Written by Denis Dompierre CPA, CGA M. Fisc, Tax Manager | Levy Pilotte
This tax memorandum is of interest to US citizens living abroad and is mainly directed toward US citizens living in Canada.
The 2017, US tax reform introduced the Global Intangible Low-Taxed Income regime (GILTI).
In summary, US citizens who are shareholders of certain Canadian corporations, may be subject to US income tax, if the corporation’s income is more than an arbitrary 10% return on its tangible depreciable capital assets. The title of the tax is somewhat misleading, because a corporation with no intangible assets can cause a GILTI tax problem for its shareholders. We understand that the US Internal Revenue Service (“IRS”) intended these rules to deter the shifting of profits to other lower tax jurisdictions.
The GILTI rules, which applied for the first time in 2018, may affect US individuals or corporations who own shares of a Controlled Foreign Corporation (CFC). A CFC is a foreign corporation in which 50% or more of its votes or value are owned by US shareholders. Ownership can also be direct, indirect or constructive.
For GILTI to apply, a US shareholder must own 10% or more of the voting power, or 10% or more of the total value of all classes of shares of a CFC.
How does GILTI work?
A minimum tax is imposed based on worldwide profits of a CFC. The tax is imposed on the shareholder on a current basis if the corporation’s active business income exceeds the arbitrary 10% rate of return on its tangible depreciable capital assets. Accordingly, there may be US personal tax imposed with no corresponding distribution by the corporation.
To be subject to GILTI, active business profits must exceed 10% of a corporation’s depreciable tangible assets. The excess is re-characterized as intangible income and is added to the shareholder’s US taxable income.
US individuals and US corporate shareholders of CFCs are caught by these provisions. Individuals are disadvantaged as their US federal tax rate could be as high as 37%, versus a 21% federal tax rate for corporations. In addition, in most cases, corporations may be able to deduct half of their GILTI income inclusion, resulting in a 10.5% effective tax rate for a corporation. However, an election is available which mitigates this disadvantage for individual shareholders. The individual can elect under Section 962 of the Internal Revenue Code (“IRC”) to be taxed as a corporation for purposes of the income required to be reported from the CFC and therefore take advantage of the reduced corporate rate and 50% GILTI deduction.
The shareholders of service companies that do not invest heavily in depreciable fixed assets would normally be subject to GILTI. Additionally, the shareholders of professional corporations are significantly affected.
The Section 962 election for an individual to be taxed as a corporation and a related GILTI high-tax exception may result in no GILTI tax for corporate income that is taxed locally at rates higher than 90% of the US corporate tax rate of 21%. Therefore, in Canada, it is the shareholders of small business corporations who may bear most of the GILTI tax as their corporate tax rate in Canada may not qualify for the high-tax exception or may not be enough to offset the tax imposed under the 962 Election. The proposed regulations for the GILTI high-tax exception were released on June 14, 2019. Once the regulations are finalized, this election will apply to taxable years of CFC’s beginning on or after the date the regulations are published. Thus, these potential tax benefits of the high-tax exception were not available to individual shareholders for 2018, or for any taxation year currently in progress.
The GILTI inclusion is classified as foreign source income, so there may be a foreign tax credit (or deduction) available if dividends were paid during the year by the CFC. There are special rules that prevent foreign tax credit manipulation using non-GILTI income. There is no foreign tax credit carry-back or carry-forward available (unlike regular US foreign tax credits).
It appears that US legislators intended that income taxed as GILTI will not be taxed again when profits are distributed. As part of the transition to GILTI, a one-time transitional tax under Section 965 was introduced. It essentially taxed a CFC’s retained earnings as of the end of 2017 calculated under US tax rules in the hands of its US shareholders. Again, this tax applied even though the retained earnings were not paid out to the shareholders. This undistributed income was to be taxed to the extent it had not previously been subject to US tax. Section 965 income is also not intended to be taxed twice. However, GILTI and Section 965 tax are complicated rules and there are pitfalls that could result in double tax.
When making US tax calculations like GILTI, corporate income must be calculated under US tax principles, so Canadian profits may require accounting adjustments.
As with most other US tax rules, GILTI is complicated, and therefore requires careful analysis, which is time consuming.