U.S. Taxation of Foreign Income After Tax Reform
January 30, 2018
We’ve all heard about the profits that publicly-held U.S. corporations have generated overseas, and how those profits have, until now, escaped U.S. income taxation by virtue of not having been repatriated to the U.S.
It should be noted, however, that many closely-held U.S. corporations are also actively engaged in business overseas, and they, too, have often benefited from such tax deferral.
What follows is a brief description of some of the rules governing the U.S. income taxation of the foreign business (“outbound”) activities of closely-held U.S. businesses, and the some of the important changes thereto under the Tax Cuts and Jobs Act.[1]
Taxation of Foreign Income
U.S. persons[2] are subject to tax on their worldwide income, whether derived in the U.S. or abroad.
In general, income earned directly (or that is treated as earned directly[3]) by a U.S. person from its conduct of a foreign business is subject to U.S. tax on a current basis; for example, the income generated by the U.S. person’s branch in a foreign jurisdiction.
However, income that is earned indirectly, through the operation of a foreign business by a foreign corporation (“FC”), is generally not subject to U.S. tax on a current basis; instead, the foreign business income earned by the FC generally is not subject to U.S. tax until the income is distributed as a dividend to a U.S. owner.[4]
CFC Anti-Deferral Regime
That being said, the controlled foreign corporation (“CFC”) anti-deferral regime may cause a U.S. owner of a CFC to be taxed currently in the U.S. on its pro rata shares of certain categories of income earned by the CFC (“Subpart F income”) regardless of whether the income has been distributed as a dividend to the U.S. owner.
A CFC generally is defined as any FC if U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that are “U.S. Shareholders” – i.e., U.S. persons who own at least 10% of the CFC’s stock (which, prior to the Act, was measured by vote only).
In effect, the U.S. Shareholders of a CFC are treated as having received a current distribution of the CFC’s Subpart F income[5], which includes foreign base company income, among other items of income.
“Foreign base company income” includes certain categories of income from business operations, including “foreign base company sales income,” and “foreign base company services income,” as well as certain passive income.
The U.S. Shareholders of a CFC also are required to include currently in income, their pro rata shares of the CFC’s untaxed earnings that are invested in certain items of U.S. property, including, for example, tangible property located in the U.S., stock of a U.S. corporation, and an obligation of a U.S. person.[6]
Several exceptions to the definition of Subpart F income, including the “same country” exception, may permit continued deferral for income from certain business transactions.[7] Another exception is available for any item of business income received by a CFC if it can be established that the income was subject to an effective foreign income tax rate greater than 90% of the maximum U.S. corporate income tax rate.[8]
A U.S. Shareholder of a CFC may also exclude from its income any actual distributions of earnings from the CFC that were previously included in the shareholder’s income.
The Act
For the most part, the Act did not change the basic principles of the CFC regime; these anti-deferral rules will continue to apply[9], subject to certain amendments.
However, the Act also introduced some significant changes to the taxation of certain U.S. persons who own shares of stock in FCs.
CFCs
The Act amended the ownership attribution rules so that certain stock of a FC owned by a foreign person may be attributed to a related U.S. person for purposes of determining whether the U.S. person is a U.S. Shareholder of the FC and, therefore, whether the FC is a CFC.[10] For example, a U.S. corporation may be attributed shares of stock owned by its foreign shareholder.
The Act also expanded the definition of U.S. Shareholder to include any U.S. person who owns 10% or more of the total value – as opposed to 10% of the vote – of all classes of stock of a FC. It also eliminated the requirement that a FC must be controlled for an uninterrupted period of 30 days before the inclusion rules apply.
Dividends Received Deduction (“DRD”)
The Act introduced some new concepts that are aimed at encouraging the repatriation of foreign earnings by U.S. taxpayers; stated differently, it removes an incentive for the overseas accumulation of such earnings.[11]
The keystone provision is the DRD, which allows an exemption from U.S. taxation for certain foreign income by means of a 100% deduction for the foreign-source portion of dividends received from specified 10%-owned FCs by regular domestic C corporations[12] that are U.S. Shareholders of those FCs.
