The new US global intangible low-tax income (GILTI) regime was introduced as part of US tax reform changes announced in December of 2017 and applies to foreign corporation’s first tax year beginning after 2017.
How the GILTI Rules Work
The GILTI rules require US taxpayers who own 10% or more of the votes or value of a “controlled foreign corporation” (CFC), such as a Canadian company in which more than 50% of the shares are owned by US taxpayers who each own at least 10% of the shares, to include in their income for US tax purposes amounts earned by the CFC that exceed a certain rate of return threshold.
These rules are meant to discourage US companies from shifting profits to foreign subsidiaries in low tax countries since such profits can be repatriated tax-free to US corporate shareholders. These rules can apply not only when a CFC earns income on patents and other intellectual property, but also when it earns service income that exceeds a certain rate of return threshold.
In simple terms, the profits of the CFC that exceed a 10% return on the CFC`s depreciable tangible assets are taxed under this new regime. Where a CFC does not use a lot of depreciable property in its trade or business (such as those providing professional services), most of the CFC’s income will be included in the base subject to the GILTI tax.
Where the US shareholder is a US domestic corporation, the US corporation may deduct an amount equal to 50% of the GILTI income inclusion when computing income. As well, the US domestic corporation is entitled to a credit for 80% of its pro-rata share of the foreign corporation’s taxes attributable to the GILTI income inclusion; which essentially means a full exemption from GILTI tax provided the foreign corporation pays tax on its GILTI income at a rate of at least 13.125%. The problem with these rules is that these two provisions do not apply if the US shareholder is a US individual. For the US individual shareholder, there will be a GILTI inclusion and only the normal foreign tax credit provisions will apply. Without proper planning, double tax may occur as the GILTI income inclusion and related US tax payable occurs in the year the income is earned by the Canadian corporation whereas the only creditable Canadian tax for foreign tax credit purposes occurs in the year a dividend is paid from the Canadian corporation to the individual US shareholder.
For example, the GILTI rules will apply to Dr. Smith, a Canadian resident / US citizen doctor, if he operates a medical practice through a Canadian corporation (“Medco”) that earns an amount of income that exceeds 10% of Medco’s tangible business assets. Assuming Medco earns $400,000 from medical services, owns $20,000 of medical equipment, and pays a $100,000 annual salary to Dr. Smith, $298,000 of Medco’s income will be reportable on Dr. Smith`s US tax return and taxed at rates of up to 37%.
For Canadian tax purposes, Dr. Smith will be subject to Canadian tax on Medco’s retained income only when Medco pays out such income as a dividend to him. As mentioned previously, this will result in double tax because of the timing mismatch between when income is recognized for US and Canadian tax purposes.
In order to avoid the punishing effects of the new GILTI tax regime, Dr. Smith could:
- consider changes to his shareholdings in the company and how he is compensated,
- reduce amount of small business deduction,
- change the legal structure of Medco’s business,
- renounce his US citizenship, or
- make a special election for US tax purposes.
The pros and cons of each option should be reviewed with your DMCL tax adviser before implementing any changes.
Change in Ownership
Dr. Smith could restructure his share ownership in Medco so that he only owns voting shares that cannot receive dividends while his Canadian citizen/resident spouse owns the non-voting shares. Dr. Smith would then draw a salary for his services (which would reduce the GILTI inclusion) instead of being paid a dividend on the shares of the company. Consideration would have to be given to how the new tax on split income rules in Canada would impact the distribution of dividends from the company to Dr. Smith’s spouse as well as other US and Canadian tax issues related to the restructuring.
Adjust Small Business Deduction
Dr. Smith could possibly take advantage of the exception from the GILTI tax that applies to income that is subject to tax at the corporate level of at least 18.90% but this would mean that Medco would have to give up some or all of the small business deduction which reduces the general corporate income tax rate on Medco’s income from approximately 27% to 12%.
Convert to an Unlimited Liability Company
Dr. Smith could convert Medco into an unlimited liability company under the laws of BC, Alberta or Nova Scotia. This may trigger US tax in respect of any unrealized gains on the corporation’s assets, but if there are not any significant gains the conversion to a ULC should not result in significant US taxes. Under this option, Dr. Smith would be required to include all of Medco’s income in his income for US tax purposes every year (whether or not such income was paid out to him) but would be able to claim a foreign tax credit for the Canadian corporate tax paid by the corporation. This would however mitigate the benefits of the tax deferral currently enjoyed by Dr. Smith in respect of income retained in his corporation which is only subject to Canadian corporate taxes at rates of approximately 12%.
Renounce US Citizenship
Dr. Smith could renounce his US citizenship so that he would no longer be subject to US tax laws. Of course he would have to consider whether he would be subject to any US tax on renunciation under the US expatriation regime for “covered expatriates”.
Make a US Tax Election
Dr. Smith could make a special election under Section 962 of the US Internal Revenue Code so that he would be subject to US tax as if he were a US Corporation; thereby entitling Dr. Smith to the 50% deduction available to US corporations in respect of their GILTI income inclusion and possibly an indirect foreign tax credit for the foreign taxes paid by the foreign corporation. Careful consideration should be given to the negative US tax treatment of any future dividends paid by his Canadian corporation under this election.
If you would like to discuss the impact of the GILTI tax regime in your specific situation, please contact your DMCL Tax Advisor.