While GILTI is a US tax, it can be a significant problem for US shareholders resident in Canada. As explained below, provisions which reduce Canadian taxes owing may ultimately result in additional US tax payable where they disqualify the taxpayer from access to the GILTI high-tax exception. While in some cases planning may help reduce the most extreme negative implications, US shareholders of Canadian controlled private corporations (“CCPCs”) need to be aware of these potentially expensive newly released regulations.
On July 20, 2020 the US Treasury and the Internal Revenue Service (“IRS”) released a hefty package of final and proposed regulations (collectively the “2020 Final Regulations” or simply the “Regulations”) dealing with the high-tax exception to so-called global intangible low-taxed income, or GILTI, as it has come to be known. Introduced in the Tax Cuts and Jobs Act of 2017 (“TCJA”), GILTI piggybacks on, and expands the subpart F rules that were introduced nearly 60 years ago. Key concepts to this discussion are controlled foreign corporations (“CFC”) and US shareholders of CFCs. A US shareholder is a US person who holds directly or indirectly or is considered to own constructively at least 10 percent of the shares of a foreign (i.e., non-US) corporation either by vote or by value. The foreign corporation qualifies as a CFC if US shareholders control more than 50 percent of its shares either by vote or by value. Unless one of several exceptions applies, US shareholders must report subpart F income or the GILTI of the CFC on their US tax returns, resulting in the elimination of the deferral of tax on the foreign earnings of a CFC.
For a US shareholder who is tax resident of Canada, these changes can have seriously negative tax consequences. The US taxes Subpart F and GILTI inclusions at full ordinary tax rates of up to 37 percent, whereas an actual dividend of CFC earnings not subjected to subpart F or GILT inclusions should generally benefit from a reduced tax rate of 20 percent as qualified dividends. Unless there is an accompanying actual distribution of the subpart F or GILTI earnings, there has been no dividend taxable for Canadian tax purposes. However, in the future, when there is an actual dividend, that dividend will be taxable by Canada, but not the US as it was previously taxed as a subpart F or GILTI inclusion. This asymmetrical treatment can wreak havoc with foreign tax credit planning. In some cases tax planning may be able to salvage the symmetry needed for foreign tax credits, but this provisions limits makes it so a Canadian resident US shareholder would not benefit from most of the basic Canadian tax planning techniques available for CCPC shareholders.
Although the original aim of GILTI was to prevent US-based multinational groups, especially in the high-tech sector, from “parking” their earnings indefinitely in subsidiaries resident in low-tax jurisdictions like Ireland or deemed, through aggressive tax planning, not to be resident anywhere, the sweep of GILTI is prodigious. Although the very name GILTI includes the words “intangible…income,” in truth, GILTI potentially applies to any form of income unless it falls within certain enumerated exceptions. For instance, classic subpart F income (usually passive kinds of income like dividends, interest, rent or royalties or gains on the sale of assets producing such passive income) is one major exception. That is cold comfort since subpart F also results in inclusion in income for the U.S shareholder. GILTI also provides an exception for certain “high taxed” income. This is accomplished by means of incorporating by reference the high-tax exception under the subpart F rules. The new final regulations, which supersede regulations in proposed form issued in 2019, deal with the application of the high-tax exception relative to GILTI, while harmonizing those rules with the high-tax exception for subpart F income.
Key Elements of the Regulations
Retroactive Tax Elections
Application of the high-tax exception requires a tax election. The Regulations allow for retroactive elections for taxable years beginning after December 31, 2017. This period coincides with the first taxable to which the GILTI rules applied. The election is made on a year-by-year basis, whereas the 2019 Proposed Regulations had required that the election remain effective for a 60-month period.
The Regulations replace the notion of grouping foreign entities according to qualified business units with the concept of “tested units.” Tested units include controlled foreign corporations, interests in foreign pass-through entities and branches of a CFCs.
Grouping of Tested Units
The Regulations require that tested units within a single country must be grouped for purposes of high-tax exception.
Let us assume, as a base case, that a US citizen is a tax resident of Canada and directly or indirectly controls both a holding company (“Holdco”) with passive investments and an operating company (“Opco”) or a professional corporation (“PC”). The corporations are all organized in Canada and qualify as CFCs. In that case, they would be grouped as one single tested unit.
Threshold for High Foreign Tax
The Regulations provide some clarifications on how to determine the threshold for “high tax.” The relevant section of the Internal Revenue Code defines high tax as a “an effective rate of tax imposed by a foreign country greater than 90 percent of the maximum rate of tax specified in section 11.” Section 11 provides the rate(s) of corporate income tax. Under current law, that maximum rate is 21 percent. This means that the effective foreign tax rate must exceed 18.9 percent (21% X 90%). Despite complex rules dealing with the allocation of income and expenses between related parties in different jurisdictions, disregarded entities that are taxable in their own right in different jurisdictions, interest income and expense, etc., the most general statement of the formula for determining the effective foreign tax rate is the quotient of the amount, expressed in US dollars, of the foreign income taxes paid or accrued divided by the US dollar amount of the tentative tested income item, increased by the amount of foreign income tax.
