I’m a U.S. citizen and I want to set up a business in Europe. What is this GILTI tax everyone is warning me about?

The lure of massive European markets, combined with the often global ambitions of American online entrepreneurs, commonly leads U.S. business owners to expand their businesses to Europe. But as soon as a U.S. citizen or tax resident sets up and owns a European company (or any other non-U.S. company for that matter), things quickly start getting very murky and complicated on the tax front. I am an attorney, not a tax advisor. But having assisted multiple American businesses with their EU setups in close cooperation with stellar U.S. tax counsel, I think (and hope) this note can help highlight for U.S. shareholders the main U.S. tax issues they will have to hammer out together with their tax experts as they plan to expand their business to Europe. It strikes me that U.S. shareholders are often unaware of these issues prior to planning their expansion. They shouldn't be. Ignorance in this specific matter may prove quite costly.

What on earth is GILTI tax?

During Donald Trump’s first presidency, the U.S. government took measures to discourage U.S. residents from moving their businesses outside of the U.S. To achieve this purpose, Trump enacted the Global Intangible Low-Taxed Income Tax (“GILTI”). Mindful that the reader is likely not well versed in any of this stuff, I will proceed very slowly. It's complex, so bear with me. As soon as you (as a U.S. shareholder) set up a European company and own more than 50% of its shares, the company will be deemed a ‘controlled foreign corporation’ (a “CFC”). When I speak of your ‘foreign company’ in this note, I refer to a CFC as just described.

The yearly profit which your foreign company makes will be captured by Trump’s GILTI tax. Under GILTI, your CFC’s profit qualifies as a deemed distribution to the CFC’s U.S. shareholder. The U.S. shareholder will have to include the yearly profit of the CFC in his or her yearly personal income tax filing in the United States and pay ordinary U.S. income tax rates on that foreign profit. So GILTI hits U.S. individual shareholders in their personal income tax. U.S. personal income tax rates are high. Generally around 37% (at the date of this note). Bear in mind that this 37% will be levied in addition to the tax levied in the foreign jurisdiction where your company is based. So imagine you, as a U.S. tax resident, have incorporated your foreign company in Ireland and you have EUR 100.000,- in profit. This one hundred thousand will be subject to Irish corporate income tax rates at 12.5%. So your foreign company will already undergo this 12.5% tax hit. In addition to that, because of GILTI, the U.S. shareholder will also have to include that profit in his or her U.S. personal income tax filing and pay U.S. income tax on it (generally at 37%). This is a massive combined tax hit. In line with the purpose of GILTI, this really discourages U.S. shareholders from setting up businesses abroad.

Also, remember that under GILTI your CFC’s profit is considered to be a ‘deemed’ distribution to you. Not an actual distribution but a deemed distribution. This means that you will owe the GILTI tax on the CFC’s profit regardless of whether you actually send your foreign company’s money home to the U.S. or not. When you actually do distribute the foreign company’s CFC to your account back home, you will also (additionally) have to pay U.S. federal income tax on it. Yeah, it's pretty bad….

Bad to worse

The bad situation gets even worse. As U.S. shareholders know all too well, they also have to deal with state tax in addition to federal tax. So, in theory, a resident of California who owns shares in a CFC in Europe, will be hit with four buckets of tax in relation to his EU company’s profit: the corporate income tax at local rates in the CFC’s European jurisdiction; the GILTI tax at 37% on the CFC’s profit regardless whether this is distributed or not; ordinary U.S. federal income tax  (up to 37%) once you actually distribute the profit to California; and California state tax at (around) 13.3% on the distributed profit. Obviously, this situation is untenable from a business perspective. Apparently, Trump is aware of that as well and therefore the legislation around GILTI does allow U.S. residents ways to mitigate the described tax doom. Let’s proceed to that now in order to lighten the mood.

How to mitigate the GILTI tax hit

The most impactful thing you can do as a U.S. shareholder to mitigate your U.S. tax when you set up a company in Europe, a company which is deemed a CFC due to its majority U.S. ownership, is to carefully and intelligently select the jurisdiction of your new foreign company. This is important in two ways. First of all, it impacts your tax rate on your income when you actually distribute profits (as dividends) from your foreign company to your personal account back home in America. Distributions are taxed in the U.S. either at the ordinary dividend rate of 37% or at the qualified dividend rate of 23.8%. So you want your dividend to fall in the qualified-dividend bucket. Qualified-dividends refer to dividend received from foreign companies which are located in countries with which the United States has concluded beneficial tax treaties. A U.S. shareholder thus acts prudently by making sure he sets up his foreign company in a jurisdiction where an existing U.S. treaty allows you to qualify distributions from your foreign company in said jurisdiction as ‘qualified-dividend’. The Netherlands is such a jurisdiction. Profit distributed to a U.S. shareholder from a Dutch company will thus be taxed at the lower 23.8% qualified-dividend rate and not the higher 37% rate.

