The Tax Cuts and Jobs Act (TCJA), signed into law on December 21, 2017, resulted in sweeping changes in the US tax laws for the first time since 1986. While much of the focus has been placed on TCJA’s impacts on domestic activities of individuals and businesses (e.g., 20 percent pass through deduction, lower corporate tax rate), the impact on international activities also warrants a similar level of attention and analysis.

The TCJA fundamentally changes the way multinationals are taxed on their worldwide income. Prior to the TCJA, the tax goal for most outbound multinationals was to defer paying US income taxes on the income earned by foreign subsidiaries until the earnings were repatriated back to the US shareholder parent. Outbound tax planning strategies included optimizing foreign tax credit utilization and circumventing the anti-deferral provisions of the Internal Revenue Code, also known as sub-part F.

The major international tax law changes under TCJA includes a participation exemption system for domestic corporate shareholders, whereby dividends from foreign subsidiaries are subject to 100 percent dividend received deduction. As a transition to the participation exemption system, the TCJA enacted I.R.C. §965, whereby US shareholders of a controlled foreign corporation (CFC) were subject to a deemed repatriation of all untaxed earnings and profits of the CFC on December 31, 2017. The §965 tax was commonly referred to as the “toll tax” and the “transition tax.” Needless to say, many taxpayers were faced with a higher than usual tax liability on April 15, 2018 as a result of §965.

While the participation exemption system is welcomed by many corporate shareholders, the TCJA also introduced a new anti-deferral provision under I.R.C. §951A, known as global intangible low-taxed intangible income (GILTI), that could diminish or eliminate the benefits afforded under the participation exemption system.

Under §951A, beginning in 2018, a United States shareholder of a CFC must include in income its pro-rata share of GILTI from the CFC. In order to appreciate the magnitude of this provision, one must have a good grasp of some important defined terms under the Internal Revenue Code.

First, a United States shareholder is defined as a US person who owns 10 percent or more of the total combined vote or value of the CFC’s stocks. It should be noted that the TCJA added the “value” test in the definition of a United States shareholder.

Second, a controlled foreign corporation is any foreign corporation if more than 50 percent of the total voting power of all classes of stock entitled to vote or 50 percent of the value of the stock is owned by or considered owned by a US shareholder on any day during the taxable year of such foreign corporation. In other words, GILTI only applies to CFCs. If the foreign corporation has majority non-US shareholders, GILTI would generally not be applicable.

Observation: Instead, the minority US shareholder(s) should look to the Passive Foreign Investment Company provisions to determine the US income tax consequences of the foreign corporation. A strong argument can be made that the Passive Foreign Investment Companies (PFIC) regime leads to a less desirable income tax result than the CFC regime.

GILTI is the excess of the foreign corporation’s net CFC tested income over its net-deemed tangible income return. Once again, a solid understanding of the defined terms under the GILTI provision is needed. Net CFC tested income is the foreign corporation’s tested income over its tested losses. Tested income is the foreign corporation’s net income other than the following:

• Subpart F income
• US effectively connected income
• Amount of income excluded under high-tax exception
• Dividend received from a related person
• Oil and gas income

Tested losses are the excess of the deductions against tested income over the foreign corporation’s gross income.

Observation: If the foreign corporation’s net CFC tested income is negative, then the foreign corporation should not be subject to GILTI. Also, a US shareholder’s subpart F income is limited to the CFC’s current year earnings and profits.

Net deemed tangible income return is the excess of:

• 10 percent of the aggregate of the shareholder’s pro rata share of qualified business asset investment of each CFC, over
• Interest expense used for calculating net CFC tested income.

A foreign corporation’s qualified business asset investment (QBAI) is the quarterly average of the CFC’s aggregated adjusted basis, calculated using the alternative depreciation system, in a specified tangible property (i.e., depreciable property used in a trade or business).

Observation: The mechanics in calculating GILTI may suggest Congress’s intentions behind the GILTI provisions: Unless a foreign corporation has real substance (i.e., property, plant, equipment) in the foreign jurisdiction, the utilization of a foreign corporation to conduct business is discouraged and will lead to current US taxation in most, if not all, of the foreign corporation’s current year profit.

The impact of the GILTI provision is demonstrated by the following example:

Dave, a US citizen, lives full time in Singapore. Dave owns 100 percent of a Singapore corporation, in which he conducts his IT consulting business. Due to the nature of the business, the only asset in the corporation is his laptop, which has an adjusted basis of $1,000 USD. The company’s 2018 net income is $150,000 USD.

This simple yet common fact pattern would yield the following income tax results in 2018:

• CFC tested income: $150,000 (assumes the company has no subpart F, US ECI, etc.)
• Qualified business asset investment: $1,000
• Net deemed tangible income return: $100 (QBAI x 10 percent)
• GILTI: $149,900 ($150,000 - $100)

On his 2018 US income tax return, Dave would need to include GILTI of $149,900 on his Form 1040 as ordinary income. The GILTI would be subject to tax at Dave’s ordinary tax rate. If Dave paid Singaporean income tax in 2018, Dave would be able to utilize foreign tax credits to mitigate the effects of double taxation on the GILTI.

