By Anthony Diosdi
The U.S. federal income tax liability associated GILTI or “global intangible low-taxed income” is dramatically different to an individual U.S. shareholder of a controlled foreign corporation (“CFC”) compared to a U.S. shareholder that holds a CFC through a pure passthrough entity such as an S corporation. Individual CFC shareholders of CFCs are subject to GILTI tax at federal rates of up to 37. Absent planning, no indirect foreign tax credits are available to offset the income liability imposed on a GILTI inclusion. Furthermore, each CFC shareholder (within the meaning of Internal Revenue Code Section 951(b)) must attach an IRS Form 5471 to their individual income tax return. Filing the Form 5471 Information Return of U.S. Persons With Respect To Certain Foreign Corporations, requires disclosure about the CFC, as well as detail concerning its income, deductions, earnings and profits, cost of goods sold or operations (if relevant), income or other taxes paid or accrued elsewhere and a balance sheet. See generally, Instructions to Form 5471 and Treas Reg Section 1.6038-2. On the other hand, individuals that hold CFC shares through S corporations can potentially receive the benefit of flow-through foreign tax credits and they will not likely need to attach an IRS Form 5471 to their individual income tax return.
Because the liabilities associated with GILTI inclusions are so excessive, many CFC shareholders have elected to drop their CFC share into an S corporate structure. This remedy certainly has benefits such as a single layer of U.S. tax associated with GILTI inclusions, simplicity, because such a structure avoids various anti-deferral rules of the Internal Revenue Code, flow-through of foreign tax credits without the usual 20 percent haircut, and the potential avoidance of the filing of a complicated Form 5471. But with these benefits come a number of downsides. For example, holding a CFC through an S corporation may not be an efficient structure if the foreign corporation is operating in a zero or low-tax jurisdiction and although a S corporate shareholder may not be required to attach a Form 5471 to his or her individual income tax return, his or her share of foreign source income and allocatable foreign tax credits will need to be computed their flow through an equally complicated Schedule K-2, “Partners” Distributive Share Items – International” and Schedule K-3, “Partner’s Share of Income, election.” This article will provide an overview Part III, Section 3 of Schedule K-2 and K-3 used to calculate creditable foreign tax credits associated with GILTI inclusions.
Overview of Foreign Tax Credit Rules
As a general rule, a U.S. individual may receive a “direct” foreign tax credit for foreign taxes that he or she paid. In the case of a U.S. corporation that owns stock in a foreign corporation, the U.S. corporation may be entitled to an “indirect” or “deemed” credit for the foreign taxes paid by the foreign corporation when the foreign income is earned and distributed to the domestic corporation in the form of a dividend. Only a levy that is a tax qualifies to be creditable as a foreign tax credit. A foreign tax credit is permitted only to the extent that the creditable foreign tax is “paid or accrued.” The foreign tax credit is generally limited to a taxpayer’s U.S. tax liability on its foreign source income. This limitation is computed by multiplying a taxpayer’s total U.S. tax liability in that year by the ratio of the taxpayer’s foreign source taxable income in that year to the taxpayer’s worldwide taxable income in that year. Under current law, the limitation is applied separately to a “passive category income” basket and “general category” basket. In addition to general category income and passive category income, the 2018 Tax Cuts and Jobs Act added two new categories of income to which a foreign tax credit limitation applies under Internal Revenue Code Section 904 – non-passive GILTI Income and foreign branch income. Thus, while the Section 904 limitation applies separately to non-passive GILTI inclusions, passive GILTI remains in the passive limitation category. Any excess foreign tax credits in the GILTI limitation do not carry back or forward to other taxable years.
In order to determine foreign source taxable income in each basket for purposes of calculating the foreign tax credit limitation, a taxpayer must allocate and apportion deductions between U.S.-source gross income and foreign-source gross income. The allocation and apportionment rules are complex but key to the operation of the foreign tax credit limitation. If expenses are over-allocated to foreign income, the taxpayer’s foreign tax credit limitation will be lower. See Foreign Tax Credit Planning – What Every Practitioner Show Know, Bilzin Sumberg Baena Price Axelrod LLP (12/9/2015) Jeffrey L. Rubinger.
Part III, Section 3 for K-2 and K-3
In Part III, Section 3, question 1, the S corporation assigns foreign taxes paid or accrued associated with GILTI to column (b). The S corporation should attach a separate statement to the Schedule K-2 and K-3 reporting the following:
1) The date on which the taxes were paid or accrued;
2) The exchange rate used;
3) The amounts in both foreign currency and U.S. dollars as per Internal Revenue Code Section 986(a).
For column (a) of Part III, Section 3, the S corporation must enter a code for the type of tax paid to a foreign jurisdiction. The codes for types of foreign tax are as follows:
Code Types of Tax
WHTD Withholding tax on dividends
WHTP Withholding tax on distributions of PTEP
WHTB Withholding on branch remittances
WHTR Withholding tax on rents, royalties, and license fees
WHTI Withholding tax on interest
ECI Taxes paid or accrued to foreign countries on effectively connected
OTHS Other foreign taxes paid or accrued on sales income
OTHR Other foreign taxes paid or accrued on services income
OTH Other foreign taxes paid or accrued
Taxes assigned to GILTI category income previously taxed earnings and profits or “PTEP” are reported under column (b). However, the S corporation should not report taxes assigned to GILTI income if the GILTI inclusion was already reported in a shareholder’s annual PTEP accounts.
In Part III, Section 3, question 2, the S corporation must reduce the foreign tax available for credit by taxes paid on mineral income, the international boycott provisions, any failure to file penalties, taxes with respect to splitter arrangements (the definition of a “foreign tax credit splitting event” is broad and could reach a variety of situations such as transfer pricing adjustments or a shift of deductions and timing differences under U.S. and foreign law), and taxes on foreign corporate distributions.
In Part III, Section 3, question 3, the S corporation must report foreign tax redeterminations. Internal Revenue Code Section 905 governs situations in which the amount of foreign taxes are credited and adjusted for purposes of redeterminations. Section 905 exists because of the so-called “relation back doctrine” that is applied to accrual of foreign taxes and contested taxes. A contested tax liability for an underlying foreign tax is assessed in the tax year it is determined. Thus, when a liability is resolved, it ultimately “relates back” to the year of the original assessment. In addition, if a tax paid is refunded, the refund is treated as reducing a foreign tax expense for that year. Under Internal Revenue Code Section 905(c), the amount of a foreign tax credit provided under Section 901 of the Internal Revenue Code must be adjusted up or down on an amended tax return. Any redeterminations under Internal Revenue Code Section 905 must be listed in Part III, Section 3, question 3.
As noted above, significant tax savings can be realized for U.S. taxpayers who hold CFCs through a pure flow-through structure such as an S corporation. However, holding a CFC through a S corporation can add another layer of complexity to compliance requirements. Anyone considering transferring CFC shares to an S corporation or currently holds CFC shares through an S corporation, should seek guidance from a qualified international tax attorney regarding IRS compliance requirements.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.