March 9, 2018
By Andre Velarde
Published in Tax Notes
The Tax Cuts and Jobs Act has brought newfound attention to an election by individuals to treat themselves as corporations, as well as important questions about uncertainties surrounding its interplay with newly enacted international provisions.
Section 962 was drafted in 1962 and until recently was largely unknown to many practitioners. Under that section, U.S. individual shareholders may annually elect to be taxed at the corporate tax rate for their section 951(a) subpart F inclusions. The taxpayer may also claim the deemed- paid foreign tax credit under section 960. The election has its limits, however, as under section 962(d), when an actual distribution is made, the earnings and profits from a controlled foreign corporation that exceed the tax applicable under the section 962 election are also treated as income.
The TCJA committee report, in a terse footnote about section 965, cites to the section 962 election as a way for individuals and investors in U.S. passthrough entities to receive corporate rates for the transition tax inclusion, without further explanation. Guidance from the IRS and Treasury may be needed to clarify its operation in conjunction with section 965 or the tax on global intangible low-taxed income (GILTI).
In a February letter to the IRS and Treasury about section 965 guidance, the New York State Bar Association requested that Treasury and the IRS consider relief under section 965(o) for individuals so that taxes paid on the section 965 inclusion are not greater than what a corporation would pay. It argues that the reference in the conference report to the section 962 election may be interpreted as only referring to the rate election under section 962(a) and not section 962(d). Such an interpretation “would be consistent with recognizing that section 965 is not an identical regime to subpart F because it provides for both an income inclusion and a deduction” with the result being individuals could treat the full amount of the section 951(a)(1) inclusion as previously taxed income.
Another letter to the IRS and Treasury from Kelley Drye & Warren LLP, dated February 28, also notes the potential impending consequences from the interaction of section 965 and the section 1411 3.8 percent tax on net investment income, asking for guidance on the matter. The letter points out that taxpayers may make a section 962 election to offset the transition tax with foreign tax credits, but since section 962 applies to tax imposed under chapter 1 of the code and the NII tax is imposed under chapter 2A, it is unclear what the significance of such an election is on section 1411.
While the impact of section 965 is weighty for many taxpayers, in the future, the interpretation of GILTI may prove even more important for some.
Under section 951A, GILTI acts as a minimum tax on foreign profits. Each U.S. shareholder of a CFC is subject to tax on GILTI, defined as the excess of its pro rata share of tested CFC income over a 10 percent return (reduced by some interest expense incurred by CFCs) on its pro rata share of the depreciable tangible property of each CFC. Importantly, section 250 allows a 50 percent deduction for domestic corporations on their GILTI income, effectively lowering the rate to 10.5 percent.
Summer Ayers LePree of Bilzin Sumberg dismissed arguments based on section 962 statutory language that would seek to disallow section 965(c) deductions or deductions for GILTI under section 250 . The statutory language makes no mention of allowable deductions. Section 962 regs state that an electing taxpayer may not reduce its income by any deductions of the U.S. shareholder, but as LePree has previously pointed out, the regs do not have a similar prohibition against corporate-level deductions, like GILTI.
“It’s a pretty old provision, and in 1962 they would have had no reason to have thought about these types of deductions because nothing like this existed . . . and it’s a new question,” LePree argued.
The NYSBA notes that the statutory and regulatory language under section 962 would apparently not apply the deduction under section 250 for determining income subject to the corporate rate. It goes on to argue, however, that applying the deduction is “more consistent with the statutory scheme of putting the individual U.S. shareholder in the same position as if the individual owned the CFC shares indirectly through a U.S. corporation.”
LePree said she knows Treasury is discussing the implications of the election to several international issues, but she would not speculate on which way the government will side when guidance is released. She added that the legislative history behind section 962 was clear in its intention to place U.S. individuals who invest directly in a CFC in parity with individuals who invest in a CFC through a U.S. C corporation.
