Planning Options to Defer the Recognition of Subpart F or GILTI Income- Section 962 Election vs. High-Tax Exception: The Epic Showdown

By Anthony Diosdi

Prior to the enactment of the 2017 Tax Cuts and Jobs Act, Controlled Foreign Corporations (“CFCs”) were able to defer the U.S. taxation of foreign source income through tax planning. The 2017 significantly reduced (but did not eliminate) a CFC’s U.S. shareholder’s ability to defer the U.S. taxation of foreign source income. This article will discuss two remaining options available to CFC shareholders to defer the recognition of U.S. tax on foreign source income. CFC shareholders can make either a so-called 962 election or a high-tax exception (also known as a Section 954 election) to defer the taxation on foreign income. This article will compare and contrast each of these elections.

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 global intangible low-tax income (“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. A Section 250 deduction allows U.S. shareholders to deduct (currently 50%, but decreases to 37.5 percent but decreases to 37.5 percent for taxable years beginning after December 31, 2025) of the corporation’s GILTI inclusion (including any corresponding Section 78 gross-up).

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:

FC 1 $81,000
FC 2 $81,000

Total federal tax liability $162,000 x 37% = $59,994

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 one the E&P from FC 1 and FC 2 associated with the 962 PTEP is distributed to him. In this case Tom will owe an additional $59,994 (assuming federal tax from the first layer of 962 tax cannot be used to offset the second layer of 962 tax) in federal income tax (excluding Medicare tax). Tom’s total federal tax liability associated with the 962 election will be $77,004. In this example, by making the 962 election, Tom increased his tax liability by $17,010 ($77,004 – $59,994 = $17,010). But, Tom has had the benefit of deferring his tax liability. 

Translation of Foreign Currency Issues

Anyone considering making a 962 election must understand there will likely be foreign conversion issues. A CFC will probably use a foreign currency as its functional currency. Anytime a 962 election is made for a CFC which has a functional currency that is not the dollar, the rules stated in Section 986 and 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 (“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. However, the individual making a 962 election file the federal tax return with an attachment. 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. It also allows the CFC shareholder the opportunity to claim 80 percent of foreign tax credits. As discussed above, making a 962 election converts the E&P for purposes of Section 959 to PTEP. In certain cases this may allow shareholders of a CFC plan shareholder loans or investment in U.S. property without triggering the recognition rules of Internal Revenue Code Section 956. Section 956 is an anti-abuse rule designed to prevent the enjoyment of the benefit of repatriation to the United States of untaxed foreign earnings. Section 956 imposes an immediate tax on the U.S. shareholder’s proportionate share of the CFC’s E&P if the CFC invests in U.S. property. U.S. property includes things such as loans to U.S. borrowers and investments in U.S. real estate.

A 962 election also 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.

The Section 954 High-Tax Exception

For many years, CFC shareholders and U.S. multinational corporations were able to utilize a high-tax election to defer Subpart F income. However, when the GILTI taxing regime was announced in late 2017, a corresponding high-tax election was not available. Shortly after the enactment of the GILTI taxing regime, CFC shareholders, U.S. multinational corporations and their advisors began lobbying the Department of Treasury (“Treasury”) and the IRS to issue regulations to permit the use of a high-tax election for GILTI income. On July 20, 2020, the Treasury promulgated final regulations which permit a high-tax election for global intangible low-taxed income (“GILTI”). This was welcome news to many CFC shareholders, U.S. multinational corporations and their advisors. In general, the Final Regulations enable CFC shareholders and U.S. multinationals 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% based on the current 21% corporate tax rate).

The Required Subpart F Income and GILTI High-Tax Election Threshold Rate

The 2019 Proposed Regulations and the 2020 Final Regulations set the threshold rate for claiming the Subpart F income and GILTI high-tax election at 90 percent of the U.S. federal corporate tax rate. This is currently 18.9 percent (90% of the highest U.S. federal corporate tax rate, which is 21%). With that said, there has been a lot of talk in Washington about increasing the U.S. federal corporate tax rate. If the U.S. corporate tax rate is increased, the minimum threshold rate necessary for claiming the Subpart F income and GILTI high-tax election would also increase. 

Tested Unit Standard

The effective foreign tax rate for purposes of the high-tax exclusion is calculated on a tested-unit basis. The tested unit approach applies to the extent an entity, or the activities of an entity, are actually subject to tax of a foreign country as a tax resident or permanent establishment. The final regulations define three categories of tested units:

1. A controlled foreign corporation (“CFC”);

2. An interest that the CFC holds directly or indirectly in a passthrough entity that: a) is a tax resident of a foreign country, or b) is not subject to tax as a resident but is treated as a corporation for purposes of the CFC’s tax law;

3. A branch of the CFC that either: a) gives rise to a taxable presence in the country in which the branch is located, or b) gives rise to a taxable presence under the owner’s tax law, and the owner’s tax law provides an exclusion, exemption, or other similar relief (such as a preferential rate) for income attributable to the branch. See Treas. Reg. Section 1.951A-2(c)(7)(iv)(A).

