U.S. individuals who have significant (10 percent or greater) participation in controlled foreign corporations (CFCs) have cause to celebrate after the recent publication of proposed Treasury Regulations on March 4, 2019 implementing a special deduction newly available under the global intangible low-taxed income (GILTI) provisions of the CFC rules. (Prop. Regs. Section 1.962-1.)
Participation Exemption
As part of the 2017 Tax Cuts and Jobs Act (the TCJA) Congress introduced a “participation exemption” for dividends received by a domestic corporation from a 10 percent or greater-owned CFC, but at the same time broadened the income of a CFC attributed and taxed directly to such corporate shareholders to include GILTI, that is, net income of the CFC in excess of a 10 percent notional rate of return on the CFC’s tangible assets. Tax on GILTI attributed from a CFC to a domestic corporate shareholder is imposed at a reduced rate of 50 percent of the normal corporation tax rate (currently 21 percent),that is, 10.5 percent. This reduction is achieved by allowing the corporate shareholder a deduction of 50 percent of the amount of the GILTI under Internal Revenue Code Section 250. Eighty percent of the foreign tax paid by the CFC on its GILTI is allowable to the U.S. corporate as an “indirect” credit against its U.S. liability, so where foreign corporation tax is paid at an average rate of 13.125 percent or greater, U.S. liability of the U.S. corporate shareholder is eliminated.
U.S. individual 10 percent or greater shareholders of CFCs aren’t treated so favorably. While required to recognize GILTI inclusions to the same extent as domestic corporations, they aren’t eligible for either the Section 250 deduction or the indirect credit for foreign taxes paid by the CFC. Accordingly, for an individual, the GILTI inclusion is potentially taxable at 37 percent rather than 10.5 percent and without the possibility of reduction for credits.
IRC Section 962
This brought into focus Section 962, a somewhat obscure provision of the CFC rules that allowed an individual U.S. shareholder of a CFC to elect “in lieu of” the tax regime described above to be taxed on his CFC inclusions at the rate that would be applicable if he used a domestic corporation to hold his CFC shares and taking into account the indirect foreign tax credit that the hypothetical domestic corporation could claim. The downside of a Section 962 election is that, consistent with the treatment of the CFC shares as being held by the electing individual through a notional domestic corporation, any distribution from the CFC will be treated similarly to a distribution from a domestic corporation, that is, taxable as a dividend to the extent of the corporation’s current and accumulated earnings.
When Section 962 was enacted in 1962, the corporation tax rate of 35 percent compared favorably with individual rates of up to 70 percent, making the Section 962 election potentially attractive, but relatively soon after this, individual rates fell, and the Section 962 election ceased to be a tax-effective option. However, with the dramatic cut in the corporation tax rate under the TCJA from 35 percent to 21 percent, as compared with a current top individual rate of 37 percent, Section 962 is back in the limelight.
The TCJA was silent about whether the notional corporation tax computation under Section 962 could take into account the Section 250 deduction. This was of vital importance to individual CFC shareholders as it could spell the difference between no tax on GILTI inclusions (in cases where foreign corporation tax of 13.125 percent or more was being paid) and a “dry” tax charge of 10 percent or more, with the prospect of further tax when distributions from the CFC were received. Failing a favorable outcome of the Section 250 issue, other options, frequently having a significant upfront tax cost, had to be explored, for example, introducing an actual domestic corporation as a holding vehicle for the CFC participation or making a transparency election for (and notionally liquidating) the CFC.
Following the enactment of the TCJA, the first commentators who weighed in on the subject, some of them very prestigious law firms and professional associations, were categoric in asserting that the Section 250 deduction couldn’t be claimed in computing liability under a Section 962 election. Nonetheless, we and other voices in the wilderness took an opposing view, arguing that on a correct reading of the relevant statutes the Section 250 deduction was clearly allowable and urging the Treasury Department to confirm the availability of the Section 250 deduction to individual CFC shareholders who were attributed GILTI income and elected Section 962.
Proposed Regs
The proposed Section 250 regs are among the last of the major regulations implementing the TCJA’s foreign provisions. One look at the proposed regs makes it clear why they were delayed—the Section 250 deduction is fundamental both to the GILTI rules and to the domestic tax relief given to foreign derived intangible income (FDII), and are extremely detailed.
Insofar as the Section 962 election is concerned, the Treasury Department accepted the basic argument advanced by those (ourselves included) who supported the availability of the Section 250 deduction, namely that the 1962 legislative history of Section 962 indicated that Congress intended by the election to put individual shareholders of CFCs on the same footing as those who invested in CFCs through a domestic corporation. This could only be achieved by allowing the Section 250 deduction in the computation of the notional corporation tax liability.
We continue to await vital guidance on other issues under the TCJA, but it’s certainly a good sign that the Treasury has shown some sympathy for individual taxpayers in this latest release.