For years, section 962 was a relatively obscure tax-planning mechanism. The Tax Cuts & Jobs Act, however, changed that, pushing the so-called section 962 election into vogue. Section 962 allows an individual shareholder of a controlled foreign corporation to elect to be taxed as a domestic C corporation. As a result, a taxpayer making a section 962 election would be taxed at a 21% rate on a controlled foreign corporation’s undistributed subpart F income and at favorable GILTI rates on GILTI inclusions from a CFC (inclusions related to global intangible low-taxed income). The election may also entitle the individual to take advantage of a deemed-paid foreign tax credit under section 960.
In effect, section 962 creates an alternative tax regime applicable to individual U.S. shareholders investing abroad through CFCs. The election is intended to put individuals who directly own foreign investments on even footing with individuals whose foreign investments are held through a domestic corporation.
What is a Section 962 Election?
Section 962(a)(1) provides that an individual who is a U.S. shareholder may generally elect to be taxed on amounts included in the individual’s gross income under section 951(a) in “an amount equal to the tax that would be imposed under section 11 if such amounts were received by a domestic corporation.”
Section 962 allows an individual shareholder of a controlled foreign corporation to elect to be taxed as if the individual shareholder was a domestic corporation. In addition to direct owners, a section 962 election can be made by an individual U.S. shareholder who is considered, by reason of section 958(b), to own stock of a foreign corporation owned (within the meaning of section 958(a)) by a domestic pass-through entity, including a partnership or an S corporation.
The individual shareholder is also deemed to have paid his or her share of the foreign tax attributable to the income. This treatment allows the taxpayer to utilize an indirect foreign tax credit.
However, when an actual distribution of the income is made, that distribution is included in the shareholder’s income to the extent that it exceeds the tax previously paid on the inclusion. In the end, this treatment is designed to approximate the tax that would have been imposed if a domestic corporation had directly earned the income and distributed it to the shareholder.
History of Section 962
Sec. 962, Election by Individuals to Be Subject to Tax at Corporate Rates, was enacted as part of the Revenue Act of 1962, P.L. 87-834 and as part of the original subpart F regime in 1962. At the time, the difference in individual and corporate tax rates was substantial, with the highest marginal tax rate for individuals topping out at 91%.
Congress enacted section 962 to ensure that individuals’ tax burdens with respect to the undistributed foreign earnings of their CFCs would be “no heavier than they would have been had they invested in an American corporation doing business abroad.”[1]
The Senate Finance Committee’s report at the time explained that section 962 was intended to avoid the inequitable result of taxing a U.S. taxpayer at high rates on the foreign corporation’s earnings that he does not actually receive. In other words, section 962 was intended to treat a U.S. taxpayer in the same manner with respect to undistributed foreign earnings from a foreign corporation that they would be treated if the corporation was an American corporation doing business abroad.
What is a Controlled Foreign Corporation (CFC)?
A CFC is a foreign corporation more than 50% of whose stock (in terms of voting power or value) is owned (directly, indirectly, or constructively) by United States shareholders (U.S. shareholders).
A U.S. shareholder is a United States person, as defined in section 957(c), who owns (directly, indirectly, or constructively) 10% or more of the total combined voting power or value of the CFC’s stock.
How is a U.S. shareholder of a CFC taxed?
A U.S. shareholder owning CFC stock on the last day of the CFC’s taxable year is required to include its pro-rata share of the CFC’s subpart F income in the shareholder’s gross income.
The TCJA requires that a U.S. shareholder recognize an inclusion of a CFC’s global intangible low-taxed income (GILTI).
Previously-Taxed Income
Section 959 coordinates the subpart F rules with the general rules that govern distributions from corporations. Section 951 generally taxes a US shareholder’s pro rata share of certain categories of the CFC’s income even though the taxpayer may not actually receive a distribution from the corporation. Section 959 generally allows the taxpayer to later receive an actual distribution in a corresponding amount tax free.
Generally, any distribution that is excluded from gross income under section 959(a) is treated as a distribution that is not a dividend, although the distribution reduces E & P.
Actual Distributions
When a U.S. shareholder later receives an actual distribution of E & P from a CFC that was previously included in the U.S. shareholder’s gross income (section 962 E & P), the shareholder is required to include the distribution in gross income to the extent that it exceeds the U.S. tax previously paid with respect to any section 951(a) inclusion. In effect, the 962 E & P is bifurcated into two categories: excludable 962 E & P and taxable 962 E & P.
Excludable section 962 E & P is equal to the amount of U.S. income tax previously paid on section 951(a) inclusions. The remaining amounts constitute taxable section 962 E & P.
The end effect is to treat an actual distribution of taxable 962 E & P as though it was first received by the hypothetical domestic corporation and then redistributed to the individual taxpayer.
Any distribution in excess of the tax previously paid on the distributed E & P is fully taxed as a dividend, although the taxpayer is entitled to any applicable deemed paid foreign tax credit.
[1] S. Rept. 1881, 1962-3 C.B. 784, at 798.
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