Observation: For individual taxpayers, absent any elections or tax planning (both discussed below), GILTI will lead to double taxation on the earnings of the foreign company (i.e., foreign tax at the company level and US individual tax on the deemed income at the individual level).

Dave can consider paying himself a salary from the Singapore company to avail himself of the foreign earned income exclusion.

The salary is an expense that could decrease the company’s tested income and reduce the GILTI inclusion.

The impact of GILTI differs dramatically between corporate and individual shareholders. US corporate shareholders are allowed a deduction equal to 50 percent of the GILTI income, resulting in an effective tax rate of 10.5 percent. However, an individual does not receive the benefits of any deductions against GILTI and the GILTI is taxed at the individual’s ordinary tax rate, which can be as high as 37 percent.

In addition, US corporate shareholders are allowed a deemed foreign tax credit of up to 80 percent of the foreign taxes imposed on GILTI. Individuals, on the other hand, are not eligible for deemed paid foreign tax credits.

Observation: The international tax provisions, in particular the participation exemption, GILTI, and indirect foreign tax credits, are welcomed for corporate shareholders. My view is that the income tax consequences for multinationals that are individual and pass-through entities were not contemplated thoroughly during the drafting of these legislations.

Not all is doom and gloom for individual shareholders. I.R.C. §962 allows for an individual shareholder of a CFC to elect to be taxed as a corporation for purposes of subpart F income. Prior to the TCJA, this election was often overlooked due to the pre-TCJA corporate tax rate of 35 percent. The §962 election would allow an individual taxpayer’s GILTI to be taxed at 21 percent. In addition, the election would also allow an individual shareholder to avail himself or herself of the deemed foreign tax credit under §960, which but for this election, is only allowed for corporate shareholders.

The downside of a §962 election is that the earnings that are included currently under this election would be taxed again upon an actual distribution from the CFC at a future date. Furthermore, it is unclear whether the §962 election would allow the individual shareholder to also take advantage of the 50 percent GILTI deduction as discussed above.

Individual shareholders may also consider interposing a domestic holding corporation to hold the shares of the CFC. By doing so, the domestic corporation may be able to avail itself of the 100 percent dividend received deduction and the 50 percent GILTI deduction. Similarly, pass-through entities who are shareholders of CFCs may consider a conversion to a domestic corporation for the same reasons. However, while a domestic holding company structure may be beneficial from an international tax perspective, one must keep in mind that dividends, if any, from the domestic company will be subject to a second layer of tax at the individual shareholder level.

Finally, individual shareholders may also consider a check-the-box election under the entity classification regulations to treat the foreign corporation as a partnership (if there is more than one owner) or a disregarded entity (if there is one owner) for US tax purposes. Under a passthrough structure, the GILTI provision, along with other anti-deferral provisions under subpart F, would not be applicable. The losses and income of the foreign entity would flow through to the US shareholders. In addition, any foreign income taxes paid by the foreign entity would also flow through, which would allow the individual shareholder to benefit from any direct foreign tax credit.

Observation: Generally, a check-the-box election may be retroactive up to 75 days of filing the Form 8832. Revenue Procedure 2009-41 allows for a retroactive election up to three years and 75 days.

For a new foreign entity, the election to treat the entity as a passthrough would generally be tax free. However, for an existing entity, the election would cause a deemed taxable liquidation under I.R.C. §331. Therefore, before an election is made, one must examine carefully the consequences of a §331 liquidation.

Observation: Individual shareholders of CFCs should review the CFC’s operations and estimate the impact of the GILTI provisions. 2018 estimated tax payments may need to factor in any potential GILTI inclusions on the 2018 income tax return.

Tax advisors should approach international tax planning under a set of new lenses. The pre-TCJA planning that involves deferral of income tax on foreign earnings will no longer be effective due to the GILTI provision and the participation exemption system. As discussed above, individual shareholders will shoulder the tax consequences of GILTI far worse than domestic corporate shareholders. For advisors with multinational clients, the first half of 2018 was dominated by discussions and calculation of the §965 transition tax, which is a one-time tax. However, for 2018 and beyond, the focus should change to more holistic international tax planning under the TCJA.

Note: As this article is going to press, the IRS and Treasury released proposed regulations to provide additional guidance on the GILTI provisions. The 157-page proposed regulations addressed areas where clarifications were much needed (i.e., calculation of tested income, net investment income tax, stock basis adjustments). However, the proposed regulations failed to provide guidance in other key areas (i.e., §250 deductions, §962 election, and interaction with foreign tax credit provisions).

Moses Man is the CEO of M Squared Tax PLLC, a CPA firm specializing in international taxation for individuals and small businesses. He is the Chair of the WSCPA International Tax Committee, which is planning the International Tax Conference. Hear Moses discuss International Taxation under TCJA - Impact on Individuals and Small Businesses at the 2018 Pacific Tax Institute, October 29-30. You can contact him at moses@msquaredtax.com.

This article appears in the fall 2018 issue of the WashingtonCPA Magazine. Read more here.

Learn more at the Pacific Tax Institute, October 29-30, at the Bell Harbor International Conference Center in Seattle. Register here.