Americans abroad who are individual shareholders of small business corporations in their country of residence have been very negatively impacted by the Section 951A GILTI and Section 965 TCJA amendments. In June of 2019, by regulation, Treasury interpreted the 951A GILTI rules to NOT apply to active business income when the effective foreign corporate tax rate was at a rate of 18.9% or higher. Treasury’s interpretation was reasonable, consistent with the history of Subpart F and consistent with the purpose of the GILTI rules. Now, Senators Wyden and Brown are attempting to reverse Treasury’s regulation through legislation. This is a direct attack on Americans abroad.
As many readers will know the 2017 US Tax Reform, referred to as the Tax Cuts and Jobs Act (TCJA), contained provisions which have made it difficult for Americans abroad to run small businesses outside the United States. In the common law world a corporation is treated as a separate legal entity for tax purposes. In other words the corporation and the shareholders are separate for tax purposes, file separate tax returns and pay tax on different streams of income. The 2017 TCJA contained two provisions that basically ended the separation of the company and the individual for U.S. tax purposes. In other words: there is now a presumption (at least how the Internal Revenue Code applies to small business owners) that active business income earned by the corporation will be deemed to have been earned by the individual “U.S. Shareholders”. To put it another way: individual shareholders are now presumptively taxed on income earned by the corporation, whether the income is paid out to the shareholders or not!
The effect of this on individual Americans abroad has been discussed by Dr. Karen Alpert in her article: “Callous Neglect: The impact of United States tax reform on nonresident citizens“.
The expansion of the Subpart F Regime
The Subpart F rules were established in 1962. The principle behind them was that individual Americans should be prevented from, using foreign corporations to earn passive income, in jurisdictions with low tax regimes (or tax regimes that have lower taxes than those imposed by the United States). The Subpart F rules have (since 1986) included a provision to the effect that investment income (earned inside a foreign corporation) which was subject to foreign taxation at a rate of 90% or more of the U.S. corporate rate, would NOT be subject to taxation in the hands of the individual shareholder.
To put it another way (with respect to investment income):
1. It was mostly investment/passive income that was subject to inclusion in the incomes of individual shareholders as Subpart F income; and
2. Passive income that was subject to foreign taxation at a rate of 90% or more of the U.S. corporate tax rate (now 21%) would NOT be considered to be Subpart F income (and therefore not subject to inclusion in the hands of individual shareholders).
To coordinate my background discussion with the Arnold Porter submission described below, I will refer to exclusion of investment income subject to a 90% tax rate as “HTKO” (High Tax Kick Out).
The basic principle was (and continues to be):
If passive income earned in a foreign corporation is taxed at a rate of 90% or more of the U.S. corporate tax rate, that there was no attribution of that corporate income to the individual U.S. shareholder.
In its most simple terms, the Subpart F rules are found in Sections 951 – 965 of the Internal Revenue Code. They are designed to attribute income earned by the corporation directly to the U.S. shareholder, without regard to whether the corporate profits were paid to the shareholders as a dividend. Note that many developed countries have similar rules. Many developing (from a tax perspective) countries (for example Russia) are adopting Subpart F type rules. The U.S. rules are more complicated, more robust and (because of citizenship taxation) apply to the locally owned companies of individuals, who do not live in the United States.
Punishing them for their past and destroying their futures – The expansion of the Subpart F Regime to active business income
The TCJA established the principle of subjecting the shareholder to taxation on ACTIVE BUSINESS income earned by the corporation:
Retroactively – The Section 965 Transition Tax imposed taxation on the shareholder to ACTIVE BUSINESS income earned by corporations from 1986 to 2017
Prospectively – The Section 951 GILTI Tax imposed taxation on ACTIVE BUSINESS income earned by corporations from January 1, 2018
Imagine how this would effect individual Americans abroad who are simply trying to run small businesses (in the form of a small business corporation) in their country of residence. Those individuals are now subject to taxation in the following ways:
By their country of residence (in a moment I will use Israel as an example)
– their corporations are subject to taxation
– the shareholders are subject to taxation
By the United States
– individual Americans abroad, who are shareholders in small business corporations, are subject to taxation by the United States
– individual Americans abroad, who are shareholders in their small business corporations, are subject to taxation on the undistributed profits on active business income earned by their corporations.
In other words, individual Americans abroad, who are shareholders in their small business corporations, are now subject to at least triple taxation on their active business income! There is/was no exclusion for active business income (as there is for passive income) if the corporation is taxed in the foreign country at a rate of 90% of the U.S. corporate rate (18.9%)
Arnold Porter demonstrates how triple taxation on U.S. citizens in Israel results in a tax rate of 75%
In submissions to U.S. Treasury, dated November 12, 2018, the Washington law firm of Arnold Porter, demonstrated how, the Section 951A GILTI rules could lead to a tax rate of over 75% on income earned by Israeli corporations.