“It would be egregiously inequitable not to allow individuals to claim these deductions,” LePree said about the potential lack of availability of the section 250 GILTI deduction and section 965(c) deduction for individuals. “I don’t think that Congress necessarily intended it to be that way. It wasn’t malice; it was negligence. No one thought long or hard enough about individuals.” LePree said she expects some relief for individuals, but she was less certain that Treasury would see fit to issue guidance allowing individuals to take the GILTI deduction.
There is another outstanding question pertaining to section 962(d) and when an actual distribution is made from a CFC. It’s not clear whether that distribution is properly treated as made by a deemed U.S. C corporation, and thus a qualified dividend subject to a lower rate, or if it is a distribution by the CFC, and therefore ordinary income if paid from a CFC resident in a non-treaty country.
If the goal is to put the U.S. person in the same position as if they had invested through a U.S. C corporation, it should be a qualified dividend, LePree argued. She said the issue is especially important to her practice with clients operating in Latin American countries, given the lack of tax treaties with many of those nations that would otherwise reduce the tax owed on a CFC distribution.
The issue is currently before the Tax Court in Barry M. Smith v. Comm’r, No. 14900-15, for income received by an S corporation from a Hong Kong CFC. Both the government and the petitioner have filed motions for partial summary judgment. The government sees the inquiry as a simple one limited to whether the CFC is a qualified foreign corporation from a country with an income tax treaty with the U.S., which a Hong Kong subsidiary is not. Quoting legislative history, the petitioner argues that congressional intent behind section 962 makes it clear that by nature of the election, the income must be viewed as paid by a deemed U.S. corporation.
Section 962 ’s legislative history states that the purpose of the section “is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. [Section 962 ] gives such individuals assurance that their tax burdens, with respect to these undistributed foreign earnings, will be no heavier than they would have been had they invested in an American corporation doing business abroad.”
Robert Russell of Alliantgroup LP said he believes Treasury did have the authority to opine on the GILTI deduction, but he wonders where it might rank in the government’s priorities, given everything that needs to be done following the tax bill.
“My hope is there will be enough clamor for [Treasury] to provide clarity on this issue. Although the tax bill spent a lot of effort focusing on flow-throughs in general, it is clear very little consideration was given that these entities, or individuals for that matter, could be operating globally. Perhaps certain industry groups that have traditionally been in flow-though structures, such as private equity, living with this bad answer out of tax reform are interested and they are big enough to have a voice,” Russell said.
Still, given the money at stake, Russell does not foresee private equity firms waiting around for guidance. Rather, they will look to engage in self-help, he reasoned: Affected taxpayers will move to put a U.S. C corporation underneath their flow-throughs that will hold all their CFCs to avoid the necessity of the section 962 election, a move Russell said he has already seen some of his clients make. In addition to GILTI deductions and foreign tax credits, having a U.S. C corporation in the structure will reward these taxpayers with the dividends received deduction, as well as the foreign derived intangible income provisions, he noted.
“I’m worried about the people that aren’t going to do these reorganizations,” Russell said. “If you don’t make a [section] 962 election, when you’re filling out your first tax return with GILTI, your eyes are going to pop out of your head. ‘How do I have all this phantom income with GILTI with no foreign tax credits?’”
LePree noted that while, in the future, taxpayers should be able to engage in self-help restructuring using actual U.S. C corporations to avoid the uncertainty behind the election altogether, the ones who will be left out are those without tax advisers. This makes the current situation a “trap for the unwary,” she warned.
“Going forward, I think you are going to see a lot of U.S. people dropping their foreign structures into U.S. C corps,” LePree surmised. “With respect to section 965 issues, however, it is too late to modify affected structures, and without a clear roadmap of what the implications are, it’s very difficult to plan right now.”
Robert M. Russell, Esq., CPA, has accomplished a lifetime of success in little more than a decade of legislative practice, having solidified his presence as a congressional authority on international tax policy and other cross-border matters.
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