Achieving a 10.5% Tax Rate Can Be Your Reality
I really think that the Internal Revenue Code garnered such a mythology around it such that my clients sometimes view me as a sorcerer who can conjure up the right tax law to magically make their tax liability $0 or close to it, especially many months after the tax year has passed. Unfortunately, tax planning never works that way and requires a proactive approach, long before the transaction and taxable year have closed. To that end, when the right steps are taken, we can collaboratively structure your tax outcome to the most optimal point. One of these optimal points is taking advantage of international taxation, specifically, Subpart F and GILTI. While they may sound like daunting acronyms straight out of a taxing tax textbook, they're vital for anyone venturing internationally. Let's unravel these and see how you can harness them to your benefit.
Subpart F – The Slayer of Most Tax Strategies
Introduced in 1962, Subpart F legislation aimed to prevent U.S. entities from parking income in offshore low-tax jurisdictions, thereby deferring U.S. tax. So, instead of waiting until that income is repatriated to the U.S., Subpart F swoops in and says, “Let’s tax some of that now.”
Certain types of income, notably 'passive' incomes like interest, dividends, and rents, get caught in the Subpart F net and are subject to U.S. taxation, even if they aren't physically brought back to the U.S.
Alternatively, ‘creative’ non-tax people have these awesome ideas where they’ll form a corporation overseas and run income and expenses abroad, outside of the US, while continuing to do all of the heavy lifting on the work within the US. This doesn’t work since this income is really sourced to the US and should be taxed here, even if paid out of a foreign corporation.
Sometimes, folks do the above but hire a few, low level team members in the foreign country to create the appearance that the work is truly happening overseas, thus outside of the purview of the US tax system. This generally won’t work either if the work is deemed to be “on behalf of” the US person. This is where Subpart F plays a role and ends up taxing this income anyway under US ordinary rates.
GILTI
Fast forward to 2017. The Tax Cuts and Jobs Act introduces GILTI - Global Intangible Low-Taxed Income. Think of GILTI as Subpart F’s younger, more aggressive sibling. Its mission? To tax U.S. shareholders of Controlled Foreign Corporations (CFCs) on their global intangible income.
However, GILTI isn’t just about intangibles. It applies to active business income that exceeds a routine return on tangible assets. The concept of GILTI is basically to tax anything that isn’t taxed under Subpart F. However, if you play your cards right, this works out to be a fantastic outcome.
The GILTI Outcome
Here's where it gets even more interesting: For corporations, the effective tax rate for GILTI income is 10.5%, thanks to a 50% deduction against GILTI income. But remember, this rate is before the application of foreign tax credits, which can further mitigate the GILTI hit. This reduced rate underscores the legislation's goal to ensure U.S. corporations remain competitive in the global marketplace while also discouraging profit-shifting strategies.
Therefore, a common tax structure one might see is something like this. US individual wholly owns a US C Corporation, which in turn wholly owns a Foreign Corporation. The ultimate tax outcome will depend on which country you end up incorporating in, so a country with a little to 0% tax rate would end up providing you this optimal tax structure.
I would be remiss to say that this tax outcome is more akin to a tax deferral strategy than a permanent tax reduction strategy. While it’s true that the income taxed at the CFC level is deemed distributed to the C Corporation, thus resulting in no further to the US C Corp, taking dividends from the C Corp to you as a shareholder will result in another level of taxation.
This isn’t a deal killer however. Since this is a tax deferral strategy, your cashflow isn’t being consistently cut down by large tax bills (up to around 50% in California) in the intervening years. You can use these funds to invest in all sorts of cool things, like real estate, marketable securities, and so forth. The keys to success to employ this strategy is ensure that you have an active, real business outside of the US and that the facts and circumstances surrounding this business provide enough of a story to exit the Subpart F realm and therefore taxed under GILTI instead.
Summary
I’ll caveat everything I said above to make one important point: this strategy takes a lot of work and careful structuring. Since the Code itself doesn’t provide a lot of bright line tests, you will need to carefully consider the facts and circumstances around your business overseas to ensure that you’re achieving the tax outcome you desired. We can help you get there and are always ready to chat and show you the way.
