Introduction
Our last article focused on the impact of IRC 965 (a.k.a. the repatriation tax or transition tax) on US citizens resident in Canada. IRC 965 was brutal for those impacted by it, forcing them to choose between retroactive double taxation on corporate earnings not yet distributed or accelerating Canadian personal tax due to early distribution of corporate earnings. While 2017 marked the passing of the transition tax, 2018 marked the beginning of an even more punitive regime: IRC 951A or the GILTI (Global Intangible Low-Taxed Income) regime. This article will provide an overview of the GILTI rules and their implications, as well as exploring planning options that should be considered by those subject to the rules.
The basic rules
The GILTI rules were designed to “make America great again” by discouraging US companies from shifting profits to low-tax jurisdictions. Under the GILTI regime, such profits are taxed in the US currently, but can be repatriated (or distributed) to the US owner with no additional US tax. From a US corporate perspective (think large US multi-national corporations), the rules make sense based on the US government objective of encouraging corporations to either bring foreign profits back to America or, even better, investing in America in the first place.
Who is subject to GILTI?
The rules apply to US citizens, residents or domestic entities (e.g. corporations) who are US shareholders of controlled foreign corporations (CFCs) in the year. A US person must own (or be considered to own) 10% or more of the combined voting power or value of the company to be a US shareholder. In general, controlled foreign corporation is a foreign corporation in which US shareholders own more than 50% of the combined voting power or value of the company.
What are the implications of GILTI?
In general, income earned by a CFC that is GILTI is taxed in the hands of the US shareholder as regular income whether or not the corporate income has been distributed. GILTI is generally the active business income of the company minus an allowable return on depreciable assets. For intangible or service-based companies, GILTI will often be practically 100% of the profits of the company. Excluded from GILTI are most sources of investment income (because they are already attributed to the US shareholder as Subpart F income), effectively connected income (because it is already taxable in the US) and certain other types of income.
Since the GILTI rules are designed to severely limit offshore business activities, foreign tax credits (FTCs) are subject to significant additional limitations. Specifically, GILTI income is placed in a separate FTC basket and only foreign taxes attributable to the GILTI income can be used to offset the US tax levied on GILTI. Furthermore, there is no carryback or carry forward of foreign taxes attributed to GILTI. Therefore, any FTC planning intended to minimize GILTI must be current and precise. Failure to properly align the foreign tax with the GILTI income can result in significant double taxation.
Is GILTI unfair to individual taxpayers?
While US lawmakers were clearly targeting US corporations in designing the GILTI rules, they were aware that the rules would have implications to US individuals, including US citizens living abroad. Despite this knowledge, and perhaps due to the mad rush to pass the US tax reform bill, legislators passed the GILTI rules in a form that is particularly unfair to US citizens resident abroad. This is particularly true for US citizens resident in Canada due to our integrated tax system that encourages tax deferral using corporations.
While US corporations receive a deduction equal to 50% of their GILTI inclusion, guidance so far does not appear to allow US individual taxpayers to receive this deduction. Even when individuals elect to be taxed as a US corporation (see IRC 962 election below), they do not appear to be permitted this lucrative deduction. If such individuals were allowed the 50% deduction, they would not have any US tax liability as long as the Canadian tax rate paid by the CFC was at least 13.125% (very close to the small business tax rate in most provinces). This apparent oversight is very unfortunate for US citizens resident in Canada since it would have provided a relatively easy planning “out” from GILTI for many situations. At the time of writing, there does not appear to be any meaningful acknowledgment from lawmakers or the IRS that a legislated solution is being considered.
In addition, unlike the Subpart F rules, the GILTI rules do not have a high-tax exception available. If such an exception were available, the income would not be includible in the US shareholder’s income if the CFC paid a corporate tax rate which was at least 90% of the US corporate tax rate of 21% (i.e. 18.9%). If lawmakers extended the high-tax exception to the GILTI regime, it would eliminate GILTI for the majority of large Canadian CFCs (since most are paying high-rate corporate tax in Canada, ranging from 26.5% to 31%). This would be a very logical solution, considering Canada is far from a low-tax jurisdiction.
The IRC 965 blocker issue
Over the past several months, there has been a steady stream of guidance from the IRS with respect to GILTI, the most recent clarifying the order in which earnings and profits (E&P) are distributed from CFCs. As an apparent favour to US corporations subject to IRC 965, the IRS has indicated that distributions will first come from the CFC’s IRC 965 pool of E&P (considered “previously taxed” since it has been subject to US tax under the IRC 965 rules). This makes sense from a corporate perspective but is, once again, punitive to US citizens resident in Canada. As a result, those who have IRC 965 E&P (basically, retained earnings that existed at December 31, 2017) must first distribute 100% of this E&P (in the form of dividends) before being able to distribute any GILTI E&P. This severely limits the ability to match the GILTI income inclusion with Canadian tax paid on the ultimate distribution. If the GILTI E&P is distributed in any year but the year in which it was earned, the foreign tax on the dividend is not allowed as a FTC and double tax results.
Planning to minimize GILTI
US citizens resident in Canada who are subject to GILTI should take the rules very seriously. Failing to manage GILTI in a year could ultimately result in combined tax rates exceeding 86% (a combination of Canadian corporate tax on corporate profits, US individual tax on GILTI inclusion and, finally, Canadian personal tax on the ultimate distribution of earnings). Lawmakers need to step in (or up) and create a fix, as there is currently no silver bullet. For the time being, taxpayers need to consider all avenues available to them to minimize the impact. Below are some of the strategies we are using.
