By Anthony Diosdi
Internal Revenue Code Section 951A requires US shareholders of a controlled foreign corporation (‘CFC”) to include the corporation’s income determined to be in excess of specified return on investment in depreciable tangible personal property (i.e., GILTI). For most purposes, a GILTI liability operates in a similar manner as a subpart F inclusion. To offset GILTI inclusions, Internal Revenue Code Section 250 allows US C corporate CFC shareholders to deduct a portion (currently 50 percent, but decreases to 37.5 percent for taxable years beginning after December 31, 2025). The current Section 250 limitation may result in US C corporate CFC shareholders being subject to federal tax on a GILTI inclusion at a rate of only 10.5 percent. Typically, US C corporations are taxed at a rate of 21 percent for federal income tax purposes.
The federal income tax consequences of a GILTI inclusion is dramatically different for individual US shareholders of a CFC. US individual shareholders of a CFC are subject to a federal tax up to 37 percent and 3.8 percent medicare tax on a GILTI inclusion. This has resulted in a number of individual US shareholders of CFCs seeking planning opportunities to reduce the US tax consequence of a GILTI inclusion. One such planning opportunity is making a so-called Section 962 election. Internal Revenue Code Section 962 allows an individual US shareholder of a CFC to elect to be subject to corporate tax rates (under Sections 11 and 55 of the Internal Revenue Code) on GILTI inclusions. A Section 962 election should be made with a taxpayer’s individual income tax return. See Treas. Reg. Section 1.962-3(b). The election must be made on an annual basis.
The attractiveness of a Section 962 election is clear for individual US shareholders to pay a federal tax rate of only 10.5 percent (after taking into account the current federal corporate tax rate of 21 percent and the 50 percent Section 250 deductions domestic corporations are permitted to take). The short-term benefits of making a Section 962 election are clear for an individual CFC shareholder. However, there are long consequences that should be considered by anyone considering making a Section 962 election.
The US federal income tax consequences of a US individual making a Section 962 election are as follows. First, the individual is taxed on amounts included in his gross income under Section 951(a) at corporate rates which is currently 21 percent. 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 Section 951A, Section 962(d) requires that the earnings be included in the gross income of the shareholder again to the extent they exceed the amount of US income tax paid at the time of the Section 962 election. See Better Late than Never The Increasing Relevance of Section 962 in Outbound Tax Planning (2019), by Summer A. LePree and Jeffrey L. Rubinger.
To implement this form of recapture tax, the Income Tax Regulations discuss two categories of Section 962 earnings and profits. The first category is excludable Section 962 earnings and profits. This equals the US federal tax paid on the CFC distribution under Section 951(a). The second category is taxable section 962 earnings and profits. This represents the amount of federal tax liability that was excluded from the GILTI inclusion as a result of the Section 962 election. See Treas. Reg. Section 1.962-3(b)(1). In other words, as a result of making a Section 962 election, the electing US shareholder will be subject to a second layer of tax. This will take place when the CFC actually distributes the foreign earnings that have already been included in gross income under Section 951(a). This does not mean the second layer of tax will always be taxed at ordinary income tax rates. In certain cases, this second layer of tax could be taxed as a “qualified” dividend under Section 1(h)(11) of the Internal Revenue Code.
Qualified dividends are eligible for a special lower tax rate. In order to be considered “qualified” dividends, three conditions must be satisfied. The three conditions are as follows: 1) the dividends must be paid by a US corporation or a qualified foreign corporation; 2) the dividends are not of those listed under “Dividends that are not qualified dividends;” and 3) the holding period requirement must be satisfied. A foreign corporation is considered “qualified” when it meets any one of the following three conditions: 1) the corporation is incorporated in a US possession; 2) the corporation is eligible for benefits of a comprehensive income tax treaty with the US that the Treasury Department determines is satisfactory for this purpose and that includes an exchange of information program; or 3) the stock for which the dividend is paid is readily tradable on an established securities market in the United States.
Section 959 Ordering Rules for 962 PTEP Distributions
A 962 election will result in Section 959 ordering rules considerations. It should be understood that a GILTI inclusion creates previously taxed earnings and profits (“PTEP”) of a CFC. This is the case regardless of the fact that the income inclusion is fully or partially offset by a Section 962 election. Where any part of the E&P of a CFC consists of PTEPs, the ordering rules of Section 959 must be considered. A PTEP distribution is subject to the following ordering rules: 1) PTEP attributable to Section 959(c)(1) investments in US property; 2) PTEP attributable to subpart F inclusions under Section 959(c)(2); and general current and accumulated E&P under Section 959(c)(3). The Section 959 ordering rules are subject to the “last in first out” (“LIFO”) method taking into consideration the year the income was earned. In addition to the Section 959 ordering rules, the Internal Revenue Service (“IRS”) and the Department of Treasury issued Notice 2019-01 which stated that proposed regulations will be issued which will vary the ordering of PTEPs and require the maintenance of a system to track the various forms of PTEP.
