Demystifying the GILTI High Tax Exception (or - Exclusion): An Expert's Insight
In the intricate realm of international taxation, the Global Intangible Low-Taxed Income (GILTI) stands out as a pivotal subject.
Introduced under the Tax Cuts and Jobs Act (TCJA), GILTI's primary objective is to deter U.S. taxpayers from diverting their income to low-tax foreign jurisdictions.
However, nestled within GILTI is the provision known as the "GILTI High Tax Exception".
This article offers a deep dive into this provision, elucidating its nuances and ramifications.
GILTI: A Brief Recap
Before exploring the high tax exception (exclusion), it's imperative to grasp GILTI's essence.
GILTI targets U.S. shareholders of Controlled Foreign Corporations (CFCs), ensuring they don't gain undue advantages by accumulating substantial profits in low-tax foreign nations.
Essentially, GILTI mandates that certain foreign incomes may be taxable, even if not yet repatriated.
The GILTI High Tax Exception (or - Exclusion): What Is It?
This provision offers relief when the income from a foreign corporation is already subjected to a substantial tax rate in its native country.
If this foreign income undergoes taxation at a rate that's at least 90% of the U.S. corporate tax rate (currently 21%), it can be exempted from GILTI.
“Foreign base company income and insurance income shall not include any item of income received by a controlled foreign corporation if... such income was subject to an effective rate of income tax imposed by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11.” - 26 USC 954
Key Aspects of the GILTI High Tax Exception
The core components of GILTI High Tax Exception that dictate how the provision operates and how taxpayers can leverage it for optimal benefits:
1. Effective Foreign Tax Rate
The foreign income should be subjected to an effective tax rate exceeding 90% of the U.S. corporate tax rate, translating to an effective foreign tax rate above 18.9%.
This rate is crucial as it ensures that the income is genuinely high-taxed and not just a mechanism to bypass the GILTI provisions.
NOTE! This rate is not static; any changes in the U.S. corporate tax rate could affect the threshold for the high tax exception.
2. Election Flexibility
Taxpayers can choose the GILTI high tax exception annually, offering adaptability based on changing financial landscapes.
This annual election provides taxpayers with the flexibility to assess their foreign income streams and the associated tax rates each year, allowing them to make the most informed decision regarding the exclusion.
Pro Tip: it’s crucial to be aware of the election deadlines and the necessary documentation to ensure a smooth election process.
3. Tested Units Approach
The regulations have shifted from the QBU-by-QBU method to a more precise "tested units" approach. This change was implemented to prevent companies from manipulating their income structures to artificially reduce their GILTI.
Under this approach, income is assessed based on specific business units rather than the broader QBU method. This granularity ensures a more accurate representation of the income and its associated tax rate, making it harder for corporations to exploit loopholes.
GILTI High Tax Exception Examples
To better grasp the nuances of the GILTI High Tax Exception, let's delve into a few practical examples.
These scenarios will illustrate how the provision can play out in real-world situations, offering clarity on its implications for U.S. shareholders:
Example 1: Meeting the Effective Foreign Tax Rate
Scenario: John, a U.S. shareholder, owns a Controlled Foreign Corporation (CFC) in Country A. The CFC generates an income of $100,000, and Country A imposes a tax of $20,000 on this income.
Analysis: The effective foreign tax rate for John's CFC in Country A is 20% ($20,000 tax on $100,000 income). Since this rate exceeds the threshold of 18.9% (90% of the U.S. corporate tax rate of 21%), the income qualifies for the GILTI High Tax Exception.
John can exclude this income from GILTI on his U.S. tax return.
Example 2: Falling Short of the Effective Foreign Tax Rate
Scenario: Jane, another U.S. shareholder, has a CFC in Country B. The CFC earns $150,000, and Country B's tax on this income amounts to $25,000.
Analysis: The effective foreign tax rate for Jane's CFC in Country B is 16.67% ($25,000 tax on $150,000 income). This rate falls short of the 18.9% threshold.
As a result, Jane cannot exclude this income from GILTI under the High Tax Exception.
Example 3: Impact of Changing U.S. Corporate Tax Rate
Scenario: Mike owns a CFC in Country C. The CFC has an income of $200,000, with Country C imposing a tax of $38,000. Initially, with the U.S. corporate tax rate at 21%, Mike's income qualifies for the exception. However, the next year, the U.S. corporate tax rate increases to 23%.
