Time Travelling with the Section 962 Election

Eli S. Noff, Esq. CPA, Partner
Peter Palsen, International Tax Advisor 

It is undisputed that U.S. individuals who own foreign companies were treated unfavorably under the Tax Cuts and Jobs Act of 2017 (TCJA) compared to U.S. corporate shareholders. However, an election that allows individuals to treat themselves as corporations can, in the right circumstances, help alleviate the harsh results.

Changes to the Taxation of Income of Foreign Corporations

Prior to the changes made by the TCJA, shareholders of U.S.-controlled foreign corporations who avoided Kennedy-era anti-deferral rules were generally only taxed on the income of such foreign corporations when they received a distribution from the foreign corporation. Under TCJA, such shareholders are now subject to the Global Intangible Low Tax Income (GILTI) regime. GILTI represents a substantial expansion of the anti-deferral rules, generally requiring U.S. shareholders to include in current taxable income their proportionate share of the earnings of U.S-controlled foreign corporations in the year earned (subject to a reduction for a deemed 10% return on certain depreciable assets).

Shareholders who are regular U.S. corporations (as contrasted to S-Corporation or other pass-through entities) were granted a deduction of 50% of the GILTI inclusion – thus allowing at least half of the earnings to be exempted from U.S. tax). Furthermore, regular U.S. corporate owners are allowed to use foreign taxes paid by the foreign corporations to offset U.S. tax on the inclusion in U.S. taxable income of the foreign earnings (subject to a 20% haircut of foreign taxes under GILTI). Of additional benefit to these shareholders, the corporate rate of tax to be offset by foreign taxes was slashed from 35% to 21%.

Individual owners (including individuals owning foreign corporation shares through S-Corporations or other pass-through entities) were left feeling kicked to the curb. Historically, such owners were willing to accept the loss of foreign tax credit offset as a trade-off to receive long-term U.S. tax deferral of the earnings. While individuals saw their highest marginal tax rate move down slightly as a result of TCJA, they can now be faced with current taxation of most foreign corporation earnings - whether distributed or not.

Damage Control

As a result of the TCJA changes, many U.S. individual owners of foreign corporations began to consider transferring the shares of foreign corporations to newly-formed regular U.S. corporations. Access to the lower corporate tax rate, the ability to claim the 50% deduction against GILTI, and the foreign tax credit offset could result in a substantial reduction of U.S. income tax compared to direct ownership. While the individual would be subject to tax on a later distribution of the income from the U.S. corporation, such distribution would normally be eligible for the qualified dividend rate (generally 20%, but potentially also including the 3.8% net investment income tax and state taxes as applicable).

However, organizing and operating a regular U.S. corporation holding foreign shares can have significant U.S. and foreign tax and administrative cost consequences. The Treasury Department and the IRS noted these burdens in recently-issued proposed regulations in which they increased the effectiveness of another Kennedy-era provision - the Section 962 election, which provides an alternative to individuals to receive regular corporation treatment without the need to create an actual regular corporation. While the use of a Section 962 election does not exempt the underlying income from taxation, it can effectively revert an individual to the taxation-upon-distribution treatment in place prior to the enactment of the TCJA.

Benefits of The Section 962 Election

Under Section 962 of the Internal Revenue Code, an individual U.S. shareholder of a U.S.-controlled foreign corporation may elect for a taxable year (the election is year by year) to be effectively treated as a corporate recipient for all amounts included in U.S. taxable income under the anti-deferral rules (both the new GILTI and the historic rules, which were largely unaffected by TCJA). The election is also available to an individual owning a U.S.-controlled foreign corporation through a pass-through entity like a partnership or S-Corporation.

The keys to the effectiveness of the election to minimize U.S. tax on anti-deferral income are:

  • the use of the 21% corporate tax rate to determine the baseline U.S. tax liability,
  • access to the 50% Section 250 deduction against GILTI (although such offset is not available against income included under the historic anti-deferral rules),
  • the availability of the foreign tax credit mechanism to offset the calculated U.S. tax with foreign taxes on the included income (subject to the GILTI haircut of foreign taxes), and
  • A special rule that prevents the spillover of personal or business deductions that could otherwise impair the use of foreign tax credits or subject the 50% deduction to a taxable income limitation.

Considering all of the above factors, the Section 962 election can make sense if there are sufficient foreign tax credit offsets available. In contrast, if there are no foreign taxes attributable to the included earnings, a residual U.S. federal tax liability of 10.5% to 21% could result (depending on whether the income is GILTI or historic anti-deferral income). Absent sufficient foreign taxes, a Section 962 election may not be beneficial, since additional U.S. tax is required to be paid upon the later distribution of the income from the foreign corporation.

The election is generally due by the extended due date of the U.S. tax return for the year to which the election applies. However, under certain circumstances, an election has been permitted to be made on an amended return.

What the Section 962 Election Does Not Do

Typically, the inclusion of foreign earnings under U.S. anti-deferral rules permits such earnings to be distributed at a later time free of U.S. federal income tax (on the basis that the earnings have already been subjected to U.S. tax inclusion, even if offset by foreign taxes). However, a special rule under Section 962 limits this "previously taxed income" status to only the amount of residual U.S. tax paid after the credit offset. As an example, if $100 of earnings are included in the Section 962 calculation and $2 of tax is paid, only the $2 can be distributed without again being subjected to U.S. taxation. As such, the election will not ultimately avoid taxation of the earnings, but as previously noted, will result in the taxation of the income in a manner more closely resembling the pre-TCJA "taxation upon distribution" regime. Note that special rules under the 3.8% net investment income tax also generally defer such tax until the later distribution of the earnings.

Furthermore, in contrast to the situation involving the use of an actual regular corporation, the Section 962 election may not allow future receipt of the income by the individual shareholder to be subject to the qualified dividend rate (generally 20% rate of federal income tax) unless the shareholder is entitled to such treatment at the time of later distribution (e.g., the earnings are distributed by a tax resident of a country with which the U.S. has a comprehensive tax treaty). A recent court case rejected a taxpayer assertion that the deemed receipt of the income by a U.S. corporation under Section 962 would result in a later dividend of such income from the foreign company being treated as having been distributed by the notional U.S. corporation.

In many cases, state taxation of the earnings subject to the Section 962 election will be uncertain. Most U.S. states do not have guidance specific to Section 962 elections, and since states generally do not allow foreign tax credits to individuals, it is possible that tax deferral might not be available - and in the extreme case double taxation could result at the state level (or at least a round of correspondence with the state to explain the adjustment to avoid double taxation).

Finally, the election does not reduce the compliance burden. Additional forms will be required to be filed to make the election and support the foreign tax credit offset. Furthermore, an election under Section 962 requires complex calculations of earnings, and taxes attributable to such earnings, as well as ongoing tracking of earnings that remain subject to tax on future distribution.

The Takeaway

The taxation of earnings of foreign corporations has fundamentally changed under the TCJA. The Section 962 election can allow some individuals to time travel back to the pre-TCJA regime, but it is possible that an alternative structure involving a regular C corporation could provide greater long-term tax benefits. Since most of the salient international change areas of the TCJA have now been the subject of regulations, a meaningful analysis of alternative structures should now be undertaken.