We all have guilty pleasures (no pun intended). One of my guilty pleasures used to be watching WWE wrestling. WWE battles were always epic and you never knew who was going to be the hero or villain in any given match. Just like WWE characters, tax regulations can be a hero in one case and become a dreaded villain in another. For those that have had the pleasure of trying to make sense of the new Global Intangible Low-Tax Income (“GILTI”) regime and the Foreign-Derived Intangible Income (“FDII”) tax rules, you may feel like you are in the middle of a WWE battle. Not only is GILTI and FDII needlessly complicated, it’s unclear which of these provisions is the hero or the villain.
What Exactly is the GILTI Tax Regime
Beginning on January 1, 2018, U.S. shareholders of CFCs, will be required to include GILTI income. To reduce the impact of the new GILTI inclusion, Internal Revenue Code Section 250 allows certain U.S. shareholders to deduct a portion (currently 50 percent, but reduced to 37.5 percent after December 31, 2025) of that GILTI inclusion (this includes a corresponding Section 78 gross-up which acts to increase the GILTI inclusion to an amount prior to the inclusion of foreign tax) and a portion (currently 37.5 percent but reduced to 21.875 percent after December 31, 2025) of a corporation’s FDII. The Internal Revenue Code provides a formula to compute a GILTI inclusion and Section 250 deduction. Although GILTI and FDII were intended to achieve maximum effective tax rates of 10.5 percent and 13.125 percent respectively, taking into consideration numerous limitations, GILTI can produce unintended results with effective tax rates that greatly exceed the tax rates discussed above.
The Mathematics of GILTI
GILTI involves an incredibly complicated calculation. A U.S. shareholder’s GILTI for a taxable year is the excess, if any, of the U.S. shareholder’s “net CFC tested income” for the taxable year over that shareholder’s “net deemed tangible income return” for the taxable year. Net CFC Tested Income with respect to any U.S. shareholder is the excess (if any) of the aggregate of the shareholder’s pro rata share of the “tested income” of each CFC with respect to which the shareholder is a U.S. shareholder. See IRC Section 951A(c).
Expressed as a mathematical formula, GILTI is computed as follows:
GILTI = Net CFC Tested Income – Net Deemed Tangible Income Return = [Tested Income – Tested Loss] – [10% of qualified business asset investment “QBAI” – Certain Interest Expense]
More specifically, the GILTI formula is broken down as follows:
The tested income of a CFC is the excess (if any) of the gross income of the CFC determined without regard to certain items (listed below) over deductions (including taxes) properly allocable to that gross income. The items excluded from gross income are:
Any U.S. source income effectively connected by conduct by such corporation with a trade or business within the United States.
Any gross income taken into account in determining Subpart F income within such corporation.
Any gross income excluded from the foreign base company and insurance income.
Any dividend received from a related person as defined in Internal Revenue Code Section 954(d)(3); and
Any foreign oil and gas extraction income.
The tested loss of a CFC is the excess (if any) of deductions allocable to the CFC over the aggregate of a tested income of each CFC held by a U.S. shareholder. To deny taxpayers any double benefits, any tested loss of a CFC increases Earnings & Profits for purposes of applying the Subpart F current year Earnings & Profit limitation contained in Internal Revenue Code Section 952(c)(1)(A).
Net Deemed Tangible Income Return
The net deemed tangible income with respect to a U.S. shareholder is the excess (if any) of 10 percent of the shareholder’s pro rata share of the QBAI of each CFC, over the amount of interest expense allocable to net CFC tested income for the taxable year to the extent the interest income attributable to such expense is not taken into account in determining net CFC tested income.
QBAI equals the CFC’s average aggregate adjusted bases for Specified Tangible Property during the taxable year. QBAI is measured at the close of each quarter and the adjusted basis is determined by using the alternative depreciation system under Internal Revenue Code Section 168(g).
Foreign Tax Credits for GILTI
A corporation that has a GILTI inclusion is treated as having paid foreign income taxes equal to 80 percent of the product of its “inclusion percentage” and the aggregate “tested foreign income taxes” paid or accrued by its CFCs as defined under Internal Revenue Code Section 960(d).
