Due to the complexity of these rules, the effective tax rate computed here undoubtedly contains errors and omissions. Many explicit and implicit assumptions have been made in the computations.

You should consult a tax professional for individual advice regarding your own situation. This analysis, and the commentary related to this analysis, should not be relied upon for any purpose whatsoever.

General Assumptions:

• The owner is a U.S. individual.
• The individual is taxed at the highest marginal U.S. income tax rate on ordinary income (37%).
• The individual is subject to the net investment income tax of 3.8%.
• The individual resides in the U.S.
• The foreign entity is classified as a corporation (and not as a flow-thru entity) in its home country. In other words, the foreign income tax is imposed on the entity itself and is not imposed on the owners of the entity.
• The foreign entity is on the accrual method of accounting and it accrues its foreign income taxes.
• The foreign year end of the foreign entity is the same as the U.S. year end of the foreign entity.
• The foreign income taxes are creditable foreign income taxes.
• Pre-tax income under U.S. tax principles equals taxable income under foreign tax principles. This assumption may not be realistic. See the book-to-tax adjustments discussion for Scenario 1.
• U.S. state income taxes are not considered.
• Current year profits are distributed on a current year basis so that dividend withholding taxes (if any) are imposed each year.

Assumptions about the foreign entity (when classified as a corporation):

• The foreign entity is a limited liability company that is controlled by 10% U.S. shareholders.
• No entity classification election has been made to treat the entity as a flow-through for U.S. tax purposes.
• The foreign entity is a controlled foreign corporation ("CFC").
• If a GILTI high-tax exception election is available, it will be made.
• If the CFC is located in a treaty country, the CFC qualifies for benefits under the treaty.
• If a treaty applies, the individual is taxed at the highest U.S. tax rate on qualified dividend income (20%).
• The CFC does not have losses.
• The tax law for 2025 applies.
• The individual owns an interest in only one CFC.
• The CFC has no QBAI.
• The CFC has no Subpart F income. (Subpart F income would generally only affect the tax rate if a Code §962 election is made.)
• No loans are made from the foreign entity to the U.S. owner or to a person related to the U.S. owner, and the CFC makes no investments in U.S. property. See Code §956.
• U.S. states may tax foreign earnings at the time of inclusion or at the time of distribution.

It is often necessary for entities to make adjustments to convert book income to taxable income. Form 1120 (for corporations) and Form 1065 (for partnerships) both have Schedule M-1, which is used exactly for this purpose.

These adjustments are important because the GILTI high-tax exception election requires a foreign corporate income tax rate of at least 18.9%. This rate is based on actual foreign income tax paid or accrued divided by pre-tax income as computed under U.S. tax principles. If the U.S. pre-tax income is higher than expected, the GILTI high-tax exception election may not be available.

For example, China allows companies to double deduct R&D expenses. In contrast, the U.S. requires foreign-performed R&D expenses to be capitalized and amortized over a 15-year period. In this circumstance, for certain years the Chinese taxable income may be much lower than U.S. taxable income. This may mean that the Chinese tax is reduced enough so that the effective Chinese corporate tax rate is below 18.9% (the statutory rate in China is generally 25%). In this circumstance, no GILTI high-tax exception election would be available.

The model is deficient in that it does not take these adjustments into consideration. If U.S.-adjusted pre-tax income is 100 and Chinese-adjusted pre-tax income is 40, the Chinese tax may only be 10 (40 X 25%). The foreign corporate rate in this circumstance would only be 10% (10 / 100). Because the GILTI high-tax exception election may be important in computing the effective tax rate, this factor should be taken into account when performing an actual effective tax rate analysis.

Losses incurred in a foreign corporate entity can effectively result in double taxation of future profits earned through the foreign entity.

For example, assume a foreign corporation begins its operations with a loss of $100 in year 1. Also assume that, under foreign law, the loss of $100 is allowed to be carried forward as a net operating loss ("NOL") to reduce future foreign taxable income of the foreign corporation. NOLs are not allowed for purposes of computing tested income. If the foreign corporation has profits in year 2 of $100, no foreign income tax will be due on those profits. As a result, no high-tax exception election is available and a Code §962 election is not helpful. In year 2, the U.S. shareholder will have a GILTI inclusion of $100, and the U.S. shareholder will pay U.S. tax on that inclusion.

The GILTI inclusion does increase the U.S. shareholder's tax basis in the shares of the foreign corporation. Code §961(a). However, that increase in basis only benefits the U.S. shareholder in the future when the shares of the foreign corporation are disposed of.

