Proposed Regulations Provide Relief for Individual and Pass-Through Shareholders of Controlled Foreign Corporations

Summary

On March 4, the US Treasury and the IRS issued proposed regulations (the “Proposed Regulations”) under Sections 250 and 962 of the Internal Revenue Code (the “Code”) providing guidance on legislative changes enacted as part of the Tax Cuts and Jobs Acts, P.L. 115-97 (2017) (the “Act”). As described below, this guidance provides welcome relief to US individual and pass-through owners of certain foreign corporations with respect to the taxation of their share of such foreign corporations’ non-US earnings by providing certain deductions that were not clearly available under the statutory language.

Background

Before the Act, the US employed a worldwide taxation system that taxed domestic and foreign income of a US person on a current basis but, subject to the application of the controlled foreign corporation (CFC) and passive foreign investment company anti-deferral regimes, generally delayed US federal income taxation of income earned through an ownership interest in a foreign corporation until such income was repatriated in the form of a dividend (generally referred to as the “deferral regime”). This deferral regime resulted in US multinational corporations accumulating significant earnings abroad.

Very generally, the Act ended the deferral regime and instead implemented a partial territorial taxation system that exempts certain foreign earnings by providing US corporations with a 100% dividend received deduction for dividends from foreign subsidiaries.¹ However, via a new Code Section 951A, the Act created a significant exception to this territorial taxation system by subjecting 10% US shareholders of CFCs to current US federal income tax on their “global intangible low-taxed income” (GILTI). Despite its name, GILTI is not limited to low-taxed income from intangible property. Rather, GILTI is a US shareholder’s pro-rata share of its CFCs’ “tested income” (generally, most of their income in excess of a 10% return on the tax basis of their depreciable tangible property), which casts a much wider net than what the acronym GILTI might suggest on its face.

To limit the tax burden from the GILTI inclusion, Congress provided deductions under Code Section 250 (the “Section 250 Deductions”) for:

• 50% of a US corporation’s GILTI (the “GILTI Deduction”); and
• 37.5% of a US corporation’s foreign income in respect of intangible property located in the US (referred to as foreign-derived intangible income or “FDII” and this deduction, the “FDII Deduction”).²

Although tax on GILTI is applicable to all 10% US shareholders of CFCs, like the dividend received deduction under Code Section 245A, the Section 250 Deductions are only available to “domestic corporations” under the statutory language. Accordingly, individual taxpayers and partnerships that hold interests in CFCs may be at a significant rate disadvantage relative to corporations and may be incentivized to hold their shares in such CFCs through domestic corporations.

Individual 10% US shareholders of CFCs have long been entitled to make an election under Code Section 962 to be taxed at the corporate income tax rate with respect to certain income of their CFCs (including GILTI since the Act) and to take advantage of foreign tax credits with respect to such income (the “Section 962 Election”).³ However, until the Proposed Regulations, it was not clear whether individual shareholders making a Section 962 Election could obtain the benefit of either of the Section 250 Deductions.

Effect of Proposed Regulations

The Proposed Regulations would allow an electing individual to reduce his or her taxable income by the GILTI Deduction that would otherwise be allowed to a domestic corporation. The Proposed Regulations do not, however, permit individual taxpayers to receive a FDII Deduction.

We anticipate that shareholders, including investors in private equity funds and other pass-through entities with significant foreign operations, will find meaningful relief in the Proposed Regulations. However, US shareholders must carefully weigh various considerations when deciding whether to make Section 962 Elections as compared to instead holding their interests in CFCs through domestic corporations. These considerations include:

• The administrative burden associated with annual elections, tracking CFC earnings and profits that are attributable to the GILTI inclusion, and maintaining hypothetical tax accounting for the fictional “corporation” resulting from a Section 962 Election.
• The inability of an individual to benefit from the Section 245A participation exemption for dividends from CFCs even if the individual makes a Section 962 Election.
• The double taxation of a CFC’s foreign earnings inherent to a Section 962 Election. Under the elective regime, the GILTI Deduction reduces the tax the US individual will bear on a current basis with respect to its GILTI. However, the individual is taxed again, often at the highest individual marginal income tax rate, when cash is distributed in an amount that exceeds the amounts of tax previously paid as a result of the Section 962 Election (see illustrative example below).⁴
• Exit considerations, such as the preference of potential buyers to purchase a CFC or a US blocker or the potential tax costs, must be taken into account.
• Alternatively, the benefit of a complete flow-through structure should also be weighed against the use of corporations or the Section 962 Election. If a CFC makes an election to become a disregarded entity for US federal income tax purposes, there will be an exit tax cost on the deemed liquidation of the CFC, but the foreign income will no longer be subject to GILTI. Instead, foreign earnings will be subject to the US corporate income tax, which may be offset by its allocable foreign tax credits.

In addition to the GILTI Deduction relief for individual US shareholders, the Proposed Regulations provide guidance on the computation of Section 250 deduction with general rules for determining a domestic corporation’s Section 250 deduction, rules on how to apply the taxable income limitation in Sec. 250(a)(2), definitions that apply for purposes of the proposed regulations, and clarity on the treatment of related party transactions for purposes of FDII.

As with almost all aspects of the substantial changes the Act made to the US federal income tax system, taxpayers will need to carefully determine, often through detailed modeling exercises, whether the Proposed Regulations, coupled with a Section 962 Election, may create a benefit for them.

¹ The 100% dividend received deduction for dividends from foreign subsidiaries is codified as Code Section 245A. As part of the transition to the new partial territorial regime, the Act ended US tax deferral by way of a deemed repatriation under new Section 965 of the Code.

² GILTI and the GILTI Deduction, in conjunction with the GILTI foreign tax credit rules under Section 960(d), essentially act as a minimum tax on foreign earnings for US shareholders with an effective tax rate of 13.125% (before expense allocations). The FDII Deduction results in an effective tax rate of approximately 13.125% as well.

The GILTI deduction and the FDII deduction are reduced to 37.5% and 21.875%, respectively, in taxable years beginning after December 31, 2025, resulting in an effective tax rate of 16.406% for both types of income.

³ The Section 962 Election is an annual election made on a timely filed U.S. tax return, allowing taxpayers flexibility in determining whether to continue to make the Section 962 Election or to be taxed as an individual in future years. Electing individuals should also file Form 8993, “Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI)” to receive their GILTI Deduction.

⁴ See Smith v. Comm’r, 151 T.C. 5 (2018) (ruling that distributions from a CFC to a Section 962 Election electing individual should, generally, be taxed at ordinary rates rather than the qualified dividend rate, but also reserving on the treatment of CFCs in a jurisdiction where the United States has a tax treaty or instances where the CFC is publicly traded on a US stock exchange).