Making Sense of the Complex GILTI Formula
The GILTI formula excludes Subpart F income, income that is effectively connected with a U.S. trade or business, and a number of other types of income for purposes of determining a CFC’s taxable income to a shareholder. The GILTI formula then includes a 10 percent return on investment from tangible depreciable assets or QBAI. The GILTI tax regime then makes a presumption that tangible property should provide an investment return no greater than 10 percent. In other words, GILTI assumes that income earned in excess of a 10 percent return on a CFC’s QBAI comes from intangible property and is subject to an inclusion for taxation purposes. The problem with this assumption is that GILTI assumes income is generated from intangible property whether or not income is generated from intangible property. This means that GILTI will not only target high tech companies that may have transferred intangible assets offshore such as patents, GILTI will impact CFCs that earn most of their money from selling goods and services. Only CFCs that have a large tangible asset base which can be used in the GILTI calculation may escape GILTI’s heavy hand. Unfortunately, many small to mid-sized CFCs do not have a large tangible base to apply to the GILTI calculations.
Assuming that a CFC does not have a large tangible asset base to reduce its exposure to the GILTI, is there any other tax planning options available? Fortunately, there are a number of other options available to reduce a CFC’s GILTI inclusion. In cases were a large tangible base cannot be used to offset a GILTI inclusion, this includes holding a CFC through a C corporation.
The GILTI Tax Rates for Non-Corporate and Corporate Holders of CFCs
Shareholders of C corporations that hold CFCs are provided two significant benefits that are not available to individuals that hold CFCs either directly or through other entities. Shareholders of C corporations that hold CFCs can deduct 50 percent of any GILTI inclusion. These shareholders can also reduce their GILTI liability with foreign tax credits (The Internal Revenue Code grants corporate U.S. shareholders of CFCs a deemed credit of up to 80 percent of foreign taxes imposed on a CFC’s GILTI). This means that without taking into consideration foreign taxes paid by a CFC, corporate shareholders of CFCs may be assessed only a 10.5 percent federal tax on its GILTI inclusion. On the other hand, U.S. persons who hold CFCs directly or through other structures are not eligible to claim the 50 percent deduction and potentially may not reduce their GILTI inclusion with foreign tax credits. In other words, instead of being potentially subject to a 10.5 percent federal tax on GILTI inclusions, non-corporate U.S. shareholder are subject to a 37 percent federal tax on such income. To make matters worse, an additional 3.8 percent net investment income tax is imposed upon most GILTI income. This net investment tax is only assessed on individuals holding CFCs, but not corporate shareholders holding CFCs.
C corporations that hold CFCs may also benefit from the high-tax exception for GILTI inclusions. If the CFC can establish that it was subject to an effective tax rate of at least 90 percent of the highest U.S. federal corporate tax rate, the CFC will not be subject to a GILTI inclusion. Currently, taking into consideration the combination of the 50 percent deduction and foreign tax credit inclusions, under the high-tax exception, there is no GILTI inclusion it the CFC is subject to a foreign tax rate of 13.125 percent or greater.
So what does a GILTI tax computation look like? Below, please see Illustration 1. and Illustration 2. which demonstrate an extremely simple GILTI inclusion on an individual shareholder of a CFC compared to a corporate shareholder of a CFC. Illustration 1 assumes that an individual U.S. person owns a CFC and is subject to a 20 percent rate. It is further assumed that the CFC has $1,000,000 of tested income before foreign taxes and the CFC has no QBAI. Illustration 2 assumes the same facts. However, in Illustration 2, the CFC is wholly owned by a U.S. Subchapter C corporation.
Individual Holder of a CFC
Net CFC Income $1,000,000
Foreign tax $200,000 (assuming a 20 percent effective rate)
GILTI Inclusion $800,000
Individual Tax (37%) $296,000
Net Investment Tax $30,400
Total Global Tax $326,400
Corporate Shareholder of a CFC
Net CFC Income $1,000,000
Foreign tax $200,000 (assuming a 20 percent effective rate)
GILTI Gross Up $1,000,000
GILTI deduction $500,000
GILTI Inclusion $500,000
Corporate Tax (21%) $105,000
Foreign tax credit (80%) $160,000
U.S. Tax $0 ($105,000 – $160,000 = ($55,000))
Total Global Tax $200,000
Given how much tax a proper corporate structure can save, any CFC shareholder must carefully consider entity planning for GILTI purposes.
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 is 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.
In a mathematical formula, the FDII calculation can be expressed as follows:
FDII = Deemed Intangible Income x Foreign-Derived Deduction Eligible Income/
Deduction 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 manufacture 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 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 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 it’s CFC foreign tax liability. Legal arguments could be made that the 50 percent deduction applies to CFCs that are owned by U.S. persons or Subchapter S corporations in cases where a Section 962 election has been made. As of this date, the Internal Revenue Service and the Treasury have not provided any guidance on this issue.
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 one of the founding partners of Diosdi Ching & Liu, LLP, a law firm with offices located in San Francisco, California; Pleasanton, California; and Fort Lauderdale, Florida. Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – firstname.lastname@example.org
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.