In general, a “specified 10%-owned FC” is any FC with respect to which any domestic corporation is a U.S. Shareholder.[13]
The term “dividend received” is intended to be interpreted broadly. For example, if a domestic corporation indirectly owns stock of a FC through a partnership, and the domestic corporation would qualify for the participation DRD with respect to dividends from the FC if the domestic corporation owned such stock directly, the domestic corporation would be allowed a participation DRD with respect to its distributive share of the partnership’s dividend from the FC. In addition, any gain from the sale of CFC stock that would be treated as a dividend would also constitute a dividend received for which the DRD may be available. That being said, it appears that a deemed dividend of subpart F income from a CFC will not qualify for the DRD.
In general, the DRD is available only for the foreign-source portion of dividends received by a domestic corporation from a specified 10%-owned FC; i.e., the amount that bears the same ratio to the dividend as the undistributed foreign earnings bear to the total undistributed earnings of the FC.[14]
The DRD is not available for any dividend received by a U.S. Shareholder from a FC if the FC received a deduction or other tax benefit from taxes imposed by a foreign country. Conversely, no foreign tax credit or deduction is allowed for any taxes paid or accrued with respect to any portion of a distribution treated as a dividend that qualifies for the DRD, including any foreign taxes withheld at the source.[15]
It should be noted that a domestic C corporation is not permitted a DRD in respect of any dividend on any share of FC stock unless it satisfies a holding period requirement. Specifically, the share must have been held by the U.S. corporation for at least 366 days during the 731-day period beginning on the date that is 365 days before the date on which the share becomes ex-dividend with respect to the dividend. The holding period requirement is treated as met only if the specified 10%-owned FC is a specified 10%-owned FC at all times during the period and the taxpayer is a U.S. Shareholder with respect to such specified 10%-owned foreign corporation at all times during the period.
Transitional Inclusion Rule[16]
In order to prevent the DRD from turning into a “permanent exclusion rule” for certain U.S. corporations with FC subsidiaries, the accumulated earnings of which have not yet been subject to U.S. income tax – and probably also to generate revenue – the Act requires that any U.S. Shareholder (including, for example, a C corporation, as well as an S corporation, a partnership, and a U.S. individual) of a “specified FC” include in income its pro rata share of the post-1986 deferred foreign earnings of the FC.[17] The inclusion occurs in the last taxable year beginning before January 1, 2018.[18]
This one-time mandatory inclusion applies to all CFCs, and to almost all other FCs in which a U.S. person owns at least a 10% voting interest. However, in the case of a FC that is not a CFC, there must be at least one U.S. Shareholder that is a U.S. corporation in order for the FC to be a specified FC.
The deferred foreign earnings of such a FC are based on the greater of its aggregate post-1986 accumulated foreign earnings as of November 2, 2017[19] or December 31, 2017, not reduced by distributions during the taxable year ending with or including the measurement date.[20]
A portion of a U.S. taxpayer’s includible pro rata share of the FC’s foreign earnings is deductible by the U.S. taxpayer, thereby resulting in a reduced rate of tax with respect to the income from the required inclusion of accumulated foreign earnings. Specifically, the amount of the deduction is such as will result in a 15.5% rate of tax on the post-1986 accumulated foreign earnings that are held in the form of cash or cash equivalents, and an 8% rate of tax on those earnings held in illiquid assets. The calculation is based on the highest rate of tax applicable to U.S. corporations in the taxable year of inclusion, even if the U.S. Shareholder is an individual.[21]
Installment Payments
A U.S. Shareholder may elect to pay the net tax liability resulting from the mandatory inclusion of a FC’s post-1986 accumulated foreign earnings in eight equal installments. The net tax liability that may be paid in installments is the excess of the U.S. Shareholder’s net income tax for the taxable year in which the foreign earnings are included in income over the taxpayer’s net income tax for that year determined without regard to the inclusion.