Bonuses
Some business owners and incorporated professionals extract most of their corporate profits annually. If this is the case, the easiest way to manage GILTI is to simply “bonus out” the profits to the shareholder (at least those in excess of the allowable return). Care should be taken to ensure the salary/bonus is deductible in Canada and in the US. While bonusing doesn’t need to be an “all or nothing” strategy, any income retained and taxed in the company can still result in GILTI. While straightforward, this solution will be a rude awakening for business owners accustomed to deferring significant amounts of Canadian tax by leaving profits in their companies. Most entrepreneurs will be looking for other options.
Dividends
Dividends and foreign tax credits can also be used to manage GILTI. However, this strategy will be more complicated if there is any “IRC 965 E&P” in the company (see above). If no IRC 965 E&P exists, paying a dividend in the year of GILTI inclusion to create Canadian FTCs sufficient to eliminate the US tax may be a viable strategy. Doing so will, however, not leave much opportunity for deferral since only the Canadian personal tax will be eligible for FTC.
Subpart F position
Historically, some real estate companies and professional corporations took the position that their income was not Subpart F income because, in the case of a real estate company, the shareholders or employees actively managed the real estate or, in the case of a professional corporation, the income did not meet the specific conditions of personal service income. Taxpayers will want to revisit the reasoning that led to these conclusions since the Subpart F regime is more taxpayer friendly than the GILTI regime. An advantage of the Subpart F regime over the GILTI regime is the fact that Subpart F income typically falls into either the passive or general limitation FTC basket. In both cases, the tax credits can be carried forward or back, unlike GILTI tax credits. This provides much more flexibility in managing US tax exposure.
In addition, if the CFC’s income is subject to Canadian corporate tax of at least 18.9%, the income might be subject to the above-mentioned high-tax exception, eliminating inclusion entirely. Of course, the devil is in the details. There are several technical nuances to this position, including how the IRS would view refundable taxes paid in Canada. Also, the cost of being wrong could be extremely high given the potential 86% flow-through tax cost.
IRC 962 election
One of the most attractive strategies for taxpayers involves electing under IRC 962. Under this provision, an individual taxpayer can elect to be taxed as a US corporation. US tax reform reduced corporate tax rates significantly, which means this election could drop the potential US tax on a GILTI inclusion from 37% to 21%. Furthermore, by making this election, a taxpayer can claim a foreign tax credit for 80% of the corporate taxes paid on the GILTI income by the CFC. In some cases, this will eliminate all US tax. However, if the CFC claims the small business deduction, the effective tax rate may be too low to fully eliminate US tax. Nonetheless, if minimizing the current year tax cost is a priority, the IRC 962 election is a powerful tool. Of course, future distributions of income (in the form of dividends) will result in taxable income in both Canada and the US, but Canadian FTCs typically eliminate the US tax (except for the Net Investment Income Tax).
An enhancement to this strategy to potentially fully eliminate US tax on GILTI would be to forego claiming the Canadian small business deduction, thus increasing Canadian tax sufficiently to fully offset US tax. The distribution of these earnings would be subject to the lower eligible dividend tax rate. This sounds simple, but this option isn’t ideal. First, due to the 80% limitation on foreign tax credits, there will be tax leakage. Second, many provinces have negative integration (such that corporate income taxed at the top corporate rate already carries a flow-through tax disadvantage). Nonetheless, if elimination of double tax (or outright refusal by some to pay US tax) is a priority, this strategy will be of interest.
Unlimited liability companies
Certain provinces (Nova Scotia, Alberta and British Columbia), have unlimited liability company (ULC) legislation. These companies are disregarded for US purposes, which means the income earned by the ULC is simply income of the owner of the ULC. Also, these disregarded entities are not CFCs and not subject to GILTI. Due to their hybrid nature (i.e. regarded for Canadian purposes but disregarded for US purposes), ULCs have long been planning tools for US taxpayers and are poised to see a resurgence due to their effectiveness in managing GILTI. Unfortunately, the ULC solution is not always feasible since converting a limited liability company to a ULC would be a liquidation transaction for US purposes. In addition, due to their unlimited liability, they are not suitable for all applications
Restructuring
Many US citizens resident in Canada are at their wits’ end with respect to the complexity of cross-border tax compliance. Historically, this complexity has been frustrating and expensive in terms of advisory and compliance costs. Post-US tax reform, complexity has not only significantly increased but so has the real possibility of significantly higher global tax cost. As a result, many taxpayers are reorganizing their affairs to avoid CFC status (by way of gift or otherwise). Extreme care must be taken when undertaking this type of planning, as the tax traps are many and diverse.
Renunciation
Another seemingly quick fix to the GILTI issue (and potentially all US tax issues) is to simply renounce US citizenship. Of course, for many tax and non-tax reasons this decision should not be taken lightly. Taxpayers and their advisors should closely review the US expatriation rules (IRC 877A) and their potential impact. For more information on this option, see our article Planning for U.S. expatriation – The ins and outs of IRC 877A.
Navigating two tax regimes has never been easy for US citizens resident in Canada who own Canadian corporations. US tax reform has taken the complexity and potential tax cost to unprecedented levels. It has also significantly expanded the types of income to which US tax could potentially apply. With the introduction of the GILTI regime, proper tax planning is more critical than ever before. Taxpayers are strongly encouraged to rely on advisors who fully understand US and Canadian tax regimes and can tailor a strategy to help avoid unnecessary taxation.
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