The treasury regulations under Section 962 provide a different set of ordering rules for PTEP distributions and earnings and profits of a CFC. These regulations modify the traditional 959 rules. Under these modified ordering rules, when a CFC makes an actual distribution of earnings and profits, the earnings and profits are allocated between: 1) “Excludable 962 E&P,” which represents an amount of 962 earnings and profits equal to the amount of U.S. federal corporate tax paid on 962 earnings and profits, and 2) “Taxable 962,” which is classified as the excess of 962 earnings and profits over the excludable 962 earnings and profits.”
Generally, a distribution of earnings and profits that the U.S. shareholder has already included in his or her income is not subject to additional US federal income tax. On the other hand, when a CFC distributes 962 earnings and profits, the portion of the earnings that compromises taxable earnings and profits is subject to a second layer shareholder level tax. This second layer of tax is consistent with treating the U.S. individual shareholder in the same manner as if he or she invested in the CFC through a domestic corporation.
The Section 962 regulations adopt the general Section 962 ordering rules with respect to a CFC’s distribution of earnings and profits, but modify them providing a priority between the 962 E&P and non-962 E&P. First, distributions of E&P that is 959(c)(1) (i.e. Section 956 inclusions) are distributed first, E&P that is PTEP under Section 959(c)(2) (Sections 951(a) or 951A(a) inclusions) is distributed second, and all other E&P under Section 959(c)(3) (i.e., E&P relating to the deemed tangible return, high-taxed excepted subpart F income) is distributed last. This is 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 first 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 962 E&P. the same ordering rules applies to distributions of E&P that is PTEP under Section 959(c)(2). This is, distributions of E&P that are PTEP under Section 959(c)(2) come first from 962 E&P, the excludable 962 E&P and finally taxable 962 E&P. Finally, within each subset of PTEP 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 years in descending order.
To illustrate the above ordering rules, assume that an individual U.S. shareholder wholly owns FC, which is a CFC. FC has never made distributions to the U.S. shareholder. The U.S. shareholder makes a Section 962 election for year 2018, but not for year 2017. In year 2017, FC’s total earnings for 2017 were $200. The US shareholder had a Section 951(a)(1)(B) inclusion of $100 (attributable to Section 956 income inclusion), which became PTEP under Section 959(c)92). The U.S. shareholder paid full tax on these inclusions, with the results that when the E&P is distributed it should not be subject to a second layer of tax.
In year 2018, FC’s total earnings were $80. The U.S. shareholder had a Section 951A(a) inclusion of $50, which becomes PTEP under Section 959(c)(2). The U.S. shareholder pays U.S. federal corporate tax of $5 on such inclusion. At this point, for 2018, the excludable 962 E&P is $5 and the Taxable 962 E&P is $45. The remaining $30 of FC’s earnings ($80 less $50) represented the net deemed tangible return amount, which was not currently taxable to the US shareholder. This amount falls within Section 959(c)(3).
On January 1, 2019, FC distributes $180 to the US shareholder. Under the Section 962 PTEP ordering rules, the first $100 of the distribution is considered to come out of Section 959(c)(1) PTEP, which represents the non-962 E&P comprised of section 951(a)(1)(B) inclusion of $100 in 2017 (related to Section 956). The net $5 of the distribution is considered to come out of Section 959(c)(2) PTEP, which is first from 962 E&P comprised of the Excludable 962 E&P from 2018 (attributable to Section 951A(a) amount of $50 subject to US federal corporate tax). The $45 of the distribution is also considered to come out of Section 959(c)(2) PTEP, but is from the 962 E&P compromised of the Taxable 962 E&P from 2018 (attributable to Section 951A(a) amount not subject to U.S. corporate tax). This $45 of E&P of E&P distributed is subject to a second layer shareholder tax. The next $30 of the distribution is considered to come out of the Section 959(c)(2) PTEP, but from non-962 E&P from 2017 (attributable to the Section 951(a) amount of $100 resulting from Section 965 E&P from 2017 (attributable to the Section 951(a) amount resulting from Section 965 applying). See The Modern Day Closely Held Foreign Corporation Post-Tax Reform (2020), Steven Hadjilogiou, McDermott Will & Emery, LLP Miami and Fred Murray, Chief Counsel, Internal Revenue Service.
Conclusion
The most obvious reason why an individual shareholder would choose to make a Section 962 election is the ability to defer the US federal income tax on the actual distribution from a CFC, as well as the possibility of obtaining “qualified” dividends under Section 1(h)(11) on subsequent distributions. However, making a Section 962 election can have unintended income tax consequences. A careful review of the CFC finances should be conducted to determine if making a Section 962 election makes sense in both the short and long term. Any individual shareholder considering making a Section 962 should consult with an attorney well versed in the international tax tax planning and compliance. We provide international tax planning and compliance services to CFC shareholders. We also assist other tax professionals who need guidance regarding international tax compliance matters.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.