An election to pay the tax in installments must be made by the due date for the tax return for the taxable year in which the undistributed foreign earnings are included in income. The first installment must be paid on the due date (determined without regard to extensions) for the tax return for the taxable year of the income inclusion. Succeeding installments must be paid annually no later than the due dates (without extensions) for the income tax return of each succeeding year.[22]
The Act also provides that if (1) there is a failure to pay timely any required installment, (2) there is a liquidation or sale of substantially all of the U.S. Shareholder’s assets, (3) the U.S. Shareholder ceases business, or (4) another similar circumstance arises, then the unpaid portion of all remaining installments is due on the date of such event.
S corporations
A special rule permits continued deferral of the transitional tax liability for shareholders of a U.S. Shareholder that is an S corporation. The S corporation is required to report on its income tax return the amount of accumulated foreign earnings includible in gross income by reason of the Act, as well as the amount of the allowable deduction, and it must provide a copy of such information to its shareholders. Any shareholder of the S corporation may elect to defer his portion of this tax liability until the shareholder’s taxable year in which a prescribed triggering event occurs.
This shareholder election to defer the tax is due not later than the due date for the return of the S corporation for its last taxable year that begins before January 1, 2018 (i.e., by March 15, 2018 for an S corporation with a taxable year ending December 31, 2017).
Three types of events may trigger an end to deferral of the tax liability: (i) a change in the status of the corporation as an S corporation; (ii) the liquidation, sale of substantially all corporate assets, termination of the of business, or similar event; and (iii) a transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death or otherwise, unless the transferee of the stock agrees with the IRS to be liable for tax liability in the same manner as the transferor.[23]
If a shareholder of an S corporation has elected deferral, and a triggering event occurs, the S corporation and the electing shareholder are jointly and severally liable for any tax liability and related interest or penalties.[24]
In addition, the electing shareholder must report the amount of the deferred tax liability on each income tax return due during the period that the election is in effect.[25]
After a triggering event occurs, a shareholder may be able elect to pay the net tax liability in eight equal installments, unless the deferral-ending triggering event is a liquidation, sale of substantially all corporate assets, termination of the company or end of business, or similar event, in which case the installment payment election is not available, and the entire tax liability is due upon notice and demand.[26]
Observations
As stated earlier, many closely-held U.S. companies (“CH”) are engaged in business overseas, and many more will surely join them.
Although the Act ostensibly focused on the tax deferral enjoyed by large, publicly-traded multinationals, its provisions will also have a significant impact on CH that do business overseas.
Regardless of its form of organization, a CH has to determine fairly soon the amount of its 2017 U.S. income tax liability resulting from the inclusion in income of any post-1986 accumulated foreign earnings of any CFC of which it is a U.S. Shareholder.
Similarly, in the case of any FC of which the CH is a U.S. Shareholder, but which is not a CFC, the CH must determine whether there is a U.S. corporation (including itself) that is a U.S. Shareholder of the FC. If there is, then the CH will be subject to the mandatory inclusion rule for its share of the FC’s post-1986 accumulated foreign earnings.
The CH and its owners will then have to determine whether to pay the resulting income tax liability at once, in 2018, or in installments.
Of course, if the CH is an S corporation, each of its shareholders will have to decide whether to defer the tax liability until one of the “triggering event” described above occurs.
After the mandatory inclusion rule has been addressed, the CH may decide whether to repatriate some of the already-taxed foreign earnings.
Looking forward, if the CH is a regular C corporation, any dividends it receives from a FC of which it is a U.S. Shareholder may qualify for the DRD.
C corporation CHs that may be operating overseas through a branch or a partnership may want to consider whether incorporating the branch or partnership as a FC, and paying any resulting tax liability, may be warranted in order to take advantage of the DRD – they should at least determine the tax exposure.
Still other CHs, that may be formed as S corporations or partnerships, must continue to be mindful of the CFC anti-deferral regime.
It’s a new tax regime, and it’s time for old dogs to learn new “tricks.” Woof.
[1] Pub. L. 115-97 (the “Act”). We will not cover the “minimum tax” provided under the new “base erosion” rules applicable to certain U.S. corporations – those with more than $500 million of average annual gross receipts – that make certain payments to related parties.
