29 Apr 3 Times GILTI May Still Apply To You
The danger of the new Global Intangible Low Taxed Income (GILTI) rules has been greatly reduced with the new proposed regulations recently released. These regulations allow individuals filing under Sec. 962 to receive a 50% deduction on GILTI income. Taking that into account, there are still times when individuals living abroad will get hit with the GILTI tax. Below, we will point out three scenarios when GILTI tax will still be due, even with the new beneficial rules.
What Is GILTI?
As a background to GILTI, starting in 2018 the annual profits of any controlled foreign corporation (CFC) being held by U.S. people will be taxed to the shareholders directly. Until GILTI, if the company had active income, it would stay in the company and be deferred until the shareholder took out dividends. Now, even if the money is not withdrawn, it is taxed on the individual shareholder level.
The IRS released proposed regulations for IRS code section 250, which allowed certain individual shareholders to enjoy a 50% deduction on this income pickup. This is achieved by electing IRS code section 962 allowing the individual to be taxed at lower U.S. corporate tax rates and enjoy both the 50% deduction and an 80% tax credit for the foreign taxes paid at the CFC level.
As a quick example, assume you owned 100% of a foreign corporation which earned 100USD of profit for 2018 and paid 23% foreign corporate taxes. You as the U.S. shareholder would have to report the $100 on your personal tax return and pay taxes up to 37%. It would not make a difference that the company paid $23 of tax due or that you live abroad.
If you elect Sec. 962 however, the net result would be that you get half off on the $100, taxed at the U.S. corporate rate of 21%, and get an 18.4% foreign tax credit (23%*80%.) This would end with a zero tax due result ($100/2=$50; $50*21%=$10.5; $10.5 – $18.4=no tax due).
I am oversimplifying the equation (and yet it’s still not so simple), in the hope of getting the main ideas across. For a more detailed analysis, please check out our other blog posts on GILTI here.
This can lead you to think that if you elect Sec. 962, then GILTI will never apply. However, there are indeed some very real times that it will. So let’s jump into some of the most common examples of when GILTI will still be problematic:
Your foreign corporation is in a tax haven
This may be the most common case where section 962 will still have tax due. This would be the case if your foreign corporation is created in the Bahamas, British Virgin Islands, Cayman Islands, Hong Kong, Panama, or St. Kitts and Nevis to name a few. Since they have zero corporate tax, even if you elect sec. 962, you will not have any foreign tax credits to offset your tax due. This also makes sense, as these types of entities are one of the main targets of the 2017 tax reform which created GILTI
This does not mean that Sec. 962 is not helpful. It very well might still be. Remember that if you don’t use Section 962, the individual tax rates can reach as high as 37%. Since you would still get the 50% deduction, and favorable corporate tax rates, the end result is a 10.5% tax when electing Sec. 962. This doesn’t mean Sec. 962 will always be lower, but it can be.
You have built up losses in your foreign corporation
This is a big potential issue that most do not realize. In many non-U.S. countries, if your company has prior year losses and current year income, they will wipe each other out and you will not pay foreign taxes. For example, if you had a business loss of $1M in 2018, and then in 2019 you had $1.2M of net profit, you may only pay foreign corporate tax on the $200K difference.
GILTI tax in the U.S. looks at each individual year on its own, so while there was no tax on the loss in 2018, the $1M loss will not offset the $1.2M income in 2019. This leaves you with a large amount of tax due with your 2019 U.S. tax return. This would be the case even if you use Sec. 962.
As a quick example to tie it all together: say you are still in the 23% foreign corporate tax local. You would pay foreign corporate taxes of 46,000USD or 23% of the $200,000 mentioned above ($1.2M-$1M prior year losses). Under 962 the GILTI tax would come out as follows:
$1.2M * 50% = $600,000
21% * 600,000 = $126,000
Foreign tax credits = 80% * $46,000 = $36,800
Net GILTI tax = $126,000-$36,800 = $89,200 of tax due.
Your foreign corporation is treated as an LLC or pass-through for the foreign country
An example of this would be the Israeli chevra mishpachtit which has no corporate tax in Israel, but passes all the tax to the individual shareholders. The U.S. default of these foreign LLC’s is to treat them as closed corporations, unless an election is made on Form 8832 –Entity classification election.
Hence, on your U.S. tax return, you will still need to pick up the income as GILTI. You would not have foreign corporate taxes to offset this GILTI income with the 962 election and could end up with a hefty tax bill. The real interesting question is what happens if you do not elect Sec. 962 in this case, but I’ll leave that for another time.
You will notice that the common denominator in all three of these cases, is that the foreign corporate tax was not high enough. The magic number until the year 2025 is 13.125%. If you have foreign corporate tax of 13.125% or more, than with the 50% deduction and the 80% foreign tax credit, you would end up with zero tax due on GILTI using Section 962.
With all the new regulations and updates coming out, GILTI is not as bad as it originally looked, but it is still very important to make sure you plan for and stay aware of it. If any of the above three exceptions apply to you, or you need help preparing your return with Sec. 962 to help abate any GILTI taxes, please feel free to reach out to us.
The writer is the manager of the Individual & Partnership Department at Philip Stein & Associates.