Analysis: With the initial U.S. corporate tax rate of 21%, the threshold for the GILTI High Tax Exception is 18.9%. Mike's effective foreign tax rate in Country C is 19% ($38,000 tax on $200,000 income), so he qualifies.
However, when the U.S. corporate tax rate rises to 23%, the new threshold becomes 20.7%.
Now, Mike's income no longer meets the criteria, and he cannot exclude it from GILTI.
Implications for U.S. Shareholders
For U.S. shareholders, the GILTI High Tax Exception isn't just a theoretical tax provision; it has tangible implications that can significantly impact their tax liabilities and compliance requirements.
Here's a closer look at what this means for shareholders:
1. Potential Tax Relief
Shareholders might significantly diminish their U.S. tax obligations by excluding high-taxed foreign income from GILTI.
This relief can lead to substantial savings, especially for shareholders with significant foreign income streams.
However, it's essential to weigh the benefits against the potential costs, such as the complexity of compliance and any foreign tax credits that might be sacrificed.
2. Complexity in Compliance
While the provisions are advantageous, they introduce intricate compliance layers. It's vital for shareholders to meticulously ascertain if their foreign income qualifies for the exception.
This involves understanding the nuances of the "tested units" approach, ensuring accurate documentation of foreign tax rates, and staying updated with any changes in U.S. tax law.
Given the complexities, many shareholders opt to consult with tax professionals to ensure accurate and compliant filings.
Tax Expert Recommendations
- Thorough Analysis: Before choosing the high tax exclusion, a comprehensive analysis is advisable. Factors such as U.S. net operating losses, foreign tax credits, and expense allocation against foreign source income should be considered.
- Stay Updated: Tax laws and regulations are dynamic. It's essential to stay updated with the latest changes and interpretations. Websites like the Internal Revenue Service (IRS) and Tax Policy Center offer valuable insights.
- Consider Future Implications: While the current tax year is crucial, it's also essential to project future tax scenarios. Evaluating how potential changes in foreign income, U.S. tax rates, or foreign tax rates might impact the GILTI High Tax Exception can aid in long-term tax planning.
Seek Professional Guidance: Given the complexities of international tax laws and the GILTI High Tax Exception in particular, it's often beneficial to consult with a tax pro. Their expertise can help navigate the intricacies, ensuring accurate and compliant filings.
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The GILTI High Tax Exception (or Exclusion) underscores the complexities inherent in international taxation. While it presents opportunities for tax savings, it also emphasizes the need for informed decision-making.
As global tax norms continue to shift, staying updated and seeking specialized advice remains crucial.
No, the GILTI High Tax Exception is not inherently a consistency requirement. However, if a taxpayer elects to apply the GILTI High Tax Exception, they must apply it consistently to all Controlled Foreign Corporations (CFCs) in which they are a U.S. shareholder.
This means that if you choose the exception for one CFC, you must apply it to all qualifying CFCs for that particular tax year.
Section 954(b)(4) of the Internal Revenue Code provides a high tax exception specifically for Subpart F income.
According to this section, foreign base company income and insurance income will not be considered as Subpart F income if the taxpayer can establish that such income was subject to an effective rate of income tax imposed by a foreign country that is greater than 90% of the maximum U.S. corporate tax rate.
This provision is designed to exclude from U.S. taxation the income that is already subject to a high level of foreign taxation.
The GILTI High Tax Exception, as finalized in the regulations, is not inherently retroactive. However, taxpayers have the option to apply the final regulations to taxable years of foreign corporations beginning after December 31, 2017, and before July 23, 2020, provided they apply the regulations consistently to all such years.
The Section 962 election allows individual U.S. shareholders of CFCs to elect to be taxed at corporate tax rates on their Subpart F income or GILTI inclusions. This election can provide a potential tax benefit by allowing the individual to claim a foreign tax credit for taxes paid by the CFC.
While the 962 election and the high tax exception are distinct provisions, they can interact. For instance, if an individual makes a 962 election, they might also benefit from the GILTI High Tax Exception, reducing the amount of GILTI inclusion subject to U.S. tax.