as follows:

The sales income which Subpart F is primarily concerned with income of a selling subsidiary (whether acting as principal or agent) which has been separated from manufacturing activities of a related corporation merely to obtain a lower rate of tax for the sales income. This accounts for the fact that this provision is restricted to sales of property, to a related person, or to purchase of property from a related person. Moreover, the fact that a lower rate of tax for such a company is likely to be obtained only through purchases and sales outside of the country in which it is incorporated, accounts for the fact that the provision is made inapplicable to the extent the property is manufactured, produced, grown, or extracted in the country where the corporation is organized or where it is sold for use, consumption, or disposition in that country. Mere passage of title or the place of the sale are not relevant in this connection.

It should be noted that this definition does not require any finding of a tax-avoidance purpose for the transaction.

Foreign base company income includes income generated by such trading activity whether the controlled foreign corporation buys and resells the property or merely acts as a sales agent or representative in return for a sales commission. Foreign base company sales income includes only sales income from the purchase and sale of property that is not manufactured, produced or constructed by the CFC. It does not include cases in which significant manufacturing, major assembling or construction activity is carried on with respect to the property by the CFC. For this purpose, the property sold will be treated as having been manufactured, produced or constructed by the CFC if the property is “substantially transferred” by the corporation before its sale. In addition, if the property purchased by the CFC is used as a component part of the property sold, the corporation will be treated as having sold a manufactured product, rather than component parts, but only if the operations conducted by the CFC with respect to the property purchased and sold are “substantial” and are generally considered to constitute the manufacture, production or construction of property. The application of this rule generally depends on the facts and circumstances of each case. However, the regulations contain a safe-harbor rule under which the CFC’s operations with respect to the product will be treated as manufacturing if its conversion costs (direct labor and factory burden) account for 20 percent or more of the total costs of goods sold for the product.

Even if the CFC manufactures the products it sells, income generated by sales operations handled through a branch operation outside of the country in which the CFC is incorporated will be treated as foreign base company sales income under certain circumstances. That result will occur if the combined effect of the tax treatment accorded the branch by the country of incorporation of the CFC and the country in which the branch is established is to treat the branch substantially the same as if it were a wholly owned subsidiary corporation of the CFC organized in the country in which it carries on its trade or business. See IRC Section 954(d)(2).

3. Foreign Base Company Services Income

Foreign base company services income includes any compensation, commission, fees, or other income derived from the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, and like services, where the CFC performs the services for or on behalf of a related person and the services are performed outside the CFC’s country of incorporation. See IRC Section 954(e)(1).

4. Foreign Base Company Shipping Income

The fourth major category includes income derived from the use of an aircraft or vessel in foreign commerce, from the performance of services directly related to such use of an aircraft or vessel or from the sale or exchange of the aircraft or vessel.

De Minimis Exception

Gross income of a CFC that would otherwise fall within the scope of foreign base company income is not treated as foreign base company income for the tax year is the lesser of $1,000,000 or five percent of the gross income of a CFC is foreign base company income. For purposes of applying this de minimis rule, the regulations contain an anti-abuse rule under which the income of two or more CFCs is aggregated and treated as the income of a single corporation if a principal purpose for separately incorporating, acquiring or maintaining the corporations was to prevent income from being treated as foreign base company income under the de minimis rule. See Treas. Reg. Section 1.954-1(b)(4).

Earnings Invested in U.S. Property

In connection with enacting Subpart F, Congress concluded that if any CFC loaned its accumulated earnings that were not Subpart F income to its U.S. shareholder, effective repatriation of the earnings to the United States had occurred and, consequently, the transaction should be treated as a constructive dividend. This treatment was based on the theory that, because the U.S. shareholder had use of the money loaned to it, it could reasonably be treated as if it had received the funds as a dividend even though it had an unconditional obligation to repay the principal of the loan. Section 956 also provides for constructive dividend treatment of earnings invested in U.S. property. Section 956(c) defines U.S. property to include four basic types of property. First, U.S. property includes tangible property located in the United States. See IRC Section 956(c)(1)(A). Second, U.S. property includes stock of a U.S. corporation. See IRC Section 956(c)(1)(B). Third, U.S. property includes obligations of U.S. persons. See IRC Section 956(c)(1)(C). Fourth, U.S. property includes any right to use patents, knowhow, copyrights or similar property in the United States

