Excess profits taxes and U.S. GILTI

by | Oct 25, 2024 | Articles

By Gina Gatchell, Director

‘Excess profits taxes’ is not a term that is frequently heard here in NZ. This is unlike the term ‘capital gains tax’, which has been a longstanding political football for the country.

This week, however, we heard the term in the news after a long hiatus,  as Australian-owned ANZ Bank New Zealand Limited faced scrutiny over its profits.

This resurrected suggestions of an excess profits tax by certain political parties.

An excess profits tax was initially floated during World War One as a way to capture some of the extraordinary profits being made due to wartime demand.

More recently, it was proposed by NZ’s left-wing Green Party. This occurred in 2022, partly in response to a post-pandemic economic slump.

‘The aim of excess profits taxes is to level the playing field, so that big businesses are not able to profit in excess when so many people are struggling’ 2022 Excess Profits Tax Discussion Document.

It is interesting to note that the document makes reference to big businesses, and not all businesses that make excess profits.

Meanwhile in the U.S., at least one excess profits tax has been in existence since 2017[1] – and does not discriminate between large or small businesses.

Background

The U.S. anti-deferral regime introduced an excess profits tax effective from 1 January 2018 under the Tax Cuts and Jobs Act 2017.

The Global Intangible Low-Taxed Income Tax (GILTI) was added as Section §951(a) of the Internal Revenue Code.

GILTI is applicable to domestic U.S. persons who hold voting interests or shareholdings in corporations formed outside the U.S. 

It forms part of the U.S.’ anti-deferral tax regime contained in the Internal Revenue Code.

GILTI was enacted at the same time that the Trump administration reduced the domestic corporate tax rate to 21%.

This new category of foreign income derived by a foreign corporation acts as a disincentive for U.S. persons to make profits through foreign corporations. Those profits would otherwise escape U.S. tax, by remaining in the foreign corporation – versus being distributed to U.S. shareholders. 

From that perspective, it could be argued that GILTI is an extension of the §965 ‘transition tax’.

The transition tax was a mechanism by which unrepatriated profits of foreign corporations became taxable. It was introduced at the same time that the corporate U.S. rate was cut to 21%.

Both the transition tax, and GILTI, as well as Subpart F income all have in common the requirement for U.S. shareholders of foreign corporations to include unrepatriated income from a foreign corporation in their U.S. tax return.

Through GILTI provisions, profits made by a foreign corporation exceeding of 10% of the net tangible assets of the foreign corporation, can be subject to U.S. federal income tax in the hands of the domestic U.S. shareholder. 

Whether in fact the U.S. shareholder will pay U.S. tax on GILTI is dependent on the facts and circumstances in each case.

This is due to the operation of various interrelated parts of the Internal Revenue Code. These include Section 962 Election by individuals to be subject to tax at corporate rates, Section 901 Foreign Tax Credits, and Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI). 

As mentioned earlier, undistributed profits earned by a foreign corporation are, where those profits cannot be excluded from the  calculation of GILTI, and exceed 10% of QBAI must be included as gross income on a U.S. person’s income tax return.

Exclusions

Let’s take a look at the possible exclusions[2] from GILTI.

  • Income which is ‘effectively connected with a U.S. trade or business’.

GILTI applies only to the foreign earnings of a foreign corporation.

Therefore, any income derived by a foreign corporation which is connected with U.S. operations is not included in the GILTI calculation.

However, if U.S. tax on that income is reduced, or exempt from U.S. tax, pursuant to any income tax treaty, this exclusion cannot be used.

  • Subpart F income in the case of a controlled foreign corporation.

This is certain categories of income, mostly passive income, which does not qualify for an exemption from Subpart F income treatment under rules contained in the Internal Revenue Code.

Subpart F income can include rents, royalties, interest, and gains from the disposal of property on which the aforementioned types of income are earned. These are the more common categories and which are potentially taxable under §952 of the Internal Revenue Code.

  • High-taxed income

High-taxed income is foreign base company income, not  subpart F income, or foreign insurance income, however for which a foreign corporation has paid tax on that foreign income either in the home country or a country of operations, equivalent to at least 90% of the U.S. corporate tax rate (the ‘high tax exception’).

  • Dividend income received by the foreign corporation from a related person.[3]
  • Income from the extraction of minerals from oil or gas wells located outside the U.S. and its territories, or the sale or exchange of the assets used by the foreign corporation used to produce that income.

Any and all exclusions are aggregated. Total exclusions are then deducted from gross income.

Deductions

After applying any applicable exclusions, deductions properly allocable to the income are applied. These are made in accordance with §951A-(c)(2)(A)(ii).

This will result in ‘tested income’ or ‘tested loss’. It follows that in cases of a tested loss, there is no tested income tax to factor into the process of calculating GILTI.

In cases of tested income, this is adjusted upwards to include tested interest income, which is interest income that the U.S. shareholder receives from the foreign corporation, and then adjusted downwards with a deduction for any tested interest expense that the foreign corporation has incurred.

The result is net tested income. This is used in the next stage of the GILTI calculation.  