The high tax exemption

Please note that your foreign company’s jurisdiction can allow you to make use of GILTI’s high tax exemption to rid yourself completely of any GILTI taxation. There is an exemption to the application of GILTI tax to your CFC’s profit. If your foreign company is based in a jurisdiction where its profit is subject to an effective corporate tax rate of at minimum 18.9%, you will fall outside of the GILTI regime. This is very significant and a great way for you to prevent taxation under GILTI. Keep this firmly in mind when you choose the country where you (as a U.S. shareholder) incorporate your foreign company. Too many Americans do not take this into consideration and mistakenly choose low-tax jurisdictions (like sunny islands or Dubai), thinking they are being smart and saving money when in reality they are just triggering high GILTI taxes (up to perhaps 37%). In contrast, if you set up in the Netherlands with its (19% minimum corporate income tax rate), you can totally eliminate GILTI tax on any of your CFC’s income. Your foreign company’s profit will only be subject to the corporate income tax rate of the country of its incorporation. Any U.S. tax will be deferred until you actually distribute the money out to yourself in America. At that point, if you have chosen your CFC’s jurisdiction wisely, you can also make use of the lower 23.8% qualified-dividend rate. This combination of no GILTI tax on your CFC’s income and the option to defer U.S. tax, is a relatively very good outcome for U.S shareholders who set up companies abroad. It's prudent to also be mindful in your tax structuring of potential withholding tax on distributions from your CFC to the United States. For instance, in the Netherlands distributions from a Dutch company to the United States are subject to a 15% withholding tax. However, treaties often allow you to deduct this from your U.S. tax on the same. Confirm this with your tax counsel.

Checking boxes and making elections. What?

For Europeans (including lawyers), the U.S. ‘check the box’ system is a bit strange. Via very simple ‘check the box’ elections (made on an IRS entity classification form), a U.S. shareholder can convert his European company into a pass-through entity. The European company then no longer exists from a U.S. perspective and its income will be deemed income earned directly by the company’s individual U.S. shareholder and taxed accordingly. A ‘check the box’ election takes your foreign company outside of the GILTI regime. Remember, GILTI is levied on your foreign company’s profit. If there is no foreign company (because you checked the box on it and rendered it transparent), then there is no foreign company profit to tax at GILTI rates. So what happens then? Once you check the box, your CFC’s income will be deemed the U.S. owner’s personal income and taxed accordingly at U.S. ordinary income rates. These rates are high and the tax cannot be deferred.

There is another election a U.S. shareholder can make to mitigate GILTI taxation. This one is called the 962 election. A 962 election allows a U.S. individual shareholder to be treated as a U.S. corporation for tax purposes. You can thus convert yourself into a corporate entity. This can be helpful because the GILTI tax rate for U.S. corporations is only 10.5%. The 962 election can also allow you to use the corporate income tax levied on the CFC as a foreign tax credit to set off your GILTI tax even more. 

So is it as bad as we thought at the start of this note?

U.S. tax is very complex. There are multiple routes you can take to mitigate GILTI tax on income from your CFC. However, there is no magic trick here that reduces U.S. tax to any level to get excited about. Clients in my experience often like to defer U.S. tax on their foreign company’s profit as much as possible. Nobody likes to be hit with U.S. taxes on the U.S. shareholder’s foreign company’s profit even before the money is distributed back home. The ‘check the box’ option does not give you this deferral. Though this option eliminates GILTI (since it conceptually removes the foreign company from the equation), it exposes the U.S. shareholder to direct U.S. taxation on the foreign company’s profits at high personal income rates. This is not ideal. It's often more attractive to set up in a jurisdiction (like the Netherlands) which not only takes you out of the GILTI regime pursuant to the high tax exemption but (contrary to the ‘check the box’ route) also allows you to defer any U.S. tax on the realized profits. After all, as long as you do not distribute any of the profit out to the United States, you don’t need to worry about U.S. tax. You can reinvest the funds in Europe and grow it. Distribute funds back home incrementally as needed and just pay a little bit of U.S. tax every time you do so.

Our law firm works with reputable tax advisors who are well versed in tax matters on both sides of the water. If you reside in the United States and wish to expand your business to Europe, please contact us at marianne@starkslegal.nl for any legal assistance.