There are two more items that are excluded from the definition of “U.S. property” in Section 956(c)(2). First, Section 956(c)(2)(L) provides that securities will not be treated as U.S. property if they are acquired and held by the CFC in the ordinary course of its business as a securities dealer. Second, Section 956(c)(2)(M) provides that an obligation issued by a U.S. person will not be treated as U.S. property provided that 1) the issuer is not a U.S. corporation; 2) the issuer is not a U.S. shareholder of the CFC; and 3) the issuer is not a partnership, estate or trust in which the CFC (or any related person) is a partner, beneficiary or trustee immediately after the CFC’s acquisition of the obligation.

The GILTI (Net CFC Tested Income “NCTI”) 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 CFCs must plan for the Global Intangible Low-Taxed Income (“GILTI”) tax regime. For purposes of this article, we will not discuss the recent changes to GILTI or NCTI (“NCTI”) under the One Big Beautiful Bill. GILTI (or NCTI) 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 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).

GILTI Reduction to Foreign Tax Credits

The GILTI regime provided a haircut to foreign tax credit associated with GILTI income. For tax credits applicable to GILTI, there is an 80% limitation. Any amount includable in the gross income of a domestic corporation shall be deemed to have paid foreign income taxes equal to 80% of the product of such domestic corporation’s inclusion percentage multiplied by the aggregate tested foreign income taxes paid or accrued by CFCs. (For tax years beginning after December 31, 2025, the “haircut” is reduced from 20% to 10%. This means 90% of CFCs taxes paid on GILTI/NCTI can now be claimed as a credit, up from 80%).

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). (It is important to note that for tax years beginning after December 31, 2025, the One Big Beautiful Bill Act eliminates the 10% QBAI).

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 40 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 or individual 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.

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 50 percent of a GILTI inclusion (including any corresponding Section 78 gross-up). The Section 250 deduction decreases to 40 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.

Assuming that Tom did not make a Section 962 election, federal tax liability on the GILTI
Inclusion will be as follows:

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.

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.

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.

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.

The second layer of tax associated with making a Section 962 election that is not taxed is being subject to a Section 1248 tax.

The Section 954 High-Tax Exception

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 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.

The high tax exception results in the CFC retaining undistributed profits as E&P which could be subject to Section 1248.

Section 965 and the Impact of the Transition Tax

Prior to the enactment of the 2017 Tax Cuts and Jobs Act, CFC earnings and profits earned offshore that were not subject to Subpart F inclusions were able to escape U.S. taxation until the earnings and profits were repatriated to the United States. The enactment of Internal Revenue Code Section 965 forced CFCs to repatriate foreign earnings and profits. Section 965 imposes a one-time transition tax on a U.S. shareholder’s share of deferred foreign income. A U.S. shareholder for purposes of Section 965 is a U.S. person who directly, indirectly, or constructively owns at least 10 percent of either the total combined voting power or total value of a foreign corporation’s stock (“SFC”). The transition tax is treated as a mandatory Subpart F inclusion of foreign earnings.

Section 1248 and its Ability to Recharacterize Otherwise Capital Gain on the Sale or Disposition of Stock into Ordinary Income to the Extent of Earnings and Profits of a CFC

Before the addition of Section 1248 to the Internal Revenue Code, U.S. shareholders could “cash in” on and realize the economic benefit of the accumulated earnings of a foreign corporation at long-term capital gains tax rates. The capital gain result could be accomplished by selling stock of the foreign corporation at a price that would reflect the accumulated earnings of the controlled foreign corporation. It could also be achieved by liquidating the foreign corporation. In either event, the excess of the amount realized upon the sale or liquidation by the U.S. shareholder over the basis in the stock interest disposed of was usually taxed as long-term capital gain. By contrast, if the U.S. shareholder had repatriated the foreign earnings through dividend distributions, the earnings would have been taxed as ordinary income. Section 1248 prevents this result by, under specified circumstances treating the gain recognized on sale or exchange of the U.S. shareholder’s stock as a dividend to the extent that the gain reflects the shareholder’s interest in post-1962 undistributed earnings attributable to the stock sold or exchanged.