On the other hand, if an individual owns more than one CFC and some CFCs have tested losses and other CFCs have tested income, then it is possible that the tested losses may offset the tested income so that the "net" CFC tested income is reduced and the GILTI inclusion amount is reduced. Code §951A(b)(1).

It may be important to time distributions out of CFCs if there are GILTI inclusions and a foreign dividend withholding tax is imposed.

At times, foreign income taxes paid in one year may exceed the limitation on the amount of foreign tax credits that can be claimed (excess credit position). At other times, foreign income taxes paid in one year may be less than the foreign tax credit limitation (excess limitation position). When a U.S. shareholder has excess credits in a particular basket, the U.S. shareholder generally can carry the excess credits back one year and forward ten years before they expire. Code §904(c).

However, excess credits in the GILTI basket cannot be carried back or forward. Code §904(c), last sentence. If a U.S. shareholder has excess credits in the GILTI basket, the excess credits cannot be claimed as foreign tax credits in any year. GILTI excess credits go unutilized.

Assume that a U.S. shareholder of a CFC has GILTI inclusions of $100 for five years in a row. During the first four years, the CFC makes no distributions. In year five, the CFC distributes $500 of earnings. For U.S. tax purposes, the full $500 is excluded from U.S. taxable income as PTEP. Code §959(a).

Say that the $500 distribution is subject to a foreign dividend withholding tax of 15%. The U.S. shareholder pays $75 ($500 X 15%) of foreign income tax in year five. The $75 is allocated to the GILTI basket. Treas. Reg. §§1.861-20(d)(3)(i)(B)(2) and 1.960-3(c)(1). If in year 5 the U.S. shareholder's foreign tax credit limitation is $37 ($100 X 37%), then only $37 of the foreign dividend withholding tax will be allowed as a foreign tax credit. The excess credits of $38 ($75 - $37) will go unutilized. In years one through four, the U.S. shareholder had excess limitation. If the CFC had spread the $500 distribution over multiple years, the $38 could have been claimed as foreign tax credits.

If a high-tax exception election is made, active business income earned by the CFC should create general basket E&P. In contrast, if no high-tax exception election is available or made, to the extent the shareholders have GILTI inclusions, the E&P should be GILTI basket E&P (951A). The basket of E&P created from a Subpart F income inclusion depends on the type of Subpart F income. Generally, foreign personal holding company income would create passive basket income and foreign base company sales or services income would create general basket income.

If no high-tax exception election is made and a Code §962 election is made, the election should not affect the baskets of the E&P. Since a Code §962 election is made only when there is an inclusion, the E&P should be the same basket as the inclusion.

Typically, it is better to avoid the GILTI basket because excess credits in the GILTI basket cannot be carried forward or back. Thus, making the high-tax exception election when available is usually better.

A foreign business entity that is not a per se corporation under Treas. Reg. §301.7701-2(b) is an "eligible entity" that can elect its classification for U.S. federal tax purposes. Treas. Reg. §301.7701-3(a).

If a foreign eligible entity has defaulted to, or elected to, be classified as a corporation, the entity can generally elect to change its classification to be a flow-thru entity (i.e., a partnership if the entity has more than one owner or a disregarded entity if there is only one owner). Treas. Reg. §301.7701-3(b).

If an eligible entity that is classified as a corporation elects to change its classification, the corporation is deemed to liquidate, distributing all of its assets and liabilities to its shareholders. Treas. Reg. §301.7701-3(g)(1)(ii) and (iii).

Unless the foreign eligible entity is at least 80% owned by a corporation, the deemed liquidation is a taxable liquidation under Code §§331 and 336. In a taxable liquidation, the entity is first deemed to have sold all of its assets for fair market value. Code §336. Then, the shareholders are deemed to have sold their shares in the corporation for fair market value. Code §331.

The deemed sale of assets under Code §336 may trigger Subpart F income and/or GILTI inclusions. Typically, no high-tax exception election is available in this circumstance because the deemed gain is recognized only for U.S. tax purposes.

In a taxable liquidation, it is important to properly value the entity and/or the assets of the entity. Assets that may not be currently shown on the balance sheet may need to be valued (such as goodwill and other intangible assets). If an appraiser is used, values determined by the appraiser should be confirmed for reasonableness. A decision to change classification should not be taken lightly.

Because the U.S. tax cost of changing classification can create significant current U.S. tax, it is important to select the preferred classification (corporation or flow-thru) when the foreign entity is initially formed.

The effective tax rate analysis differs for U.S. citizens or green card holders who live outside the U.S. and own an interest in a corporate foreign entity.

