By Anthony Diosdi
Internal Revenue Code Section 962 allows a U.S. individual taxpayer that holds shares of a controlled foreign corporations (“CFC”) to elect to be taxed as a subchapter C corporation. This election is applicable to inclusions of subpart F income as defined under Internal Revenue Code Section 951(a) and Section 951A, the global intangible low-taxed income (“GILTI”) tax regime.
In 1962, Congress enacted the subpart F provisions of the Internal Revenue Code. At the time subpart F was enacted, the highest individual tax bracket was 91 percent and the highest corporate rate was 52 percent. Concerned of the impact subpart F income will have on individual taxpayers, Congress provided individual taxpayers with a way to reduce their tax liability on subpart F income through Internal Revenue Code Section 962. Section 962 allows individual taxpayers to avoid what might otherwise be a hardship of being taxed at individual high bracket rates with respect to the earnings from a foreign corporation. Section 962 gives individual taxpayers assurances that their tax burden with respect to foreign earnings will be no heavier than they would have been had he or she invested in an American corporation doing business abroad.
Over the years, the tax disparity between corporations and individuals closed. As such Section 962 was no longer considered a viable tax planning tool in international tax planning. That all changed with the enactment of the 2017 Tax Cuts and Jobs Act. This is because C corporate tax rates dropped to 21 percent. In addition, the effective tax rate that C corporations pay on GILTI income could be as low as 10.5 percent. (This accounts for the 50 percent Section 250 deductions C corporate taxpayers are permitted to claim). Individual taxpayers on the other hand could be subject to federal income rates as high as 37 percent on GILTI income. An additional 3.8 percent net investment income tax (the “NIIT”) is imposed upon the income of certain individuals. In particular, dividend income is subject to the NIIT if the recipient’s income exceeds certain thresholds. To the extent a shareholder is considered a passive investor, the NIIT generally is applicable upon the inclusion of GILTI. Corporate taxpayers are not subject to NIIT.
In almost every case, a GILTI inclusion to a non-corporate shareholder is more expensive than a GILTI inclusion to a corporate shareholder. This is why many U.S. shareholders of CFCs decide to contribute his or her CFC shares to a domestic C corporation. However, there are significant drawbacks of such a contribution. Many foreign jurisdictions, impose direct or indirect income taxes on the transfer of stock from one shareholder to another. The contribution of stock in a CFC therefore could result in a foreign income tax. Many foreign jurisdictions, also impose stamp duty or other transfer taxes on such transfers of stock. Furthermore, once the CFC is owned by a domestic corporation, the income generated from stock ownership is subject to the two layers of tax imposed by corporate form. Rather than placing CFC shares in C corporate structures, individual taxpayers may make a Section 962 election. If done properly, a Section 962 election could result in individual taxpayers paying an effective tax rate on GILTI of only 10.5 percent.
With that said, there are long-term consideration of making a Section 962 election. If an individual CFC shareholder makes a Section 962 election, a later distribution of previously-taxed earnings to that shareholder is, under Internal Revenue Code Section 962(d), again subject to tax as dividend income.
To illustrate the differences U.S. tax consequences of how CFC shares are held, consider the below examples. Assume that a U.S. person wholly owns a single CFC, and that the CFC is subject to a 30 percent effective foreign tax rate. Further assume that the CFC has $1 million tested income before taxes and no “qualified business asset investment” or “QBAI.”
Table 1. Non-Corporate Taxpayer Holding CFC
Net CFC Tested Income (before foreign taxes) $1,000,000
Foreign Taxes (30% rate) $300,000
GILTI (assumes no QBAI) $700,000
Tax (37 percent) $259,000
NIIT $26,600
Total Global Tax $585,600
Table 2. Non-Corporate Shareholder Contributes Stock to C Corporation
Net CFC Tested Income (before foreign taxes) $1,000,000
Foreign Taxes (30% rate) $300,000
GILTI (assumes no QBAI) $700,000
GILTI (After Section 78 gross-up) $1,000,000
GILTI (After Section 250 deduction) $500,000
Tax (21 percent) $105,000
Foreign Tax Credits Available (80 percent limitation) $240,000
Total Global Tax Paid by Corporate Shareholder $300,000
Tax on Distribution from Corporation to Shareholder $166,600
Total Corporate and Individual Taxes $466,600
Table 3. Non-Corporate Shareholder Makes a Section 962 Election
Net CFC Tested Income (before foreign taxes) $1,000,000
Foreign Taxes (30% rate) $300,000
GILTI (assumes no QBAI) $700,000
GILTI (After Section 78 gross-up) $1,000,000
GILTI (After Section 250 deduction) $500,000
Tax (21 percent) $105,000
Foreign Tax Credits Available (80 percent limitation) $240,000
Total Global Tax Paid by Taxpayer $300,000
The above examples demonstrates the possible global savings by making a Section 962 election. Anyone considering making such an election should understand that there are both short and long term consequences to making a Section 962 election. As with any international tax plans, there is no one-size fits all solutions. Individuals holdings CFC stocks should consult with a competent international tax attorney to determine the best way to minimize their U.S. tax consequences associated with those shares.
The tax attorneys at Diosdi Ching & Liu, LLP represent clients in a wide variety of domestic and international tax planning and tax controversy cases.
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 represents clients in federal tax controversy matters and federal white-collar criminal defense throughout the United States. 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.