Not all U.S. persons owning stock in all foreign corporations are swept into the Section 1248 net. Section 1248 applies only to U.S. persons who owned or were considered to have owned (under the rules of Section 958) ten percent or more of the voting power if the foreign corporation at any time during the five-year period before the sale or exchange when the corporation was a controlled foreign corporation (within the meaning of Section 957). This means that Section 1248 can apply even though a foreign corporation is not a CFC at the time that the shareholder sells the corporation’s stock if the corporation met the definition of a CFC at any time during the five years before the stock sale at a time when the selling shareholder met the definition of a “U.S. shareholder” in Section 951(b). It also means that Section 1248 can apply to a U.S. person’s sale of stock in a foreign corporation even if the U.S. person does not at the time of sale meet the definition of a “U.S. shareholder” in Section 951(b) if the U.S. person met that definition at any time during the five years before the sale or exchange of stock when the foreign corporation was a CFC. See Treas. Reg. Section 1.1248-1(a)(4), Ex 2.

For purposes of Section 1248, sales or exchange of a foreign stock include: 1) Section 1001 dispositions; 2) redemption treated as an exchange under Section 302(a); 3) Section 311/336 dispositions; 4) Section 301(c)(3) gain; 5) Section 367(a) gains; and 6) Section 351(b) gain. Gain subject to recharacterization under Section 1248 is limited to the lesser of the gain on the sale or exchange of the stock or Section 1248 E&P allocable to the shares that were sold. Section 128 E&P does not include in gross income Section 1293 (i.e., the PFIC tax regime). The Tax Cuts and Jobs Act introduced Section 1248(j) which provides that a deemed dividend under Section 1248(a) is eligible for a Section 245A DRD, Thus, if there is a sale or exchange of foreign corporation stock and the gain (or a portion thereof) with respect to the sale of such stock is recharacterized to the sale of such stock is recharacterized as a deemed dividend is eligible for the Section 245A DRD if the requirements of Section 245A are otherwise satisfied.

The Participation Exemption Under Section 245A

Section 245A of the Internal Revenue Code allows an exemption for certain foreign income of a domestic corporation that is a U.S. shareholder by means of a 100 percent dividends received deduction (“DRD”) for the foreign-source portion of dividends received from “specified 10-percent foreign corporations” by certain domestic corporations that are U.S. shareholders of those foreign corporations within the meaning of Section 951(b). Section 245A(a) permits C corporations that are U.S. shareholders a deduction equal to the foreign-source portion of a dividend received from a specified 10% owned foreign corporation. The foreign source portion of the dividend is the amount that bears the same ratio to the dividend as (1) that the undistributed foreign earnings of the SFC bears to (2) the total undistributed earnings of the SFC. Undistributed foreign earnings are earnings that are not (1) effectively connected income, or (2) dividends received from a domestic corporation that is at least 80-percent owned, directly or indirectly, by the qualified SFC.

The Section 245A DRD is unavailable for any dividend for any dividend received by a U.S. shareholder from a CFC that is a hybrid dividend (a hybrid dividend is a dividend received from a CFC for which the CFC received a deduction or tax benefit in a foreign country). Section 245A(e) generally denies the DRD under Section 245A for hybrid dividends (i.e., received from a CFC if the dividend gives rise to a local country deduction of other tax benefit).

Final Section 245A(e) Regulations

The proposed regulations detailed rules regarding what constitutes a hybrid deduction, how to calculate and track hybrid deduction amounts, and how to determine when a CFC made a hybrid dividend. The final Section 245(e) regulations made certain modifications to proposed regulations. For example, the final regulations specifically address Section 355 spin-off regulation transactions. The final regulations require taxpayers to allocate hybrid deduction accounts in a manner similar to E&P. Congress enacted Section 245A(e) to eliminate the double non-taxation effects of certain hybrid arrangements. However, when a U.S. shareholder has a Subpart F or GILTI inclusion with respect to a CFC and the Section 245A(e) provisions also apply, it is possible that the U.S. shareholder can face double taxation. To reduce this possibility, the Department of Treasury issued proposed regulations which permit an adjustment to a CFC’s hybrid deduction account to the extent that the CFC’s earnings are included in income under the Subpart F or GILTI tax regimes. Instead of providing for a dollar-for-dollar reduction in the hybrid deduction account by the amount of the inclusion that takes into account the potential benefit of foreign tax credits and the Section 250 deduction.