Let us assume that Holdco and Opco (or PC) are Alberta resident CCPCs. Opco earns exclusively income that qualifies as small business income, and Holdco earns exclusively investment income. First of all, it is important to note that the investment income earned by Holdco is not considered tested income because it is subpart F income. It is therefore excluded from our formula for determining the effective foreign tax rate for GILTI purposes, although it may also be eligible for the high-tax exception for subpart F purposes.
Opco pays the general rate tax at the federal level of 15 percent, as well as the Alberta 8 percent corporate rate, for a combined rate of 23 percent, which, of course, exceeds the threshold of 19.1 percent generally required for the high-tax exception. However, the small business deduction must also be considered. Since Holdco does not earn active business income, it presumably would not be eligible to claim any small business deduction. The small business deduction is actually a tax credit, which offers special reduced tax rates on the first CAD $500,000 of active business income. The federal rate becomes 9 percent and the Alberta rate becomes 2 percent. Therefore, for active business income eligible for the small business deduction, the foreign effective rate is reduced to 11 percent, well below the threshold tax rate of more than 18.9 percent needed for the high-tax exception. It appears that active business income must exceed CAD $1,538,462 with Canadian corporate tax in excess of CAD 293,846.15 in order for the effective Canadian corporate tax rate to exceed the 18.9 percent threshold required for the high-tax exception to GILTI.
The wording of the relevant provision of the Canadian Income Tax Act, subsection 125(1), states that the small business deduction “may be deducted” from the tax otherwise payable. Although this tax credit appears not to be mandatory, there is no mechanism for carrying it over to other taxation years, and if it is not used in the taxation year in which it arises, it disappears. If it were possible to modulate the effective Canadian tax rate by foregoing a portion of the small business deduction so as to attain the threshold for the high-tax exception, it might be possible to avoid GILTI tax and the numerous disadvantages and complications that accompany it. Although it is not certain, it appears likely that this is not possible. In prescribing the methodology for the calculation of tentative gross tested income subject to GILTI, the Regulations make reference to the regulations for the indirect foreign tax credit for underlying foreign taxes. For this reason and for want of any better point of reference at this time, it seems reasonable that we should look to the regulations governing foreign tax credits for guidance on whether the effect on the effective foreign tax rate that would result from opting out, to one degree or another, of the small business deduction.
The foreign tax credit regulations state that so-called “noncompulsory amounts” are not creditable. A noncompulsory amount is an amount that exceeds the amount of liability under foreign tax law. The amount of liability under foreign tax law implies a reasonable interpretation and application of the substantive and procedural provisions of foreign tax law. The regulation even imposes a duty on the taxpayer to exhaust all effective and practical remedies for reducing the amount of foreign tax. However, the regulation provides an important exception for options or elections under foreign tax law that shift, in whole or part, a foreign tax liability to a different year or years. A good example of this notion might be the flexibility that the Canadian tax rules give to the taxpayer to decide in which taxation year capital cost allowance will be claimed as a deduction. The term “shift” implies that the tax deduction or credit will be eventually claimed in some future year and not permanently foregone. The small business deduction does not seem to qualify as a tax attribute that can be shifted from one taxation year to another by means of an option or election. Therefore, any incremental tax that may result from not claiming the small business deduction to the full extent allowed would appear to fall within the definition of a noncompulsory amount and therefore would not be creditable. This likely means that any incremental Canadian corporate tax resulting from failure to use a portion of the small business deduction would need to be disregarded in testing for the high-tax exception.
On the other hand, to the extent that the Canadian rules may reduce the limit of CAD $500,000 for the small business deduction to the extent that the taxable capital of the CCPC and associated corporations exceeds CAD $10,000,000 or the CCPC and associated corporations earn passive income in excess of CAD $50,000, the resulting increase in the effective Canadian tax rate should be taken into account for purposes of the high-tax exception to GILTI. It is important to note, however, that the passive income that grinds the small business deduction is most likely subpart F income. That subpart F income would itself be subject to ordinary US tax rates of up to 37 percent. Nevertheless, the subpart F income itself happens to be eligible for the high-tax exception or some other exception to a subpart F inclusion.
In conclusion, GILTI is a major thorn in the side of US shareholders who are resident in Canada. The small business deduction is likely to make the high-tax exception unattainable unless the CFC or CFCs earn a sufficient amount of active business income or is otherwise reduced because of passive income or taxable capital. Although some other planning techniques may succeed in attenuating some of the most extreme effects of GILTI, US shareholders of CCPCs are forced to walk a tightrope without a net. To the extent that we are talking about active business income in a relatively high-tax jurisdiction like Canada, this situation, which does not proceed from any well-founded policy consideration, seems fundamentally unfair to hapless US citizens resident in Canada who happen to operate a business or exercise a profession through a Canadian corporation. Affected US shareholders residing in Canada who conduct business through one or more Canadian companies may wish to consult with their tax advisers about possible avenues of restructuring their business operations in order to avoid the application of the GILTI rules.
 Treas. Regs. §1.901-2(e)(5).