Multinational Business May Want to Rethink Entity Choice and Other Elections by Andrew Leonard, CPA
Posted on August 22, 2019
The overhaul of the U.S. tax code was signed into law at the end of 2017, yet many taxpayers are continuing to conduct business as usual, paying little attention to how the new law impacts their tax liabilities for 2018 and beyond. To be sure, the Tax Cuts and Jobs Act (TCJA) in its original form was a hastily drafted, confusing patchwork of new terminology and complex and often competing rules. As final guidance continues to trickle out from the IRS, U.S. taxpayers should be forewarned that putting off tax planning could prove costly, especially when they own multinational businesses.
On the international front, the TCJA aims to 1) make the U.S. tax system more competitive with other regimes around the world, 2) incentivize multinational companies to repatriate foreign earnings and invest in U.S. operations and 3) prevent multinational businesses and their U.S. shareholders from deferring taxes on foreign profits by keeping them offshore or shifting them to low-tax jurisdictions. Two of the TCJAs key provisions intended to achieve these goals apply specifically to controlled foreign corporations (CFC), defined as foreign entities with more than 50 percent value and/or voting ownership by U.S. shareholders.
These multinational businesses have always faced challenges navigating through a jungle of thorny tax issues that vary from one jurisdiction to the next. Nonetheless, tax reform brings new complexities that can have far-reaching implications based on where taxpayers are headquartered, where they operate their businesses and the types of legal entities through which they chose to conduct their businesses.
GILTI and FDII
The following provisions of the TCJA work together to create a new minimum global tax on intangible CFC income.
The new Global Intangible Low Tax Income (GILTI) regime supplements existing subpart F anti-deferral rules by subjecting U.S. shareholders of CFCs to a new minimum tax on undistributed foreign earnings that exceed 10 percent of the corporation’s return on all foreign depreciable assets, including plants, equipment and real estate, but excluding land. This will be considered a deemed dividend for which U.S. shareholders must annually include as gross income and pay a minimum tax on their pro rata share of all their CFCs’ net tested income based on foreign earnings, regardless of whether or not they actually receive distributions from the CFC.
Individual shareholders and those organized as pass-through entities are subject to a tax on GILTI at their ordinary U.S. income tax rates, which can be as high as 37 percent. In contrast, Congress carved out special benefits for shareholders organized as domestic C corporations to deduct 50 percent of income subject to the GILTI inclusion. This brings the effective GILTI tax rate down to 10.5 percent from the new corporate rate of 21 percent. After 2025, this deduction is set to decrease to 37.125 percent.
Another new category of taxable income introduced by the TCJA is foreign-derived intangible income (FDII), defined as income earned from exporting tangible and intangible products and services, such as patents, trademarks, and copyrights, held in the U.S. and sold to foreign customers.
FDII provides a unique advantage to shareholders organized as domestic corporations by allowing them to annually claim a deduction for up to 37.5 percent of FDII (21.877 percent deduction after 2026) leaving them with an effective tax rate of 13.125 on foreign derived sales and services. In other words, FDII provides domestic C corporations operating directly in foreign countries with a permanent deduction for taxes on the revenue they generate from foreign markets.
Weighing the C Corporation Advantages
With proper planning, both GILTI and FDII can provide a broad range of built-in tax savings for shareholders that are domestic corporations. Likewise, the tax code provides taxpayers with various options for structuring their interest in CFCs, such as inserting a C corporation above or between themselves and the foreign entity, making a Section 962 election to be treated as a U.S. C Corp for tax purposes, making a check the box election to be taxed as partners or disregarded entities, or even going so far as restructuring their entire operations.
Understanding which structure is best in the short and long-term requires careful analysis of different scenarios through the lens of the taxpayer’s unique circumstances. Special attention should be paid to direct and indirect ownership and current and projected earnings, expenses, depreciation of fixed assets and net operating losses (NOL) as well as the impact of future sales of CFC stock.
For example, Section 250 deductions are limited when a shareholder’s GILTI and FDII exceed taxable income, and domestic corporations will permanently lose the 50 percent GILTI deduction when the deduction results in in a NOL. In addition, while an individual shareholder making a 962 election to be treated as a domestic corporation would appear to yield the same tax benefits as a shareholder that restructures as a C corporation, other factors, such as state income taxes, foreign tax rates and treaties will come into play and affect any potential savings opportunities.
Tax reform casts a wider net of rules for a broader range of taxpayers. Whether or not the new law achieves the goal of bringing more capital investment back to the U.S. remains to be seen. In the meantime, businesses must face the challenges of coming into compliance with the new law without increasing their operating costs or their tax liabilities.
Quite often, multinational businesses can take advantage of the new tax rules to increase the tax efficiency that these strategies offer. However, it is recommended that businesses practice extreme care under professional guidance to avoid exposure to negative complexities embedded in the TCJA. When structured correctly the benefits can be sizable.
About the Author: Andrew Leonard, CPA, is a director with Berkowitz Pollack Brant’s International Tax Services practice, where he provides tax structuring, pre-immigration planning and a wide array of international tax and consulting services to international companies, entrepreneurs, families and foreign trusts. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at email@example.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.