First, dividend distributions from the foreign entity are likely not subject to a flat foreign dividend withholding tax rate. Instead, dividends from the foreign entity are likely taxed in the foreign country at graduated rates, or a preferential rates.

Second, the net investment income tax may not apply because it may be a social security tax that is covered by a totalization agreement (if the foreign country has a totalization agreement with the U.S.). Whether a totalization agreement applies to the net investment income tax is a complicated question.

Although the law in this area is not yet clear, some U.S. income tax treaties may allow a foreign tax credit against the net investment income tax. Alternatively, the net investment income tax may not apply because it may be a social security tax that is covered by a totalization agreement (if the indiivdual lives in the foreign country and the foreign country has a totalization agreement with the U.S.).

The U.S. federal corporate income tax rate is relatively low at 21%. U.S. corporations can avoid double taxation on CFC profits either through foreign tax credits or dividends received deductions. Although U.S. individuals who own CFCs can elect under Code §962 to be treated as if the CFC were hypothetically owned by a U.S. corporation, one might ask whether it makes sense for an individual to create an actual U.S. C corporation to own the shares of the CFC.

The effective tax rate may or may not be higher with an actual U.S. C corporation as compared to an individual owning the CFC shares directly.

When an individual directly owns shares of a CFC, generally only two levels of income tax are imposed: corporate-level income tax and shareholder-level income tax. Foreign taxes may include both corporate income tax and dividend withholding taxes. Because the dividend withholding taxes are generally imposed on the shareholder, a U.S. shareholder can generally claim the dividend withholding taxes as credits against U.S. income tax. For example, if the foreign dividend withholding tax rate is 15% and the U.S. shareholder's U.S. tax rate on qualified dividend income is 15%, the U.S. shareholder may not pay any U.S. income tax on dividends distributed by the CFC. This is the case even with a Code §962 election.

In the example above, the individual U.S. shareholder was able to claim the foreign dividend withholding tax as a foreign tax credit so that no U.S. tax was owned on the distribution. However, with an actual U.S. C corporation ("HoldCo"), it would be HoldCo that would claim the foreign tax credits. When dividends were paid by HoldCo to the individual shareholder, individual U.S. income tax would be imposed on the distribution (without any foreign tax credits being claimed by the individual). In this circumstance, the existence of an actual U.S. C corporation would increase U.S. tax and thereby increase the worldwide effective tax rate.

On the other hand, a U.S. C corporation may be advantageous where no foreign corporate income tax is paid and no foreign dividend withholding tax is paid (such as in a tax haven). For example, if a CFC paid no foreign corporate income tax, HoldCo would pay U.S. corporate income tax on the profits earned by the CFC at a 21% rate on Subpart F income inclusions or at a 10.5% rate (after considering the Code §250 GILTI deduction) on GILTI inclusions. Then, when the dividends are paid by HoldCo to the individual shareholder, individual U.S. income tax would be imposed on the distribution (at a rate of up to 23.8%). If the U.S. corporate income tax plus the U.S. individual income tax on qualified dividend income was less than the ordinary income tax rate for the individual shareholder, an actual U.S. C corporation holding the shares of the CFC may result in a lower worldwide effective tax rate.

For simplicity, this analysis assumes that current year profits are distributed on a current year basis. While in some circumstances it may be important to distribute current profits, in other circumstances it may be beneficial to defer distributions. For example, if the high-tax exception election is available or if a 962 election substantially reduces the U.S. tax currently payable, deferring distributions may defer U.S. income tax and possibly foreign dividend withholding tax.

Deferral reduces the worldwide effective tax rate. Under the time value of money, if you defer paying tax until a later year, you keep the money now and can invest it, earn a return on it, or simply use it for current operations. The longer the deferral of tax, the larger the benefit.

Some deferrals end up being permanent. If a U.S. shareholder of a CFC passes away, the beneficiaries of the estate will get a step-up in basis in the shares of the CFC. Those beneficiaries can then sell the shares of the CFC at no gain, resulting in the appreciation never being taxed.

The effective tax rate calculations above do not consider any deferral benefits.

A Code §962 election tends to be favorable (1) when no high-tax exception election is available, and (2) when the CFC is located in a treaty country and/or a significant level of foreign corporate income tax has been paid or accrued. However, in nearly all circumstances a high-tax exception election (if available) is preferable over a Code §962 election.