[2] Including all U.S. citizens and residents, as well as U.S. partnerships, corporations, estates and certain trusts. For legal entities, the Code determines whether an entity is subject to U.S. taxation on its worldwide income on the basis of its place of organization. For purposes of the Code, a corporation or partnership is treated as domestic if it is organized under U.S. law.
[3] As in the case of a U.S. partner in a partnership that is engaged in business overseas.
[4] It should be noted that certain foreign entities are eligible to elect their classification for U.S. tax purposes under the IRS’s “check-the-box” regulations. As a result, it is possible for such a foreign entity to be treated as a corporation for foreign tax purposes, but to be treated as a flow-through, or disregarded, entity for U.S. tax purposes; the income of such a hybrid would be taxed to the U.S. owner.
[5] Prior to the Act, and subject to certain limitations, a domestic corporation that owned at least 10% of the voting stock of a FC was allowed a “deemed-paid” credit for foreign income taxes paid by the FC that the domestic corporation was deemed to have paid when the related income was distributed as a dividend, or was included in the domestic corporation’s income under the anti-deferral rules.
[6] This inclusion rule is intended to prevent taxpayers from avoiding U.S. tax on “dividends” by repatriating CFC earnings through non-dividend payments, such as loans to U.S. persons.
[7] For example, the CFC’s purchase of personal property from a related person and its sale to another person where the purchased property was produced in the same foreign country under the laws of which the CFC is organized.
[8] This rate was 35% prior to the Act; the Act reduced the rate to 21%, which should make it easier for some CFCs to satisfy this exception. In that case, the U.S. Shareholder of a CFC will not be subject to the CFC inclusion rules – in other words, it can continue to enjoy tax deferral for the foreign earnings – if the foreign corporate tax rate is at least 19%; i.e., 90% of 21%. This will benefit U.S. persons who otherwise do not qualify for the DRD, discussed below.
[9] For example, CFCs should continue to refrain from guaranteeing their U.S. parent’s indebtedness.
[10] The pro rata share of a CFC’s subpart F income that a U.S. Shareholder is required to include in gross income, however, will continue to be determined based on direct or indirect ownership of the CFC, without application of the new attribution rule.
[11] This moves the U.S. toward a “territorial” system under which the income of foreign subsidiaries is not subject to U.S. tax.
[12] The DRD is available only to regular C corporations. As in the case of dividends paid by U.S. corporations to individuals or to an S corporation, no DRD is available to such shareholders.
[13] Query whether the DRD, combined with the new 21% tax rate for C corporations will encourage U.S. corporations that have substantial foreign operations to remain or become C corporations and to operate overseas only through foreign subsidiary corporations. Unfortunately, the Act also denies non-recognition treatment for the transfer by a U.S. person of property used in the active conduct of a trade or business to a FC.
[14] “Undistributed earnings” are the amount of the earnings and profits of a specified 10%-owned FC as of the close of the taxable year of the specified 10%-owned FC in which the dividend is distributed. A distribution of previously taxed income does not constitute a dividend.
[15] In this way, the Act seeks to avoid bestowing a double benefit upon the U.S. taxpayer; however, foreign withholding tax may prove to be a costly item.
[16] See IRS Notice 2018-13 for additional guidance.
[17] Any amount included in income by a U.S. Shareholder under this rule is not included a second time when it is distributed as a dividend.
[18] Beware, calendar year taxpayers.
[19] The date the Act was introduced.
[20] The portion of post-1986 earnings and profits subject to the transition tax does not include earnings and profits that were accumulated by a FC prior to attaining its status as a specified FC.
[21] A reduced foreign tax credit is also allowed.
[22] If installment payment is elected, the net tax liability is not paid in eight equal installments; rather, the Act requires lower payments for the first five years, followed by larger payments for the next three years. The timely payment of an installment does not incur interest.
[23] Partial transfers trigger the end of deferral only with respect to the portion of tax properly allocable to the portion of stock sold.
[24] The period within which the IRS may collect such tax liability does not begin before the date of an event that triggers the end of the deferral.
[25] Failure to include that information with each income tax return will result in a penalty equal to five-percent of the amount that should have been reported.
[26] The installment election is due with the timely return for the year in which the triggering event occurs.