The New International Tax Law created a new type of tax on global intangible low-taxed income (“GILTI”) that has a dual identity. On the one hand, the tax on GILTI is intended to impose a preferential tax rate of 10.5% on foreign intangible income so that the United States can compete with tax-favored foreign jurisdictions such as Ireland with a 12.5% tax. On the other hand, the tax on GILTI is also intended to work like a “minimum tax” on taxpayers who are deemed to be paying too low a tax on their foreign intangible income to discourage overseas investment. Read on to learn more about the far-reaching implications of this new tax and who the GILTI may impact.
The GILTI Computation
A 10% or more U.S. shareholder of any controlled foreign corporation (“CFC”) is required to include in gross income for the current tax year its GILTI, regardless of whether actually distributed. A 10% U.S. shareholder may be either an entity or an individual.
GILTI is computed as the income that is in excess of the standard return (statutorily assumed to be 10%) on the adjusted tax basis of active foreign tangible business assets. GILTI is taxed at a rate of 10.5%. Thus, the tax is not imposed on actual intangible income, but on hypothetical income that is assumed to be related to intangibles. In reality, companies with high profits or significant income unrelated to their tangible assets may be put in an excess income position, which would result in having to pay the tax.
The Broad Fishing Net
On the surface, the title of the tax appears to target the intangible income of high technology companies with intellectual property, such as patents and licenses. However, as the formula for computing the tax demonstrates, the GILTI tax will apply to income far beyond that of intellectual property, and likely ensnare high profit companies regardless of the intellectual property they may hold.
Highly profitable companies with “excess profits” from foreign plants, equipment and inventory may be subject to the GILTI tax even though they do not hold intangibles.
Services firms, such as attorneys, accountants, and advertisers with offices overseas may be subject to the GILTI tax as they may have “excess profits” based on the GILTI computation.
Special Computational Rules
GILTI does not include income effectively connected with a U.S. trade or business, subpart F income and certain related-party payments.
A U.S. shareholder computes GILTI in the aggregate for all its CFCs which means that companies with income can be offset by companies with losses.
Interest expense can be deducted from GILTI, but straight line depreciation must be used.
Only C corporation U.S. shareholders generally would be entitled to a tax deduction of 50% of any GILTI. Individuals and other entities are not allowed such a deduction.
Foreign Tax Credits
Foreign tax credits are allowed for foreign income taxes paid with respect to GILTI, but are limited to 80% of the foreign income taxes paid and are not allowed to be carried back or forward to other years. Foreign tax credits are only allowed for C corporations, even though all 10% shareholders are subject to the tax.
GILTI Tax Rates
Individuals are at a significant disadvantage because they are not entitled to the GILTI deduction or to foreign tax credits, and thus will be taxed on GILTI up to the maximum rate of 37%. Pass-through entities such as partnerships flow through income to their partners who are taxed at their applicable ordinary rates.
Without factoring in foreign taxes, at the new 21% corporate tax rate, the effective tax rate would be 10.5% on GILTI (computed as 21% of 50%).
If foreign tax credits are taken into account, the effective tax rate on corporations on GILTI would be 13.125% or higher (computed as 10.5% divided by 80%).
Thus, on corporations there is an effective tax rate of 10.5% on GILTI if no foreign tax is paid, which scales down to no U.S. tax on GILTI if foreign tax of 13.125% or more is paid.
- There is no carryover or carryback of excess foreign tax credits to other years, so excess credits are lost.
- The GILTI tax is payable regardless of whether there is a distribution. Taxpayers that formerly were able to defer recognition of this income will pay U.S. tax currently.
- The use of tax basis rather than fair market value in determining the return on tangible assets means that the actual return on assets is most likely understated, resulting in a higher GILTI tax.
- Since land is not a depreciable tangible asset, the actual return on assets is most likely understated and will result in a higher GILTI tax.
- Since debt of a CFC does not reduce tangible asset basis for the GILTI computation, there is an incentive to leverage the purchase of assets because the interest expense will reduce GILTI income.
- There is an incentive for taxpayers to increase the tax basis of foreign tangible depreciable assets to reduce GILTI. For example, a CFC making an acquisition of another corporation would consider (a) buying assets rather than stock, or (b) buying and electing to step-up the basis of assets.
- The Internal Revenue Service has the authority to prevent taxpayer circumvention of the GILTI tax by entering into non-economic transactions (a substance over form rule).
- Since income from the exploitation of domestically held intangible assets is subject to the regular rate of tax, it may continue to be advantageous to hold intangibles in foreign low-tax jurisdictions.
- We will continue to keep you informed as time will reveal how the GILTI tax will impact the global economy. In the interim, please contact your Friedman LLP professional for answers to specific questions.
We will continue to keep you informed as time will reveal how the GILTI tax will impact the global economy. In the interim, please contact your Friedman LLP professional for answers to specific questions.