Finally, the regulations provide that multinationals are generally required to combine tested units that are attributed gross income less than the lesser of 1% of the gross income of the CFC or $250,000. This proposed de minimis combination rule would apply to combine tested units that are not residents of, or located in, the same foreign country.

Calculating the Effective Foreign Tax Rate

In order to make a GILTI high-tax foreign exclusion, the  multinational 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.

To determine the tentative tested income, the tentative gross tested income of each tested unit first must be established. This requires that the items of gross income of a CFC are attributable to a tested unit of the CFC to the extent that they are properly reflected on a separate set of books and records of the tested unit. See Treas. Reg. Section 1.951A-2(c)(7)(ii)(B). Also, tentative gross tested income of a tested unit is adjusted by disregarded payments made between tested units of the CFC. In addition, if gross income is attributable to more than one tested unit, the item will be considered attributable to the lowest-tier tested unit. See Treas. Reg. Section 1.951A-2(c)(7)(iv)(B).

To calculate the tentative tested income, a determination is made by allocating and apportioning current-year deductions for the CFC to the tentative gross tested income item under the principles of Treasury Regulation 1.960-1(d)(3). As stated in Treasury Regulation 1.960-1(b)(4), current-year tax is the foreign tax paid or accrued by a CFC in a current year. Thus, the U.S. dollar amount of the CFC’s current-year taxes may be apportioned to the tentative tested income.

High-Tax Exclusion Election

The high-tax election must be made by the “controlling domestic shareholders” of a CFC, which are generally the 10 percent US shareholders that, in the aggregate, own more than 50 percent of the the total combined voting power of all classes of stock and undertake to act on the CFC’s behalf. If US shareholders do not, in the aggregate, own more than 50 percent of the total voting power of the CFC, the controlling domestic shareholders are all 10 percent US shareholders who own stock of the CFC. The election made by the controlling US shareholder is binding on all US shareholders of the CFC. Controlling domestic shareholders must notify other 10 percent US shareholders of the election and any revocation. In light of these rules, it is expected that shareholder agreements may provide mechanics for decisions relating to the making or revocation of high-tax elections, as well as information rights for minority US investors.

The regulations also permit multinationals to retroactively make a GILTI high-tax exclusion election or revocation on an amended tax return for a prior year so long as the amended return is filed within 24 months of the unextended due date of the original return of the controlling domestic shareholder’s inclusion year and so long as all other US shareholders of the CFC file amended returns within a single 6-month period which is within the 24-month period referenced above. If an election or revocation is made, the regulations require controlled domestic shareholders to provide notice of such election or revocation to each US shareholder that is not a controlling domestic shareholder. The final regulations apply to tax years beginning on or after July 23, 2020 and allow multinationals to retroactively apply the high-tax election to tax years that began after December 31, 2017.

Pros to Making a Section 954 Election

The regulations promulgated by the IRS and Treasury allows a CFC shareholder to make a high tax exception to Subpart F income or GILTI inclusions. This exception applies to the extent the foreign income from the CFC exceeds 90 percent of the U.S. federal corporate tax rate. Consequently, if the effective foreign tax rate exceeds 18.9 percent, the CFC shareholder can elect to utilize the high tax exception. This option is far more simple than the 962 election. Thus, the compliance cost should be less than a 962 election. When a high tax exception is used, the CFC retains undistributed profits as E&P. If the CFC is incorporated in a country that has entered into a double tax treaty with the United States, it is possible that the dividend may result in a reduced qualified dividend rate. Making a Section 954 election also eliminates the second layer of tax associated with making a 962 election.

Cons to Making a Section 954 Election

The high tax exception results in the CFC retaining undistributed profits as E&P. On the other hand, when a CFC shareholder makes a 962 election, the retained E&P is classified as a PTEP. This classification difference makes a big difference for cross-border tax planning. CFC shareholders who make a 954 election cannot make loans to U.S. borrowers and make investments in U.S. real estate from the CFC’s retained earnings. In addition, foreign tax credits may be lost through the use of a 954 election. Finally, a 954 election must be made with respect to all CFC’s controlled by the CFC. The election cannot be made on a CFC basis. This may result in the loss of cross-crediting of high-taxed CFC’s foreign taxes.

Conclusion

There is no one size fits all solution when deciding between a 962 and 954 election. Careful modeling should be done by a qualified international tax attorney should be done prior to making the decision to make a 962 or 954 election.  In addition, any CFC shareholder considering making a 962 or 954 election should carefully monitor the proposed changes to the tax law of GILTI in the “Build Back Better” legislation. If any portion of “Build Back Better” is enacted, the planning options discussed in this article could significantly change. The following changes have been proposed to GILTI in the “Build Back Better” Act:

1. A minimum 15 percent effective tax rate as per OECD Pillar 2;

2. Calculation of GILTI on a country by country basis;

3. A reduction of the GILTI QBAI from ten to five percent;

4. Carryover of net CFC tested losses;

5. Carryover of GILTI foreign tax credits.

6. Changes in the GILTI expense apportionment rules.

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 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.