By Anthony Diosdi
For those who are or will be involved in international business and investment transactions, it is important to have some basic understanding of the relevant tax laws. These series of articles are intended to warn individual shareholders of controlled foreign corporations (“CFCs”) (whether individual or corporate) of mistakes that will likely catch the attention of the Internal Revenue Service (“IRS”) and trigger a potential costly audit. This is the seven of a series of articles designed to educate CFC shareholders of mistakes that can catch the attention of the IRS.
Individual shareholders of CFCs that recognize a GILTI inclusion may be taxed at federal rates up to 37 percent, plus another 3.8 percent Medicare Tax. Absent planning, no direct foreign tax credit is available to offset the GILTI inclusion. Because the GILTI inclusion is so excessive, many CFC shareholders make a so-called Section 962 election to reduce the tax liability associated with GILTI (and in some cases subpart F income). Making a Section 962 election may also allow a CFC shareholder to claim a direct foreign tax credit to further reduce the U.S. tax consequences on foreign source income. 962 elections have become a popular way for CFC shareholders to reduce their U.S. tax consequences on foreign source income. However, 962 elections have a number of downsides. One of which includes more tax compliance requirements. If a CFC shareholder making a 962 election intends to claim a direct foreign tax credit, he or she must complete both IRS Form 1116 “Foreign Tax Credit (Individual, Estate, or Trust”) and IRS Form 1118 “Foreign Tax Credit-Corporations.” Failing to attach these forms to a CFC shareholder’s individual tax return is a mistake that will likely catch the attention of the IRS.
History of Section 962
Internal Revenue Code Section 962 was enacted in the 1960s. At the time Section 962 was enacted, the highest individual tax bracket was 91 percent and the highest corporate tax rate was 52 percent. With the enactment of Section 962, Congress provided individuals with the means to reduce their U.S. tax liability on foreign source income to a reduced corporate rate. Individual taxpayers were also permitted to claim deemed-paid tax credits under Internal Revenue Code Section 960 for taxes paid by CFCs outside the United States.
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 U.S. individuals at high bracket rates with respect to earnings in a foreign corporation. Section 962 gives such individuals assurance that their tax burdens, 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), reprinted at 1962-3 C.B. 703, 798.
Federal Tax Consequence of Making a Section 962 Election
The U.S. federal income tax consequences of a CFC shareholder making a Section 962 election are 1) the CFC shareholder is taxed on amounts included in his or her gross income under Section 951(a) or 951A are taxed at corporate rates. (The current maximum corporate rate is 21 percent compared to 37 percent for individuals). 2) the CFC shareholder is entitled to a deemed-paid foreign tax credit under Section 960 as if the individual were a domestic subchapter C corporation. 3) When the CFC makes an actual distribution of earnings that has already been included in gross income by the CFC shareholder under GILTI or subpart F income, Section 962(b) requires that the earnings be included in the gross income of the CFc shareholder again to the extent they exceed the amount of U.S. income tax paid at the time of the Section 962 election
962 Compliance Requirements
There are a minimum of four compliance requirements necessary to successfully make a 962 election. First, an annual election must be made with the CFC shareholder’s timely filed tax return to which the election relates. Second, the CFC shareholder must attach a Form 5471 along with all required schedules to his or her individual income tax returns. Third, the CFC shareholder must attach Forms 1116 and 1118 to his or her individual income tax returns. The Form 1116 must disclose the full foreign tax credits the CFC shareholder is entitled to claim. The Form 1118 must disclose all of the foreign taxes paid by the CFC regardless of the fact the shareholder is entitled to claim these credits on his or her individual income tax returns. Failure to attach Form 1116 and Form 1118 can result in the IRS disallowing the direct foreign credit(s) claimed by the CFC shareholder.
The failure of a CFC shareholder making a 962 election to attach Forms 1116 and 1118 can be a costly mistake. As discussed above, it can result in the denial of valuable foreign tax credits.
If you are concerned whether or not a 962 election was done properly on your behalf, or you are considering making a 962 election, you should consult with a qualified international tax professional. We provide international compliance assistance and international tax planning services to domestic corporations. 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: email@example.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.