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Transition Tax Is Not the Same Thing as GILTI Tax

Transition Tax Is Not the Same Thing as GILTI Tax
Ines Zemelman, EA
28 January 2022

Do not confuse section 965 Transition Tax with GILTI Tax: the former is a one-time event; the latter is annual tax starting from 2018 tax year.  Both GILTI and the Transition Tax apply to U.S. shareholders of CFCs, and the Transition Tax also applies to corporate U.S. shareholders of a foreign corporation even if it is not a CFC. 

What is the transition tax?

IRS Transition Tax is levied on the deemed repatriation of post-1986 accumulated earnings and profits (E&P) of a foreign corporation that have not been taxed by the IRS in the past.  If there is an earnings and profits deficit, U.S. shareholders would not be subject to the transition tax.  Also, pursuant to IRC Section 965, the positive earnings and profits of one foreign corporation can be offset by a deficit in another foreign corporation owned by the taxpayer.

Calculation of untaxed Earnings and Profits starts from the year where the foreign corporation became a Controlled Foreign Corporation. If the corporation was inherited by a US person in 2016, then the calculation of earnings and profits subject to Sec 965 inclusion starts in 2016.  Prior earnings and profits are disregarded.

Also, if the individual owned the corporation in the past, yet met the Substantial Presence test or become a Green Card holder in 2016 - then the calculation of untaxed earnings and profits starts in the year where he became a US person. 

Likewise, US owners of CFC who expatriated prior to November 2, 2017 do not pay Transition Tax. If they are not covered expatriate then accumulated earnings and profits in the CFC will never be taxed by the IRS.

IRS Form to be filed for Transition tax calculation

Form 965 and separate Schedules F and H are used to report:

  1. share of section 965(a) inclusions from pass-through entities, share of foreign taxes deemed paid and foreign taxes deemed paid but disallowed under section 965(g), in connection with the 965(a) inclusions from pass-through entities
  2. Section 965(c) deductions from pass-through entities.

There are mainly three types of entities related to IRC Section 965:

Controlled foreign corporation (CFC) - CFC - A CFC is a foreign corporation of which more than 50% of the total combined voting power or value is owned directly, indirectly, or constructively (within the meaning of section 958) by U.S. shareholders on any day of the tax year. 

Deferred foreign income corporation (DFIC) - DFIC is any specified foreign corporation that has accumulated post-1986 deferred foreign income as of November 2, 2017 or December 31, 2017, that is greater than zero.

Specified foreign corporation (SFC) - In addition to CFCs, an SFC is "any foreign corporation with respect to which one or more domestic corporations is a United States shareholder.

IRS GILTI Tax

​​​​​​IRS GILTI tax (Global Intangible Low-Taxed Income) is the global analogy to the Alternative Minimum Tax (AMT) - it is the share that any US owner of Controlled Foreign Corporation (CFC) must pay to the IRS every year on their portion of a CFC’s non-previously taxed and undistributed earnings each year, regardless of whether he has other taxable income or not. GILTI is a tax on income earned by a foreign subsidiary which is considered intangible income in a low tax jurisdiction.

 

US shareholders holding ownership in a CFC or multiple CFCs in accordance with section 958(a) required to include GILTI in gross income and may have a form 8992 GILTI requirement.  The main priority for GILTI is to ensure U.S. shareholders of Controlled Foreign Corporations (CFCs) are paying necessary tax on certain income generated from foreign businesses — even if it is not repatriated. GILTI does not apply to all taxpayers, and it does not apply to all types of foreign income; it is not the same as Subpart F Income.

CFC - A CFC is a foreign corporation of which more than 50% of the total combined voting power or value is owned directly, indirectly, or constructively (within the meaning of section 958) by U.S. shareholders on any day of the tax year. 

U.S. shareholder - A U.S. shareholder is a U.S. person who owns (directly, indirectly, or constructively, within the meaning of section 958) 10% or more of the total combined voting power of all the classes of voting stock or 10% or more of the total value of shares of all classes of stock of a specific foreign corporation.  A Specified Foreign Corporation is a Controlled Foreign Corporation (CFC), or other foreign corporation which is not a passive foreign investment company, with at least one U.S. corporation that is a U.S. shareholder.A U.S. person includes an individual, S corporation, partnership, or limited liability company (LLC).

Example: US person1 owns  54% of the foreign corporations and Non-US person 1 owns 46%.  Foreign corporation is a CFC because US shareholder owns more than 50% and US person is a US shareholder because ownership is more than 10%.

GILTI Forms to be Filed with IRS

US shareholder is required to file Form 8992 and attach separate Schedule A to calculate the GILTI inclusion amounts and to report related information.  If the U.S. shareholder is a member of a U.S. consolidated group, attach Schedule B (Form 8992) and one consolidated Form 8992 to the U.S. consolidated group’s income tax return instead of Schedule A. 

