As discussed in previous blog posts, resident individuals in the United States with investments in foreign corporations, including via pass-through entities such as partnerships and S corporations, must contend with immediate taxation of foreign earnings on an annual basis, generated by Controlled Foreign Corporations (CFCs), either under Subpart F or Global Intangible Low-Taxed Income (GILTI) regime.

For a corporate taxpayer, the combination of a reduced corporate rate, a special deduction and access to indirect foreign tax credits (FTCs) largely mitigates the impact of GILTI (except in scenarios where the foreign entity is paying an extremely low local tax rate). Individuals and pass-through entities receive no such benefits.

More specifically, U.S. corporations are generally subject to a 21-percent federal income tax rate on GILTI. They are also allowed to deduct up to 50 percent of GILTI (i.e., Section 250 deduction) and claim up to 80 percent of foreign taxes paid on the CFCs’ net income as a foreign tax credit. By contrast, U.S. resident individuals are generally subject to a federal income tax rate of up to 37 percent — depending on their tax bracket — and are not allowed a Section 250 deduction or a foreign tax credit for GILTI. This is when a so-called Section 962 election (“Election by Individuals to Be Subject to Tax at Corporate Rates”) should be considered.

HOW A SECTION 962 ELECTION WORKS

When a U.S. individual makes a Section 962 election, the taxpayer is treated as owning the CFC through a fictitious domestic corporation. This enables the taxpayer to benefit from the 21-percent corporate tax rate as well as the Section 250 deduction (for GILTI purposes only). Additionally, the taxpayer can take an indirect foreign tax credit for taxes paid on the CFC’s net income in the foreign country. This is an annual election and can be considered for years when there are potential benefits.

The illustration below shows the different treatment for GILTI for an individual U.S. shareholder of a CFC based on whether or not a Section 962 election has been made.

But what does this mean in actual numbers? Here is an example.

A U.S. individual wholly owns a CFC in Germany. The CFC has net tested income for purposes of GILTI calculation of $1,000. It has paid foreign taxes of $150 in Germany.

In the absence of a Section 962 election, the taxpayer is subject to U.S. tax at a rate of 37 percent ($370). The taxpayer would not be able to offset any U.S. tax by using a foreign tax credit for the taxes paid in Germany and there is no Section 250 deduction available to him or her to reduce the GILTI inclusion.

However, by making a Section 962 election, the individual’s tax burden could be reduced as follows:

No 962 election

962 election

Tax Rate

37 percent

21 percent

Sec. 250 deduction

Not available

50 percent deduction ($500)

Foreign tax credit

Not available

Available up to 80 percent of foreign taxes paid ($150*0.8 = $120)

U.S. tax effect on $1,000 tested income from CFC

$370

$1,000 tested income

-$500 Sec. 250

$500

+$150 Sec 78 gross up

$650

Corporate tax at 21 percent = $137

FTC available: $120

Remaining tax in the U.S.: $17

Effect on previously taxed earnings and profits (PTEP)

PTEP: $1,000

PTEP: $0

Excludable Section 962 Earnings and Profits: $17

Tax effect on distributions in future years ($1,000)

Tax rate: 3.8 percent Net Investment Income Tax (NIIT)

U.S. tax due: $38 ($1,000*3.8 percent)

Tax rate: 20 percent plus 3.8 percent Net Investment Income Tax (NIIT)

U.S. tax due: $234 ($938*23.8 percent)

When the taxpayer in the example above receives a distribution in the amount of $1,000 in a future year, the distribution will be taxed at a favorable rate. This is because Germany and the U.S. have a tax treaty, and under that treaty, the distribution would be eligible for a preferential 20-percent qualified dividend rate plus 3.8-percent Net Investment Income Tax (NIIT).

WHEN SHOULD A SECTION 962 ELECTION BE MADE?

Despite its benefits, a Section 962 election is not always the solution. From the example above, the election looks like a perfect way to avoid taxation on GILTI or Subpart F income. Here are some reasons why this might not always be the case:

  • If the earnings are repatriated in the same year, Section 962 election generally does not provide benefits. Also, when the taxpayer repatriates the earnings of the foreign corporation in a later year, a previous Section 962 election could increase taxes on any cash distributions in future years.
  • The federal tax treatment described above is not followed by all states. Certain states, such as California, do not tax Subpart F or GILTI until a distribution is made from the foreign entity. Accordingly, from a state-tax perspective, neither Section 250 deduction nor foreign tax credits may be available.

With that said, Section 962 election can be a helpful planning tool in the mitigation or deferral of U.S. taxes associated with owning foreign corporations. One should calculate the impact to confirm whether such an election is beneficial in a specific case.

Please contact GHJ’s International Tax Team for a more comprehensive discussion of the tax implications of ownership and income from CFCs as well as various tax planning considerations.

Kristin Popp Inegbedion Website
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Kristin Popp-Inegbedion

CATEGORIES Taxing Thoughts

Kristin Popp-Inegbedion, EA, has 10 years of experience providing international tax consulting and compliance services to clients in the U.S. and Germany. She assists clients on U.S. international tax planning and compliance. Kristin works with businesses and individuals on inbound and outbound…Learn More