If a Code §962 election is made for a GILTI inclusion, the hypothetical U.S. parent corporation is allowed a GILTI deduction (a Code §250 deduction) and only 80% of the related foreign income taxes are allowed as deemed paid foreign tax credits. In contrast, if a Code §962 election is made for a Subpart F income inclusion, no GILTI deduction is allowed, but 100% of the related foreign income taxes are allowed as deemed paid foreign tax credits. When making a 962 election, GILTI inclusions tend to result in less U.S. tax than with a Subpart F income inclusion.

If a Code §962 election is made, the E&P related to the inclusion falls within one of two categories: Excludable 962 E&P and Taxable 962 E&P. Treas. Reg. §1.962-3(b)(1). Excludable 962 E&P equals the amount of U.S. tax paid by the hypothetical U.S. corporation on the inclusion. The remainder of the E&P is Taxable 962 E&P.

In general, when a U.S. shareholder has a GILTI or Subpart F income inclusion, the "previously taxed" earnings are tracked on Schedules J and P of Form 5471. These earnings are often referred to as "PTEP" (previously taxed earnings and profits). When a CFC distributes PTEP to the U.S. shareholder, the earnings are generally not taxed in the U.S. a second time. Instead, the PTEP is excluded from income under Code §959(a).

However, when a Code §962 election is made, only the Excludable 962 E&P can be excluded from income. In contrast, a distribution of Taxable 962 E&P is taxable to the U.S. shareholder.

Generally, if shares of stock of a CFC are sold, gain on the sale may be wholly or partly recharacterized as dividend income under Code §1248. If the CFC is located in a treaty country and qualifies for treaty benefits, the recharacterization of gain as dividends likely makes no difference for U.S. federal income tax purposes.

However, if the CFC is in a non-treaty country (or does not qualify for treaty benefits), recharacterization of capital gains as dividends may cause all or a portion of the gain to be taxed at ordinary income rates. In contrast, long-term capital gains are generally taxed at reduced rates.

Therefore, in the non-treaty context, it is not possible to avoid ordinary income by not paying dividends and later selling the shares of the CFC at a gain.

The GILTI and Subpart F income high-tax exception elections are available if the foreign corporate income tax rate is at least 18.9%, which is 90% of 21%, the highest U.S. corporate income tax rate. Code §§11 and 954(b)(4).

Since 2018, the U.S. corporate income tax rate has been a flat 21%. Prior to 2018, the U.S. corporate income tax rate was graduated with the highest rate of 35%. If Congress increases the U.S. corporate income tax rate, the threshold necessary to claim the high-tax exception election will increase.

Not only might the U.S. increase its corporate income tax rate, but foreign countries might decrease their corporate income tax rates. If a foreign country reduces its corporate income tax rate so that it is below 18.9%, the high-tax exception election may no longer be available. Although a Code §962 election may still be available as a back up, Code §962 elections tend to be less desirable than high-tax exception elections, especially when the foreign country imposes a dividend withholding tax (see Distributions discussion).

The foreign corporate income tax rate assumes that the foreign entity accrues foreign income taxes for U.S. foreign tax credit purposes. If the foreign year-end is different than the U.S. year-end, the foreign corporate income tax rate may not be as expected. If the foreign tax rate gyrates unexpectedly, the GILTI high-tax exception election may not be available in all years, even when the foreign statutory rate exceeds 18.9%.

For example, if a foreign entity has a foreign year end of March 31, a full fiscal year's worth of foreign income taxes will accrue on March 31. From the preamble to proposed regulations in 2020:

In the case of foreign income taxes imposed on the basis of a taxable period, because all of the events that fix the fact and amount of liability for the foreign tax with reasonable accuracy do not occur until the end of the foreign taxable year, such foreign income taxes accrue and are creditable in the U.S. tax year within which the taxpayer's foreign taxable year ends. See § 1.960-1(b)(4); Revenue Ruling 61-93, 1961-1 C.B. 390.

Continuing the example, if the U.S. taxable year for the foreign entity is the calendar year, in the calendar year 2026, foreign income taxes that accrue on March 31, 2026 would be used in computing the foreign corporate income tax. Because the 2026 income for U.S. tax purposes spans two foreign fiscal years and the foreign corporate taxes are based on a single fiscal year, the foreign corporate tax rate for 2026 may not be as expected.

When a U.S. individual owns a 10% or greater interest in a CFC, Form 5471 is generally required. A 10% owner of a CFC is a U.S. shareholder of the CFC, and he or she can have GILTI or Subpart F income inclusions. The individual must file Form 8992 to compute whether they have a GILTI inclusion. Form 8992 should be included with Form 1040, even if the U.S. shareholder has no GILTI inclusion amount.

The FBAR and Forms 926 and 8938 may also be required.