The proposed regulations generally reduce a hybrid deduction account with respect to a share of stock of a CFC by an “adjusted subpart F inclusion” or an “adjusted GILTI inclusion” (or both) with respect to the share. This reduction, however, cannot exceed the hybrid deductions allocated to the share for the taxable year multiplied by the ratio of the Subpart F income or tested income, as applicable, of the CFC to the CFC’s taxable income. The regulations also provide ordering rules for when adjustments are required under multiple provisions.

To calculate the adjusted subpart F inclusion, a U.S. shareholder must first determine two amounts, on a share-by-share basis: 1) its pro-rata share of the CFC’s Subpart F income included in income of the shareholder’s current tax year; and 2) the “associated foreign income taxes” with respect to the Subpart F inclusion (determined by allocating foreign taxes to the Subpart F income groups under Section 960 and the regulations thereunder). Two steps must then follow. First, the shareholder will add the pro-rata share of the Subpart F inclusion and associated foreign income taxes. This is intended to reflect a Section 78 gross-up. From that amount, the shareholder then subtracts the associated foreign income taxes divided by the corporate tax rate (21% for the 2026 calendar year), which is intended to equal the amount of income offset by foreign taxes. The calculation can be expressed formulaically as follows:

Adjusted Subpart F Inclusion = Subpart F Inclusion + Associated Foreign Taxes

–   Associated Foreign Income Tax
0.21

As for the adjusted GILTI calculation, the U.S. shareholder allocates foreign taxes to the tested income group and then multiplies its “inclusion percentage.” Second, the U.S. shareholder multiplies the gross-up inclusion by the difference between 100 and the percentage in Section 250(a)(1)(B)(50% for the 2025 tax year)(Note that for the 2026 tax year, the 250 deduction is reduced to 40%). Finally, the U.S. shareholder multiplies the associated foreign income taxes by 80% (for the 2025 tax year) to take into account the prior so-called GILTI haircut to foreign tax credits. This calculation can be expressed formulaically as follows:

Adjusted GILTI inclusion = (GILTI Inclusion + Associated Foreign Taxes) x .05

– 0.8 x Associated Foreign Income Taxes
           0.21

Section 245A Holding Period

In addition to satisfying the requirements of Section 245A, U.S. shareholders must satisfy the holding period requirements of Section 256(c). Section 246 generally provides that U.S. shareholders must hold the stock of a SFC for at least 366 days during a 731-day period that is centered around the dividend.

Section 245A provides that if a corporation receives an “extraordinary dividend” with respect to stock held for less than two years before the dividend date, the basis of the corporation should be reduced by the non-taxed portion of the dividend and gain should be recognized to the extent the nontaxed portion of the distribution exceeds such basis. Extraordinary dividend means any dividend with respect to a share of stock if the amount of the dividend equals or exceeds 5 percent in the case of preferred stock, and 10 percent in the case of any other stock, of the taxpayer’s adjusted basis in such stock. Section 1059(c) lists transactions subject to Section 1059(a) without regard to the two-year holding period, they include redemption of stock (1) that are part of a partial liquidation (within the meaning of Section 302(c), (2) that are non-pro rata with respect to all shareholders, or (3) that would not have been taken into account under Section 318(a)(4).