Consolidated Group - An affiliated or consolidated group is a group of corporations with a shared parent company that is entitled to file a consolidated group return.  For a corporation to be included in an affiliated group, the parent must own at least 80 percent of the corporation’s stock and control at least 80 percent of the stock’s voting power.

GILTI Calculation

The basic formula to calculate GILTI inclusion amount is:

GILTI = Net CFC tested income (Part I of Form 8992) minus Net deemed tangible income return (Part II of Form 8992)

Net CFC tested income = Pro-rata share of Tested income minus Pro-rata share of Tested loss

Net Deemed Tangible income return = 10% of QBAI minus Specified Interest Expense

The term qualified business asset investment or QBAI means the average of a CFC's aggregate adjusted bases as of the close of each quarter of the taxable year, in specified tangible property that is used in a trade or business of the CFC and is of a type with respect to which a deduction is allowable under section 167.

Specified tangible property means any property used in the production of tested income.  It does not include assets that are amortizable such as goodwill, patent, trademarks etc.

Specified Interest Expense =  Pro Rata Share of Tested Interest Expense minus  Pro Rata Share of Tested Interest Income

Form 5471 Schedule I-1 (Information for Global Intangible Low-Taxed Income) also report information determined at the CFC level with respect to amounts used in the determination of income inclusions by U.S. shareholders under section 951A. The information in this schedule will be used by the U.S. shareholder(s) of the CFC to file Form 8992 and may assist in the completion of Form 1118, or Form 1116, if applicable

Net Invest Income Tax (NIIT), Sec 965, and GILTI

Net Investment Income Tax (NIIT) does not apply to Sec 965 deemed repatriation income and does not apply to GILTI income. However, NIIT applies whenever a US shareholder receives dividends distributions. On the flip side, dividends distributions from the CFC incorporated in the country with a Tax Treaty are qualified and taxed at the preferential rate of 15% , while GILTI income and Deemed Repatriation income are taxed at the ordinary rate.

962 election transition tax and GILTI Tax

The US individual shareholder of a CFC may take Sec 962 election to have Sec 965 income (deemed repatriation income) or GILTI income taxed at the corporate rate of 21% rather than individual tax rate of up to 37%. Sometimes the corporate tax rate may be higher than the individual’s marginal tax rate, but the individual is entitled to a credit for the indirect foreign taxes paid by the foreign corporation.  If they take the election, they may apply corporate tax paid by CFC in the resident country as a foreign tax credit. The amount of Foreign tax credit will be calculated on form 1118 (foreign tax credit for corporations) instead of form 1116 (foreign tax credit for individuals). Therefore, the individual tax return will involve manual calculations and will not qualify for e-filing.  The election can be made on an annual basis with respect to all controlled foreign corporations of the shareholder and is made on a timely filed US tax return including amended returns.

Additionally, U.S. individual shareholders of CFCs making a section 962 election are allowed to take a deduction equal to the sum of 37.5% of the corporation’s FDII plus 50% of its GILTI under section 250.  Form 8993 is used to figure the amount of the eligible deductions.  If the sum of FDII and GILTI exceeds taxable income, the deduction under section 250 is limited to taxable income.

The words "Will be furnished upon request" - on form 5471 or on the Transition Tax Statement should never be used. If used, the return will be considered incomplete and have high risk of triggering an audit.  

If the CFC owner has state tax obligations - they should review them carefully. Each state has a different position - check individually. Some states include Sec 965 income to the same extent that federal return does. Other states disallow Sec 965(c) deduction taken on the federal return and require full Sec 965(a) inclusion to become part of state taxable income.

The open question related to state reporting of Transition Tax - how does this can apply to the taxpayers who became state residents recently? Should they include to state taxable income earnings and profits accumulated over the time that they were not resident of that state?  This, and other remaining challenges and outstanding issues that have not been addressed will require further IRS guidance.

Uncertain examples

When Transition tax is calculated for a US partnership - Sec 965 income is passed through to the individual partners. However, Sch K in its current version does not have a section for reporting of partner share of Sec 965 income. How to report partner share of Sec 965 inclusion?

Others:

Understanding How to Compute a U.S. shareholder’s GILTI inclusion | Foodman CPAs & Advisors - JDSupra

Global Intangible Low-Taxed Income (GILTI) 

How Form 8992 GILTI Tax Calculations are Prepared

What is GILTI Tax and How Can You Reduce It? | Nomad Capitalist

What is GILTI: IRS Overview of Global Intangible Low-Taxed Income

GILTI Formulas and Election to Individual Taxpayers for GILTI Relief 

Ines Zemelman, EA
Founder of TFX