The taxing effect is that profits which are deemed to be in excess of 10% of the net tangible assets[4] of a foreign corporation are taxable in the hands of the shareholder. The objective of this is to provide a disincentive for foreign corporations to make excess profits.


Qualified Business Asset Investment (‘QBAI’)

In plain English language, QBAI represents net tangible assets of a foreign corporation in this context.

QBAI is measured across all four quarters of the foreign corporation’s income year. 

It is measured as the average of the foreign corporation’s aggregate adjusted bases as of the close of each quarter of its tax year in specified tangible property used in its trade or business in the production of tested income, and for which a deduction is allowable under § 167 -depreciation.

‘Adjusted bases’ is a U.S. term for written down value, or book value. In this context, it is determined using U.S. tax depreciation rates applicable to foreign property.

Observation

In NZ, due to there no longer being residential rental property depreciation, the first step in determining QBAI of a foreign corporation will be to calculate the adjusted basis/(bases) of all residential rental property.

This means that the value for accounting purposes cannot be used in the calculation of QBAI and is an important consideration because it means that QBAI will be less than the value for accounting purposes.

Specified tangible property includes depreciable property and excludes all financial assets for example, cash, trade debtors, and other receivables.

Relationship with Subpart F income

Subpart F income is calculated on unattributed earnings of a foreign corporation and then included on the U.S person’s federal income tax return.

It applies in the situation where the foreign corporation is a controlled foreign corporation for U.S. tax purposes[5].

This is in contrast to GILTI which applies whether or not the foreign corporation is controlled by U.S. persons.

In contrast to Subpart F income which is calculated at the corporation level, GILTI is calculated on all income from a foreign corporation that a U.S. person derives.

Subpart income is calculated before GILTI and is excluded from the GILTI calculation. This has the effect of preventing unattributed income from a foreign corporation being taxed twice, both as Subpart F income, and then as GILTI.  

Foreign tax credits on GILTI

GILTI is eligible for a credit for foreign taxes to the extent to which foreign tax has been paid on GILTI in the country of incorporation of the foreign corporation, or a country in which a foreign corporation has operations.

Observation

Foreign corporations deriving income in a country other than the one in which the foreign corporation was incorporated are more likely to be taxed on Subpart F income first and then GILTI. Subpart F income would arise under the Foreign Base Company Sales and/or Foreign Base Company Services provisions in the Subpart F rules. 

Example:

A, a U.S. citizen, has lived in NZ since 1985. A owns 50% in Foreign Corporation (FC), a NZ limited liability company formed in NZ.

A’s friend, B, who is neither related to A nor a U.S. person, owns the other 50% of FC.  

In 2015, FC invests in a NZ residential rental property, which cost NZ $500,000.

The accounting or book value is also NZ $500,000, since residential rental property is no longer able to be depreciated for tax purposes in NZ.  A is responsible for actively managing the property. A securing tenants, arranges maintenance and monitors the statU.S. of the property during the ownership period.

In 2021 FC sells the rental property during a peak in the NZ residential property market.

The sale price is NZ$2,000,000.

FC has made a gain of NZ $1,500,000 on the property. When converted to U.S. dollars, the gain is U.S. $1,000,000.

The cash sits in FC undistributed.   The gain is therefore subject to the Subpart F income rules.

As mentioned, A was actively involved in managing the property whilst it was owned by FC.

Therefore, the gain does not constitute Foreign Personal Holding Income for Subpart F income purposes which concern A, being a U.S. citizen.

The gain, however, may be GILTI.

The calculation is as follows:

Gross income of FC equals $500,000 minU.S. (10% of $500,000) equals $450,000 = GILTI which is allocable to the U.S. shareholder as per their shareholding percentage.

So for A, this is 50% x $450,000 equals $225,000 GILTI.

A’s federal income tax rate is 37%. The tax liability before any foreign tax credits is $225,000 x 37% equals $83,250.

A can then make an election to recharacterise Section 951A income and pay U.S. tax at the U.S. corporate income tax rate of 21%, thereby making a Section 962 election.

A makes this election when filing the U.S. tax return for 2021.

Taking the example above the result is now as follows.

GILTI $225,000

Corporate tax rate 21%

Amount to include on U.S. tax return 225000 x 21% 31,500.

A can save $83250 minU.S. $31,500 = $51,750 by making a Section 962 election.

A must also calculate the Section 250 deduction for GILTI. If the result is an allowable deduction for A, this will result in a further reduction of the $51,750 tax in this example. More to come about this shortly.

In A’s case, as the residential rental property was purchased and sold within 10 years and subject to the brightline test, thus paying NZ tax on the gain made, that NZ income tax will be allowable as a credit on A’s U.S. income tax return subject to the limitations of claiming a foreign tax credit which are written into the Internal Revenue Code.[6]


[1] It could be argued that Alternative Minimum Tax is also an Excess Profits Tax.

[2] Treas. Reg. 1.951A-2(c)

[3] §954(d)(3)

[4] This is referred to as Qualified Business Asset Investment or ‘QBAI’

[5] This is where a foreign corporation is owned, either directly, indirectly or constructively by at least 51% of persons who are U.S. persons.

[6] §901 Foreign Tax Credits

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