Section 311 and the Consequences of a Corporation Distributing Property

Nonliquidated corporate distributions are distributions of cash and/or property by a continuing corporation to its shareholders. At the shareholder level, a nonliquidating corporate distribution can produce a variety of tax consequences, including taxable dividend treatment, capital gain or loss, or a reduction in stock basis. When a corporation distributes appreciated property, Section 311(b) of the Internal Revenue Code requires that the distributing corporation recognize gain “as if such property were sold to the distributee at its fair market value.” In other words, the distributing corporation must treat the appreciated property as if it had been sold to the shareholders, triggering taxable gain. Section 245A and Section 311 interact when U.S. corporations receive distributions of appreciated property from foreign subsidiaries. Although Section 311 triggers gain recognition for the distributor on appreciated property, Section 245A allows a 100 percent deduction for the foreign-source portion of dividends for 10% -owned foreign corporations, potentially making these distributions tax-free to the U.S. parent.

Section 964(e) Stock Sales

Section 964(e)(1) provides that if a CFC sells or exchanges stock in another foreign corporation, gain recognized on the sale or exchange is treated as a dividend to the same extent as it would have been under Section 1248(a) if the CFC were instead a U.S. person. The policy underlying Section 964(e)(1) is the same as the policy underlying Section 1248, which is to prevent the conversion of ordinary income into a capital gain through the sale of stock. Thus, Section 964(e) imports the Section 1248 rules to recharacterize the stock gain as dividend in the hands of a selling CFC. This means that if the entity’s stock of which is being sold was a CFC at any time during the prior 5 years, gain generally is classified as a dividend to the extent of the shareholder’s proportionate amount of the target CFC’s earnings and profits. Section 964(e) primarily applies to CFCs that sell stock of another corporation. The gain is treated as a dividend similar to Section 1248 ordinary income rather than capital gain. U.S. corporate shareholders can often claim a 100% DRD under Section 245A on the foreign-source portion of the deemed dividend.

Application of Section 1248 to Individual U.S. Shareholders

As indicated in detail above, Section 245A in the vast majority of cases prevents domestic C corporations from being subject to 1248 tax consequences. In the case of corporate sellers, a conversion of gain into a dividend generally triggers an exemption from tax for such U.S. corporate shareholders pursuant to the Section 245A dividend received deduction. For this reason, conversion of gain into dividend may be good for corporate shareholders, assuming they meet the requirements of Section 245A.

However, Section 245A does not protect individual CFC shareholders from being subject to Section 1248 tax consequences when disposing of CFC shares. However, it is worth noting that Section 1248 has diminished relevance because of the enactment of the Section 965 transition tax. As a result of the transaction tax, CFCs no longer have large pools of untaxed E&P offshore. This does not mean that CFCs or CFC shareholders should not be concerned about Section 1248.

For example, CFC shareholders claiming a 962 election has untaxed E&P as a result of Section 962(d), the untaxed E&P may be subject to Section 1248 tax once the shareholders sells his or her CFC shares. It should be noted that in certain cases, CFC shareholders making a 962 election can take a treaty position and reclassify Section 962(d) earnings as favorable qualified dividends and avoid Section 1248 ordinary income treatment. Section 1248 can also apply when untaxed E&P comprises the 10% QBAI amount identified under Section 951A(b)(2)(A) that is carved out of GILTI. The untaxed E&P associated with the QBAI could be subject to 1248 tax on the sale of CFC stock. In addition, Section 1248 could attach to CFC stock untaxed E&P associated with a Section 954 election. Finally, Section 1248 liability could attach to untaxed E&P of a foreign corporation prior to it becoming a CFC.

In these cases,under Section 1248(a), gain recognized on a U.S. shareholder’s disposition of stock in a CFC is treated as dividend income to the extent of the relevant earnings and profits accumulated while such person held the stock. Shareholders who sell stock in a CFC, recharacterization under Section 1248(a) remains significant due to the rate differential between long-term capital gains (maximum 23.8%) and ordinary income (40.8%) (these amounts include the Net Investment Income Tax (“NIIT”)) realized by individual taxpayers. The limitation imposed under Section 1248(b) when a U.S. individual shareholder, directly or indirectly, sells the shares of a CFC, also made more relevant as a result of tax reform.

