The Most Costly Mistakes of CFC Shareholders that Catch the Attention of the IRS
Part Eight: Deducting Foreign Tax Credits Paid by a CFC
Introduction
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. This is the eighth part of a series of articles intended to warn individual shareholders of controlled foreign corporations (“CFCs”) (whether individual or corporate) of the mistakes that will likely catch the attention of the Internal Revenue Service (“IRS”) and potentially trigger a costly audit.
The new tax on global intangible low-taxed income (“GILTI”) and the taxation of subpart F income has perplexed many tax practitioners. This is particularly true with claiming foreign tax credits against these sources of income. Absent planning, an individual CFC shareholder cannot offset GILTI and subpart F inclusions with foreign tax credits for taxes paid by the CFC. Despite these rules, a large number of tax professionals incorrectly offset an individual foreign corporate shareholder’s federal tax liability for taxes paid by the CFC. This can result in a costly IRS audit.
The General Rule
The Internal Revenue Code provides that a United States shareholder of a CFC is subject to tax on the CFC’s subpart F or GILTI income. Internal Revenue Code Section 957(a) defines a “controlled foreign corporation” or “CFC” as a foreign corporation of which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned, directly, indirectly or constructively by “US shareholders.” A U.S. shareholder is a U.S. person who owns, or is considered as owning at least 10 percent of the total voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of stock of such foreign corporation.
Most CFCs generate either subpart F income or GILTI.The definition of subpart F income has five components. The most important component is “foreign base company income.” The other four components are: 1) income from certain insurance activities defined in Section 953; 2) certain international boycott-related income; 3) certain illegal bribes, kickbacks or other payments to government officials, employees or agents; and 4) income from certain ostracized foreign countries. GILTI on the other hand, is not subject to any specific categories of foreign source income. Instead, GILTI taxes just about all foreign sources not taxed under the subpart F provisions of the Internal Revenue Code.
U.S. shareholders of a CFC must include any subpart F income or GILTI as ordinary income on their individual income tax returns. The current highest federal tax rate applicable to an individual is 37 percent. Individuals receiving GILTI inclusions may also be subject to an additional Medicare tax of 3.8 percent. In addition, individual U.S. shareholders of foreign corporations cannot offset their federal tax liability with foreign tax credits paid by the CFCs. It is not too difficult to imagine scenarios where U.S. shareholders of foreign corporations pay more in federal, state, and foreign taxes than the actual distributions they receive. On the other hand, domestic C corporations that are shareholders of CFCs are taxed on subpart F and GILTI inclusions at 21 percent. In addition, corporate CFC shareholders can reduce their federal tax liabilities with foreign taxes paid by the foreign corporation. In addition, corporate CFC shareholders can claim a 50 percent deduction against GILTI income under Internal Revenue Code Section 250. In many cases, corporate CFC shareholders pay only 10.5 percent on GILTI inclusions.
As discussed above, individual CFC shareholders are not permitted to offset their federal tax liability with foreign tax credits paid by the foreign corporation. Because the liabilities of individual CFC shareholders are so excessive as a result of not being able to claim associated foreign tax credits paid by CFCs, we have noticed that many tax professionals decide to claim these foreign tax credits anyway. Claiming such a foreign tax credit will likely trigger an IRS audit and the disallowance of the foreign tax credits claimed on the CFC’s shareholder’s individual income tax returns. The IRS will likely assess significant penalties and interest against the CFC shareholder. A better way to reduce excessive CFC liabilities is through comprehensive tax planning. Below, we will discuss three options available to individual CFC shareholders which can minimize the sting of subpart F and GILTI inclusions.
The Subpart F and GILTI High-Tax Exception
The Internal Revenue Code provides a high-tax exception for subpart F and GILTI inclusions. Under the subpart F and GILTI high-tax exception, if a foreign corporation is located in a country that has an effective tax rate that exceeds 90 percent of the U.S. corporate tax rate (18.9 percent), the CFC shareholder may be able to defer or delay the U.S. tax consequences of the subpart F or GILTI inclusion. When applicable, the high-tax exception may result in the CFC retaining the undistributed profits as E&P. This would result in a subsequent distribution of this E&P being a taxable dividend to the individual shareholder of the CFC at a future date. The way to think of the subpart F and GILTI high-tax exception is as an interest free loan on a subpart F or GILTI inclusion.
There is a significant downside to making a subpart F or GILTI high-tax exception election in that making such an election does not permit the individual foreign corporate shareholder to offset their federal liability with foreign taxes paid by their CFCs. However, in certain cases, a distribution from a high-tax exception may be reduced through a tax treaty.
Establishing a Domestic Holding Company
Individual CFC shareholders may reduce their subpart F or GILTI inclusions by contributing their foreign stock to a domestic C corporation. The short-term benefits of contributing foreign corporate shares to a domestic corporation is immediate. Properly contributing CFC shares to a domestic corporation could result in a reduction in the highest federal tax rate to 21 percent on foreign source income. The shareholder can also benefit from being able to claim foreign tax credits paid by the CFC and a 50 percent deduction on GILTI inclusions. A CFC shareholder may be able to contribute his or her shares into a domestic holding company tax-free through the tax-free exchange under Internal Revenue Code Section 351.
Anyone considering contributing foreign corporate shares to domestic corporate shares must consider the long term consequence of such a transaction. Once the CFC shareholder sells his or her foreign corporate shares, the CFC shareholder will be subject to two layers of tax. Although some planning options are available to reduce the impact of the double tax associated with the sale of CFC shares, such as making a Section 338(g) election, anyone considering using this strategy must carefully weigh the income tax savings vs. the increased tax liability associated with the sale of the CFC shares before dropping CFC shares into a domestic holding company.
Section 962 Election
The Internal Revenue Code permits some individual CFC shareholders to be treated as domestic C corporations for purposes of subpart F and GILTI inclusions. A Section 962 election permits individual CFC shareholders to pay a maximum of 21 percent on subpart F inclusions and also permits individual CFC shareholders the ability to offset their subpart F liability with foreign tax credits for taxes paid by the CFC. A 962 election can also reduce the GILTI inclusion to 10.5 percent. With that said, Section 962 requires that foreign source earnings be included in the gross income of the individual shareholder again to the extent that it exceeds the amount of U.S. income tax paid at the time of the Section 962 election. In other words, depending on the CFC’s E&P, a 962 election generates a second layer of tax as if the CFC shareholder received a distribution from a C corporation. Whether or not a 962 election will leave the U.S. shareholder in a “better place” in the long run depends on a number of factors that are beyond the scope of this article. In any event, a 962 election should only be made after consulting with a qualified professional who has experience making such an election.
Conclusion
If you own shares of a foreign corporation, it is extremely important that you hire a qualified professional to not only accurately disclose foreign transactions and foreign source income, but also provide you with cutting edge international tax planning advice. We provide international tax compliance assistance and international tax planning to domestic individuals and domestic corporations. Our attorneys can explain, a reputable lawyer may also assist other tax professionals who need guidance regarding international compliance matters.
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.