Understanding the Impact of GILTI

Volume No. US-19-15

We continue to receive queries from advisors and clients who do not understand how the U.S. Global Intangible Low Taxed Income (GILTI) rules will impact them.  They read generic promotional pieces from financial advisory firms and banks, on various U.S. tax issues, and become worried over what they read. The intent of this U.S. Tax Tip is to provide an example of how the GILTI provisions may impact a U.S. citizen Canadian resident who owns a Canadian corporation that is carrying on an active business in Canada.  Each client situation, however, is different and an appropriate analysis of a taxpayer’s specific facts need to be considered in determining how GILTI will impact them.   The example below is meant to be for illustrative purposes only.

Assumptions

  • Assume that the Canadian corporation does not qualify for the small business deduction. As such it is taxed at the general corporate rate.
  • Assume that both the shareholder and the corporation are resident in Ontario and, as such, Ontario rates apply.
  • The top Ontario personal tax rate is 53.53%. The top Ontario tax rate on eligible dividends is 39.34%.  The combined federal/Ontario corporate tax rate is 26.5%.
  • Assume $1,000 of active/taxable business income
  • Assume that the entire corporate income will be treated as GILTI for U.S. tax purposes.
  • Assume the U.S. and Canadian dollars are at par.

The Impact

  • The corporation will pay $265 of Canadian/Ontario corporate tax on the $1,000 of taxable income. This will leave $735 of retained earnings in the company that can be distributed as a taxable dividend.  The $735 will be the GILTI income inclusion to the U.S. shareholder.
  • The taxpayer will include $735 as ordinary income on his U.S. personal income tax return. There is no foreign tax credit since the underlying taxes ($265) was paid by the corporation NOT by the shareholder.  GILTI is now in a separate basket for U.S. foreign tax credit purposes so the taxpayer cannot utilize any general or passive basket foreign tax credit carry forwards.
  • If the taxpayer is at the top U.S. marginal tax rate of 37%, there will be an additional U.S. tax liability of $272. Clearly this is not a good thing!  What can be done?

The IRC §962 election

Section 962 of the Internal Revenue Code (IRC) allows “in the case of a United States shareholder who is an individual and who elects to have the provisions of this section apply for the taxable year” to have his subpart F and GILTI income subject to tax at U.S. corporate rates as a hypothetical U.S. corporation.  This election has been in place since January 1, 1963 (enacted as part of the Revenue Act of 1962, P.L. 87-834) as part of the subpart F regime.  When the U.S. corporate tax rate was 35%, making this election was not beneficial to the taxpayer.  Now that the U.S. corporate tax rate was reduced to 21%, making this election is now an option.  What happens if the taxpayer makes this election?

  • The GILTI income of $735 is grossed up by the corporate taxes paid. As such there is $1,000 of income for U.S. corporate tax purposes.
  • IRC §250(A)(1)(B) allows a deduction of 50% of the GILTI inclusion in computing U.S. taxable income. In proposed regulations, issued on March 6th, the IRS stated that it will allow the 50% deduction where the taxpayer is making the IRC §962 election.  As such, the U.S. hypothetical corporate taxable income will be $500 ($1,000 – .5 x ($1,000).
  • The hypothetical U.S. corporate tax, before any foreign tax credit, will be $105 ($500 x 21%).
  • For GILTI purposes, the amount of taxes eligible to be claimed as a foreign tax credit is equal to 80% of the actual taxes paid. The Canadian corporation paid $265 of corporate taxes.  $212 ($265 x 80%) is eligible to be claimed as a foreign tax credit.
  • The allowed foreign tax credit is equal to the lesser of (i) the U.S. taxes on the foreign source income ($105 per 2) above) or (ii) the eligible foreign taxes ($212 per 4) above).
  • A foreign tax credit of $105 will be claimed. This will completely eliminate the hypothetical U.S. corporate tax liability. As such there is NO current year U.S. income tax exposure to the shareholder.
  • To make the IRC §962 election, appropriate disclosures need to be filed with the taxpayer’s return every year.

Subsequent distributions

The corporation still has $735 of retained earnings that can be distributed as a taxable dividend to the shareholder.   When the taxpayer makes an IRC §962 election, there is (in general) no addition to the previously taxed earnings and profits (PTEP) pool.  As such when the $735 is distributed, the income is taxed on the shareholder’s U.S. income tax return as a foreign source dividend.  He will pay Canadian tax of $289 ($735 x 39.34%), just as he normally would regardless of what election was made for U.S. tax purposes.  The current maximum U.S. personal tax rate on qualified dividends is 20%.  As such the U.S. tax before any foreign tax credit is $147 ($735 x 20%).  Since the associated Canadian tax of $289 would be in excess of the corresponding U.S. tax of $147, there will be no U.S. income tax.  There may, however, be the U.S. Net Investment Income Tax (NIIT) depending on the taxpayer’s modified adjusted gross income, etc.

Other provinces

Even if an IRC §962 election is made, U.S. tax could arise in those provinces where the small business rate is quite low (remember only 80% of the actual corporate taxes are eligible to be claimed as a GILTI foreign tax credit).  Manitoba, for example, has a zero provincial tax rate on small business income.  For a CCPC in Manitoba the effective tax rate is 9% (the federal rate) on the first $500,000 of active business income. In the case of a Manitoba CCPC the Canadian corporate tax would be $90 ($1,000 x 9%).  As such there would be a hypothetical U.S. corporate tax of $33 [($105 per 3) above) – $72 ($90 x 80%)]. Though there is a U.S. tax exposure, given the deferral of Canadian personal taxes, this option may still be a viable alternative.

Summary

The 2017 Tax Cuts and Jobs Act (TCJA) clearly added a lot of complexity with respect to U.S. citizens, Canadian residents who own Canadian corporations.  In our opinion Congress, in their attempt to curb abuses (real or perceived) by large U.S. multinational companies, failed to consider the impacts of these changes on small business owners.    Such taxpayers need to consider making the IRC §962 election in order to mitigate the potential impacts of GILTI.

 

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The material provided in this U.S. Tax Tip is believed to be accurate and reliable as of the date of posting. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither Cadesky Tax nor Cadesky U.S. Tax can accept any liability for the tax consequences that may result from acting based on the contents hereof.