Global businesses have faced complex tax rules since the enactment of Tax Cuts and Jobs Act. Will anything change in 2023? How can you and your business prepare? Here are our thoughts.

GILTI

The TCJA introduced the Global Intangible Low Tax Income (GILTI) provision, which aims to discourage companies from shifting profits out of the U.S. to avoid tax. Issues with GILTI continue to impact businesses into 2023.

How does this work exactly?

Intellectual property is any product of the human mind that the law protects from unauthorized use by others. Examples include patents, trademarks, industrial designs and copyrights, and income from these assets is taxed at the corporate rate. Some companies, to lower their tax liabilities, will transfer IP rights to other countries with lower tax rates.

The GILTI rules require a 10% or greater U.S. shareholder of a controlled foreign corporation (CFC) to include in current income the shareholder’s pro rata share of the CFC’s GILTI income. These rules apply to C and S corporations, partnerships, and individuals.

Tax planning strategy

There are various strategies to consider mitigating GILTI. A U.S. shareholder can elect the high-tax exclusion (HTE) which may exclude CFC income that is subject to a foreign effective tax rate of at least 18.9%, or 90% of the 21% U.S. corporate tax rate. This is an annual election made at the shareholder level by the controlling domestic shareholder and is binding on all other shareholders. If the election is made by a partnership, it is binding on all partners. If the election is made, it must be made with respect to all eligible CFCs in the group; it cannot be made on a CFC-by-CFC basis.

Another option available to individual shareholders with direct investments in CFCs and indirect investments through partnerships and S corporation is to make an election under Section 962 to be taxed as a corporation for subpart F purposes. The advantage of this election is that it allows an individual taxpayer to make a Section 250 deduction and to use indirect foreign tax credits, which are otherwise only available to domestic C corporations.

Making the election also results in GILTI inclusions being taxed at the corporate tax rate of 21%, which may provide a significant benefit for individual taxpayers in higher marginal tax brackets. Provided the foreign corporation of which the individual is a U.S. shareholder pays a tax rate of at least 13.125% in foreign taxes, the shareholder may not have a residual U.S. federal tax liability from GILTI inclusions. Like the HTE, the Section 962 election is an annual election made at the shareholder level.

There is no one size fits all solution, and the facts should be modeled to establish what will provide the best outcome.

Transfer pricing

The Inflation Reduction Act, passed in August 2022, allocated $80 billion in funding to the IRS and part of this funding is expected to go towards tax enforcement for multinational companies especially regarding their transfer pricing activity.

For years, the IRS has struggled to combat tax avoidance and abusive tax practices. Many companies have been shifting profits to divisions in lower tax jurisdictions to reduce their tax burden. The tax authority on both ends of an intercompany transaction have an interest in the economics of these transactions.

For instance, for a U.S. company transacting with a foreign subsidiary, the IRS is interested in whether the U.S. company is sufficiently renumerated for the services it provides, whereas the local tax authority in the subsidiary’s jurisdiction will be interested in ensuring that the subsidiary is not improperly eroding its tax base by paying too much for those services.

Tax planning strategy

To limit risk, companies that participate in intercompany transactions – whether that involves the distribution of goods, provision of services or the licensing of intellectual property – should strongly consider a benchmarking study to help establish and support a transfer pricing policy.

Schedules K-2 and K-3

Check out our blog IRS Provides Relief for Partnerships Preparing Schedules K-2 and K-3 for 2021. Certain domestic partnerships and S-corporations are required to prepare Schedules K-2 and K-3, which report items of international tax relevance. The schedules are extensions of Form 1065, Schedule K. Schedules K-2 and K-3 may also be required attachments to Forms 1120-S and Form 8865.

Examples of items of international tax relevance include interests in foreign entities or distributions from foreign corporations, foreign tax credit information, foreign partners’ U.S. source income, investments in foreign entities and more.

Tax planning strategy

If you have traditionally received a Form K-1 from an investment, you may have received a Form K-3 starting this past year. Form K-3 will provide the information previously found in the K-1 footnotes. This change was intended to make reporting from partnerships to partners more uniform, consistent and simpler. Unfortunately, the form is dense and relevant information can be difficult to discern for anyone that is unfamiliar with the form. Our team is experienced with these forms and can identify which information on the form is relevant for your tax return and how it should be reported.

Questions on your individual situation? Contact us. Do not forget to download our Year End Tax Planning Guides for Individuals and Businesses.