Important Section 962 Election Tax Implications

Important Section 962 Election Tax Implications

Section 962 Election

Important Section 962 Election Tax Implications to Consider: While an Internal Revenue Code Section 962 Election may be beneficial for some US Taxpayers who are hit with GILTI (or Subpart F) — it is not in the best interest for all Taxpayers who are subject to GILTI to make the election (unless they primary motivation is to seek a tax deferral).  The concept behind a Section 962 Election is that a Taxpayer should not be in a worse position and paying more US tax as a result of investing abroad as an individual than they would have paid if they were a domestic corporate shareholder making the same investment. Back when this code section was introduced, the tax rates were much higher and individuals with controlled foreign corporations, could getting stuck with an incredibly high tax in comparison to their corporate shareholder counterparts who also owned/invested in CFCs. While Section 962 was not often used, with the introduction of GILTI — and the recently issued regulations — the 962 election is in the spotlight.

26 USC 962 Election by Individuals to be Subject to tax at Corporate Rates U.S. Code

(a) General rule

  • Under regulations prescribed by the Secretary, in the case of a United States shareholder who is an individual and who elects to have the provisions of this section apply for the taxable year—

  • (1) the tax imposed under this chapter on amounts which are included in his gross income under section 951(a) shall (in lieu of the tax determined under sections 1 and 55) be an amount equal to the tax which would be imposed under section 11 if such amounts were received by a domestic corporation, and

  • (2) for purposes of applying the provisions of section 960?[1] (relating to foreign tax credit) such amounts shall be treated as if they were received by a domestic corporation.

(b) Election

      • An election to have the provisions of this section apply for any taxable year shall be made by a United States shareholder at such time and in such manner as the Secretary shall prescribe by regulations. An election made for any taxable year may not be revoked except with the consent of the Secretary.

(c) Pro ration of each section 11 bracket amount

      • For purposes of applying subsection (a)(1), the amount in each taxable income bracket in the tax table in section 11(b) shall not exceed an amount which bears the same ratio to such bracket amount as the amount included in the gross income of the United States shareholder under section 951(a) for the taxable year bears to such shareholder’s pro rata share of the earnings and profits for the taxable year of all controlled foreign corporations with respect to which such shareholder includes any amount in gross income under section 951(a).

(d) Special rule for actual distributions

      • The earnings and profits of a foreign corporation attributable to amounts which were included in the gross income of a United States shareholder under section 951(a) and with respect to which an election under this section applied shall, when such earnings and profits are distributed, notwithstanding the provisions of section 959(a)(1), be included in gross income to the extent that such earnings and profits so distributed exceed the amount of tax paid under this chapter on the amounts to which such election applied.

What does this Mean?

It means that for some US Persons subject to GILTI (and Subpart F) — they may have earnings which while previously escaped tax until repatriation — may now become subject to tax. In order to level the playing field, the US Government approved regulations which allows individuals to make an IRC section 962 Election, in order to be treated as a Corporation. Thus, Taxpayers making the 962 election will treat the GILTI income as if it first passes through a US Domestic Corporation before being distributed to the US Person. By making this election, the Taxpayer can utilize a 50% deduction and 80% of foreign tax credits to essentially reduce, if not eliminate GILTI tax.

The Basics of an IRC 962 Election

At its most basic level, the idea behind an Internal Revenue Code Section 962 election is simply that an individual shareholder investor who invests in a CFC should not be stuck paying more tax than a corporate shareholder making the same investment. And, if treating the Taxpayer as Domestic Corporate Shareholder instead of an individual shareholder will accomplish that goal — than there should be a mechanism for them do it — and Section 962 was introduced.

Until recently, the corporate tax rate was high and so a 962 election was not much of a consideration — especially in light of potential future tax implications at the time of actual distribution. With the introduction GILTI, the IRC 962 election was thrust into the spotlight in order to assist taxpayers with reducing their tax rate for GILTI income. To make individual shareholders competitive, the US Government finalized regulations authorizing individual shareholders to claim 962 to reduce GILTI.

Domestic Corporate Shareholders Can Usually Skirt GILTI Tax

For Domestic Corporations that have ownership of a controlled foreign corporation that would otherwise result in GILTI tax — they have two main benefits over an individual shareholder:

      • First, the corporate shareholder may deduct 50% of the income in accordance with Internal Revenue Code section 250.

      • Second, the domestic corporation is able to apply 80% of the applicable foreign tax credits.

Unlike a Domestic Corporate Shareholder of a Controlled Foreign Corporation, individual shareholders are not able to either deduct the 50% or apply the foreign corporations tax credit to their US individual tax return (since it was the foreign corporation and not the Taxpayer who paid the tax.) But, by making the 962 election the individual shareholder is then able to claim the credits and the deduction. While this can be a benefit — it is not always a benefit. In fact, sometimes it may put the individual Taxpayer in a worse tax position (although the payment of tax is deferred to a future date).

Here are a few things to consider about the Section 962 election:

Is the Foreign Corporation Qualified?

When the foreign corporation is a Qualified Foreign Corporation then the distributions to the US shareholder can generally receive qualified dividend treatment — which results in a competitive tax rate. Conversely, if the foreign corporation is not a Qualified Foreign Corporation, then the distributions to the US shareholder will not receive qualified treatment.

Were Foreign Tax Credits Paid?

Oftentimes, if the foreign corporation did not actually pay any foreign tax — such as countries that do not tax various categories of corporate income which is considered GILTI or Subpart F in the US — then the 80% foreign tax credit is not applicable — and the overall benefit is minimized, if not lost. Depending on when the income is actually distributed from the foreign corporation and what the US tax rate is at that time, it may actually result in a higher tax liability then had the individual not made the election.

All CFCs for Corporate Income

When a Taxpayer makes the 962 Election, it includes all Controlled Foreign Corporations in which the taxpayer is a shareholder. Depending on then the tested income, and which of the foreign corporations have GILTI vs. Subpart F — vs both — this can significantly impact any potential benefits of the election.

962 Election Should be Considered Carefully

It is important to carefully evaluate the tax benefits and detriments before making a 962 election. Taxpayers should carefully weigh whether or not the foreign corporation is considered qualified and/or if sufficient foreign tax credits were paid before making the election sufficient to realize a real US tax benefit. Taxpayers should take note that under some circumstances, it may not really be a tax benefit more than a deferral on the payment of tax — which could result in an even higher tax, depending on how the tax rules may change in the future.

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