Tax laws for foreign business income can be tricky to understand and recently, there have been a few bills that may affect the amount of tax businesses pay if they operate outside the US. These changes are set to ensure that larger corporations pay the full amount of tax due, rather than avoiding it by using tax laws set down by the countries in which they operate. However, this is having a knock-on effect on smaller businesses who are bound by the same taxation laws, but don’t pull in the same amount of profits.
What is GILTI Tax?
Global Intangible Taxed Income is paid by shareholders of controlled foreign corporations (CFC)s even if the shareholder doesn’t take a salary or any profits from the corporation themselves. The owner of a CFC should always report on any U.S federal tax and be prepared to pay 21% required by law. The concept of GILTI tax is unpopular with many business owners and shareholders as it goes against the concept of paying tax on the money you’ve earned.
In 2017 Trump passed the Tax Cuts and Jobs Act (TCJA) through congress which essentially required people who owned shares to pay their tax prior to actually receiving any money from the corporation as a result of the shares. While this didn’t have a massive effect on larger businesses who have money to burn, having to pay taxes before you’ve had the money in your own pocket without the option to defer has left some small businesses struggling to meet their bill deadline.
How Does GILTI Tax Affect Small Business Owners?
If you are the owner or shareholder of a business that runs outside the US, you may be subject to double tax. You’ll need to pay GILTI prior to receiving any funds and may also need to pay tax based on the taxation laws in the country where your business is situated.
Lots of businesses may restructure in order to avoid paying double tax. If the owner or main shareholder of a company is a US citizen or a Green Card holder, they would be subject to pay GILTI tax on their shareholding. An avoidance tactic is to switch around the business so that the person owning the majority of the company shares and assets is someone outside of the US and isn’t a US citizen. If this person owns more than a 50% share of the company, then GILTI tax wouldn’t apply, though they would still need to report income to the IRS.
Alongside shifting the ownership to avoid GILTI tax, there are certain exemptions that could cut down the costs. For example, if the main shareholder has paid tax in another country and isn’t a US citizen and resides elsewhere, they could be exempt from paying again in the US, even if the company is a US based company. Countries that pay higher tax amounts, such as Australia or the UK pay a similar tax rate to the USA. If they have paid the equivalent of 90% of their US tax bill (taxed at 21%) in another country, they would be exempt from paying again in the US. This means that they could potentially reduce their tax rate to 18.9% rather than the full 21%. This taxation should still be reported to the IRS to cover the company for the future.
The easiest way to get out of paying GILTI tax is to make sure all profits are paid out to shareholders by the end of the company’s financial year.
Remember GILTI is calculated on undistributed profits. If there’s no profit, there’s no GILTI tax.
Who is Liable for GILTI Tax?
Lots of people are under the impression that GILTI tax only applies to larger corporations as its very reason for being passed is to collect money from those overseas giants like Apple. However, in actual fact, GILTI is payable by all business owners, even if you are a small business, operating at a single premises, or even as a sole trader. This is where smaller businesses are getting hit by higher tax rates
It’s incredibly important to work out how your taxes are going to work before you go ahead and open a small business. Because GILTI can be charged prior to you withdrawing any profits as a salary, it’s essential that small businesses understand their obligations and have a plan to meet them. This is unfortunately, why so many small businesses fail after the first year.
Failing to properly declare your GILTI tax often leads to panic amendments to tax returns in the hope that the business will get away with it. However, this often leads to higher interest rates and penalties for amendments or late tax filing. If you fail to realize that you are liable for GILTI prior to filing, you should file the extra as soon as possible to lessen your penalties. One of the easiest way to avoid this though, is to get a professional involved who fully understand the ins and outs of the tax law changes and the IRS expectations.
I want to know more about US Taxes abroad
The Bad News for Small Businesses
Unfortunately, the above exemption is currently only a bill and is continuously up for review. The changes for these bills can happen quickly and it’s essential that you stay on top of them to make the most out of the tax laws and constantly stay connected with your accountant for up-to-date news. While a couple of thousand dollars may not make a massive difference to a large corporation operating in multiple countries, it could make a big difference to smaller businesses, which appear to be collateral damage in the fight for the IRS to claw back the money from businesses that it was intended for.
It’s recommended that you keep yourself in-the-know as much as possible too. Always ensure you read the most up to date blogs and watch taxation laws videos to ensure you’re fully up to date and understand the tax you need to pay. Any mistakes could cost you later.
What is Section 962?
Section 962 is designed to help people who would be affected negatively by GILTI and provides some relief from payment. The ability to use section 962 is something that should be determined on a yearly basis depending on the situation the corporation and individual is in at that current time. It’s also worth noting that this isn’t currently passed in law by congress either, so while it’s usable, it may not be forever.
Section 962 allows for people, as an individual, to be taxed at the corporation tax rate of 21%, rather than the personal tax rate of up to 37%. Essentially, this election could provide a reduction of 50% for GILTI taxpayers and reduce the foreign company profits down to between 10-13% to change the remainder to a Foreign Tax Credit. There may also be cases where the majority of the shares are owned outside the US and the tax credits in the country of ownership are much higher than the US, meaning that you can avoid paying taxes on profits, as they are offset by the Foreign Tax Credits. Depending on where your business is situated, you could offset up to 80% of the GILTI payment using Foreign Tax Credits which would leave you paying less than 20% as an individual, instead of the 37% expected.
Can You Still Use Section 962 if Your Business Structure Changes?
The only issue with electing the 962 is if you are planning to amend your business structure midway through the year. If you have a re-distribution of profits or shares midway through the year and receive profits in the form of dividends later on in that year, then these would be subject to normal US tax law later that year. This may result in your paying the corporation tax of 21% as an individual ahead of time due to GILTI, but then being taxed again on the profits at the 37% tax rate for an individual, meaning you’re paying twice and paying more than necessary.
If you plan to update your business shareholdings during the year ahead, it’s worth paying the 37%
tax rate initially, as this will avoid further charges later.
The good news is that you can elect section 962 each year depending on your yearly income, business structure and future plans, so although you may not be able to use it this year due to structural amendments, there’s no reason you couldn’t invoke this the following year to reduce your bill.
What Does the Future Look Like?
While there are currently ways around paying GILTI tax and using Foreign Tax Credits to offset your bill, there are some more changes in store over the next couple of years.
In late 2021 a proposed bill came into play, which isn’t yet in practice, but is worth preparing for just in case. The bill aims to claim even more tax from companies that aim to operate outside the US and has proposed to change the current rate from 50% to 28.5%. This means that corporations would need to pay GILTI tax on the remaining 71.5% of profits ahead of receiving them, rather than the 50% that they need to look at today.
However, they are also proposing to increase Foreign Tax Credits from 80% to 95%, meaning that, although the outgoings are higher, the amount that can be offset will also increase. This could mean that small to medium businesses are actually slightly better off in the long-run.
Taxation is one of the most important things to get right, especially for small businesses just starting up. You should consider enlisting the help of a professional service, at least for your first year, to ensure that your profits aren’t swallowed up through new bills and laws which you were unaware of.