Section 1248(b) provides for a ceiling on the tax liability that may be imposed on the shareholder receiving a Section 1248(a) dividend if the taxpayer is an individual and the stock disposed of has held for more than one year. The Section 1248(b) ceiling consists of the sum of two amounts. The first amount is the U.S. income tax that the CFC would have paid if the CFC had been taxed as a domestic corporation, after permitting a credit for all foreign and U.S. tax actually paid by the CFC on the same income (the “hypothetical corporate tax”). For example, if Cayman Islands CFC has $100 of income and pays $0 of foreign taxes, and assuming the CFC would be in the 21% income tax bracket for U.S. federal income tax purposes under Section 11 on its taxable income levels, the hypothetical corporate tax would be $21 ($21 – $0 foreign tax credits = $21).

The second amount is the additional taxpayer’s U.S. federal income tax for the year that results in gross income as long-term capital gain an amount equal to the excess of the Section 1248(a) amount over the hypothetical corporate tax (the “hypothetical shareholder tax”). Continuing with the same example and assuming the shareholder’s gain on the sale is $100, this hypothetical shareholder would be 23.8% of $79 ($100 Section 1248(a) amount less the hypothetical corporate tax of $21), or $18.80.

Adding together the hypothetical corporate tax and the hypothetical shareholder tax in this example thus yields $39.80 in U.S. tax on the $100 gain, for an effective tax rate of 39.8 percent. Given that the CFC in this example is not a resident in a treaty country (i.e., the United States does not have an income tax treaty with the Cayman Islands), the amount of gain that is recharacterized as a dividend under Section 1248(a) (i.e., $100) would be taxable at a maximum federal rate of 40.80%, resulting in $40.80 of tax. Because this amount is greater than the Section 1248(b) ceiling of $39.80, the ceiling will apply, and the U.S. shareholder will pay U.S. tax of $39.80. Therefore, with the reduction in U.S. corporate tax rates to 21%, it appears that the Section 1248(b) limitation will now yield a lower effective tax than would under Section 1248(a).

Section 338(g) Election

Section 338(g) permits a buyer of stock to elect to unilaterally recharacterize a taxable stock acquisition as a deemed asset acquisition. For various reasons, a domestic buyer of a CFC may insist on making a Section 338(g) election. When a Section 338(g) election is made, the target CFC is treated as if it sold all its assets at the close of the acquisition date in a single taxable transaction and, as a new corporation, purchased all the assets as of the beginning of the day following the acquisition date. If the fair market value of the target CFC’s assets is greater than their tax base, the deemed sale of assets, under a Section 338(g) election will result in a taxable gain to the CFC.

If the seller is a domestic corporation, the CFC target 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/NCTI purposes. The CFC’s tax year closes, and its Subpart F income and GILTI/NCTI through the date of sale are included in the gross income of the domestic seller.

When a Section 338(g) election is not made, and the domestic seller is a domestic corporation, it 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 and GILTI/NCTI for the year. 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 current year earnings that are not Subpart F income or tested income, as well as earnings arising from gain on the deemed sale of assets that are not subject to Subpart F or GILTI/NCTI. There may be a strong preference on the part of corporate sellers of CFCs for the buyer not to make a Section 338(g) election.

Where U.S. individuals sellers are involved, no deduction would be permitted under Section 245A for any gain recharacterized as a dividend under Section 1248. Consequently, individual U.S. sellers will generally prefer that buyers not make Section 338(g) elections.

Conclusion

Since the enactment of the Tax Cuts and Jobs Act, many CFC shareholders have utilized a 962 or 954 election to minimize the U.S. tax consequences associated with the CFC. In many cases, 962 or 954 elections are wonderful tools to reduce U.S. tax liabilities associated with a CFC. However, a 962 or 954 election does not provide any protection from Section 1248 tax at the individual shareholder level. In many cases, holding CFC shares through a domestic corporation will not only reduce the tax consequences associated with Subpart F income GILTI/NCTI, but will also mitigate or eliminate Section 1248 tax. There is no one-size fits all in international tax planning. As always, each situation must be carefully examined to determine how U.S. shareholders should hold CFC shares.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is the author of a number of published articles addressing cross-border taxation. Anthony also frequently provides continuing educational programs regarding various international tax topics.

Anthony 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.