The Arnold Porter submission is detailed, thoughtful and explains the rationale and history of the Subpart F rules. In relevant part the (starting on page 8) submission includes:
The following is a brief summary of the Israeli income tax system and an example of how the GILTI rules, if a broad HTKO exception is not applied to GILTI, would apply to certain shareholders of Israeli companies in a manner yielding unfair results that are inconsistent with the legislative history discussed above.
The State of Israel has a robust tax system.18 An Israeli corporation generally is subject to tax at a rate of 23 percent on its worldwide corporate income.19 An Israeli individual is subject to net income tax on his or her worldwide income at graduated rates ranging from 10 percent to 50 percent. For example, an Israeli individual earning between approximately $46,257 and $63,940 is subject to Israeli tax at a rate of 31 percent.20 An individual earning above approximately $171,351 is subject to Israeli tax at a rate of 50 percent. Certain types of income earned by individuals are subject to fixed tax rates. For example, certain interest income, capital gains and dividends are subject to tax at a rate of 25 percent (or 30 percent in the case of dividends if the recipient owns at least 10 percent of the distributing corporation), regardless of the taxpayer’s income tax
bracket. If an individual earns above approximately $171,351, the tax rates in the preceding sentence are increased by three percent. In general, Israeli taxpayers are allowed a credit against their Israeli tax liability in the amount of non-Israeli income taxes paid, but only with respect to income that is sourced outside of Israel.
The following example illustrates the potentially harsh tax consequences to a dual U.S. citizen/Israeli tax resident of not applying a broad HTKO exception to GILTI. David is a U.S. citizen by virtue of being born in the United States, but has lived in Israel for the bulk of his life and is an Israeli tax resident as a result. Thus, David is subject to worldwide taxation both in the United States and in Israel. David wholly owns an Israeli corporation (“DavidCo”) that is a software development company earning active income that is not Subpart F income. Under U.S. federal income tax rules, DavidCo is a CFC and David is a U.S. shareholder of DavidCo. Assume that, in 2018, DavidCo generates corporate taxable income of $100x, which is subject to Israeli corporate tax of $23x.
Although the $100x income of DavidCo is subject to a non-U.S. tax rate well in excess of 18.9 percent, without a broad HTKO exception applying to GILTI, David will be taxed on the remaining $77x net profits, as GILTI, at a rate of 37 percent, resulting in $28.49x of U.S. federal income tax.21 If, in 2020, DavidCo makes a distribution of the $77x to David, this will be treated as a taxable dividend to a controlling shareholder for Israeli tax purposes, subject to an Israeli tax rate of 30 percent, resulting in tax of $23.1x.22 Under Israeli tax law, the $28.49x of U.S. federal income taxes paid on the GILTI is not creditable against the Israeli tax imposed on the DavidCo dividend because such dividend is Israeli-source income. Accordingly, David’s overall effective tax rate on the $100x of DavidCo income is 74.59 percent.23
The example offered by Arnold Porter was to support their argument that ANY income earned by a foreign corporation should be subject to a HTKO (and not treated as GILTI income) if the foreign corporate tax rate was greater than 18.9%. In other words, the Arnold Porter submission argued that:
If income earned by the foreign corporation was subject to a foreign tax rate of 18.9% or more then
that income should not be treated as GILTI income at all.
To put it another way: The maximum U.S. corporate rate is 21%. Why should certain taxpayers pay a rate that is higher than the 21% maximum?
Treasury agreed with the arguments in the Arnold Porter submission – Interpreting Subpart F Generally (with the assistance of the legislative history) To Mean That High Taxed Foreign Income Should NOT Be Considered To Meet The Definition Of GILTI Income
On June 14, 2019 Treasury interpreted Section 951A in the context of the Subpart F rules to mean that high taxed income should (subject to election) be excluded from the definition of GILTI income.
At page 22 of the Notice Treasury states:
II. GILTI High Tax Exclusion
A. Expansion to exclude other high-taxed income
In response to comments, the Treasury Department and the IRS have determined that the GILTI high tax exclusion should be expanded (on an elective basis) to include certain high-taxed income even if that income would not otherwise be FBCI or insurance income. In particular, the Treasury Department and the IRS have determined that taxpayers should be permitted to elect to apply the exception under section 954(b)(4) with respect to certain classes of income that are subject to high foreign taxes within the meaning of that provision.
Obviously the devil is in the details (and there are a lot of details). But, this is clearly good news and clear relief for American entrepreneurs abroad. As I wrote in a previous post – “US Treasury proposes that foreign income subject to high foreign tax be excluded from definition of GILTI“:
Treasury Should Be Congratulated For Taking a “Purposive Approach” To The Implementation of GILTI
Rather than interpreting Section 951A in the most literal way, Treasury has adopted a purposive approach. It has utilized: the history of the Subpart F regime, the legislative history leading to the TCJA in general, the GILTI rules in particular and how the GILTI rules are to be given effect as part of the Subpart F scheme. Furthermore, the views of Treasury have clearly been shaped by comments from the profession, comments from at least one government* and the public. In fact, the June 14, 2019 Notice from Treasury appears to address the submission from Arnold Porter from the Government of Israel which describes the “literal application” of the GILTI rules on Americans abroad living in Israel and subject to the Israeli tax regime. The submission is introduced as follows:
*On behalf of the Ministry of Finance of the Government of Israel, Arnold & Porter recommends, per the attached document, that the Treasury revise Prop. Reg. 1.951A-2(c)(1) to clarify that the “high tax kick out” exception of Section 954(b)(4) applies to GILTI so as to exclude from gross tested income and, therefore, from net CFC tested income, any item of income subject to an effective non-U.S. tax rate equal to, or in excess of, a prescribed rate.
February 2020 – Two Democrat Senators Attempt to Reverse Treasury’s Common Sense Interpretation of GILTI Income
As explained by Virginia La Torre Jeker,
On February 12, Senate Finance Committee Ranking Member Ron Wyden, D-Ore., and Senator Sherrod Brown, D-Ohio, introduced legislation to prevent the Treasury Department from carving out an exception (commonly called the GILTI High Tax Kick-Out) for multinational companies to escape the so-called GILTI provisions of the Tax Cuts and Jobs Act (TCJA). The title of the proposal is the “Blocking New Corporate Tax Giveaways Act’’; a title giving you a feel for what’s to come.
The purpose of the Bill (it is only one page) is to clarify that active business business earned by foreign corporations should be taxed to the individual U.S. shareholders under the GILTI rules without regard to the rate of tax paid in the foreign country. In other words, the purpose of the Wyden bill is to reverse Treasury’s “common sense” interpretation of what should and should NOT be considered to be GILTI income.
The Senate Finance Committee issued a news release explaining the motivation for the Wyden bill. The complete news release is as follows:
Ashley Schapitl (202)224-4515
Wyden, Brown Introduce Bill to Block Latest Trump Administration Corporate Giveaway
Wyden, Brown Introduce Bill to Block Latest Trump Administration Corporate Giveaway
Washington, D.C. – Senate Finance Committee Ranking Member Ron Wyden, D-Ore., and Senator Sherrod Brown, D-Ohio, today introduced legislation to block the Treasury Department’s latest corporate giveaway—an exception to the new tax on foreign earnings that allows multinationals to essentially choose the lowest available tax rate.
The Congressional Budget Office recently estimated that the 2017 tax law’s international provisions are an even bigger tax cut than previously estimated, with $110 billion in additional revenue lost due to giveaways from Treasury Department regulations and corporate tax planning.
“When the big multinational corporations said ‘jump,’ the Treasury Department asked ‘how high?’ Treasury has overstepped its authority to unilaterally give companies billions in tax breaks on top of the hundreds of billions in tax breaks they’ve already received. Our bill would block the proposed giveaway that essentially allows corporations to choose the lowest available tax rate. Working families don’t get this perk and big corporations shouldn’t either,” Wyden said.
“While the President has been busy threatening cuts to Medicare and Social Security, his administration has been quietly shelling out billions of dollars more in tax breaks to multinational corporations. President Trump and his Republican allies in Congress have made our tax code far too lucrative for corporations as it is. They don’t need yet another tax giveaway,” Brown said.
The 2017 Republican tax law created a new tax regime for multinational corporations – “Global Intangible Low-Taxed Income,” or “GILTI.” GILTI provides a special low tax rate for U.S. multinationals, allowing them to pay a 10.5 percent tax on their foreign earnings, half the 21 percent corporate rate.
Multinationals can further lower this reduced tax rate by claiming credits for taxes paid to foreign countries, though long-standing rules limit the amount of these “foreign tax credits” a company may take.
Multinational corporations, unhappy with the combination of limits on foreign tax credits and the new GILTI regime, aggressively lobbied Treasury for a way out of paying what they owe.
The Treasury Department then went well beyond its legal authority to create the multinationals’ desired tax break. The regulations propose an elective exemption from paying any GILTI taxes on certain income, if companies pay at least an 18.9 percent effective tax rate on that income.
This GILTI High-Tax Exclusion allows companies to choose how they want to be taxed under the GILTI regime. Corporations naturally will only use the exception when it cuts taxes on their offshore income.
It’s pretty clear that Senators Wyden and Brown have little or no understanding of the Subpart F regime and that the GILTI rules are designed to impose taxation on individual shareholders on income they never received. It’s also pretty clear that Senators Wyden and Brown are perfectly happy subjecting Americans abroad with small businesses to effective tax rates of 75%. Why 75%? It’s a punishment for living outside the United States and attempting to build a life in anew country.
Senators Wyden and Brown are reinforcing the principles of the U.S. tax system which:
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