2017 Tax Reform Changes Affecting Shareholders in Foreign Businesses
In this article we will cover an important addition to the Tax Reform law enacted in late 2017 (2017 Tax Reform). The added tax is commonly referred to as Section 965 tax, transition tax, repatriation tax, or GILTI tax. It is aimed at taxing the income of U.S. Persons who are shareholders of foreign businesses that operate mostly or entirely outside of the United States. Note: A U.S. Person includes any U.S. citizen or permanent resident alien (green card holder).
Applicability of the GILTI and Section 965 tax to “U.S. shareholders”
The Section 965 tax is applicable to U.S. shareholders in “specified foreign corporations.” A “U.S. shareholder” is a U.S. Person who owns, directly or indirectly, a minimum of 10% of voting rights or value of a specified foreign corporation. A “Specified Foreign Corporation” is a Controlled Foreign Corporation (CFC), or other foreign corporation which is not a passive foreign investment corporation (PFIC), with at least one U.S. corporation that is a U.S. shareholder. As defined by the Internal Revenue Code: “A CFC is any foreign corporation if more than 50% of the total combined voting power of all classes of stock of such corporation entitled to vote, or the total value of stock of such corporation, is owned directly, indirectly or constructively by U.S. shareholders on any day of the taxable year.”
U.S. tax compliance applicable to U.S. Persons
The United States uses citizenship-based taxation wherein it asserts the right to tax U.S. Persons based on their worldwide income regardless of where they live. With this in mind, let us look closer at the meaning of the word "tax". In general, the term is used to describe anything from reporting obligations to the actual cash outflow or payments to tax authorities. The United States has treaties in place with most countries, which means a person’s income is taxed only once, and predominantly that is by the jurisdiction of the taxpayer’s country of abode. To achieve this from the U.S. tax perspective, there are mechanisms which either exclude foreign earned income from the tax base of a U.S. Person up to a certain amount (this method is called the Foreign Earned Income Exclusion), and/or allow the U.S. Person to use the taxes paid to the foreign jurisdiction as credit against the U.S. taxes calculated (this method is called the Foreign Tax Credit). With the help of either method or a combination thereof, most U.S. Persons living and working outside the U.S. will not owe any income tax to the Internal Revenue Service, provided they were duly taxed in the foreign jurisdiction.
Whether or not living outside the United States, all U.S. Persons with the minimum income reporting requirements still have to adhere to U.S. tax rules and report/declare their income annually, even if no taxes fall due with their U.S. Individual Income Tax Return (referred to hereafter simply as “U.S. tax return”).
However, this is not the case with the recently introduced Section 965 tax.
Past and present: Subpart F and GILTI
Income earned by a foreign corporation is, in general, split into two types: passive and active.
Passive Income: Passive Income (or Subpart F income in this context) would, for the most part, include income from rental activities, royalties, and investment income. It would be taxed at ordinary tax rates at the shareholder level in the year it is generated. This law has been in effect since 1962 and remains active and unchanged.
Active Income: The taxation of active income (or, for the most part, everything that does not fit in the category of Subpart F) has, on the other hand, been expanded. Post-1986 and prior to 2017, the taxation of foreign “active” profits was deferred until a U.S. shareholder received a pay-out in the form of a dividend from the foreign corporation. Companies kept track of their accumulated (deferred) Earnings and Profits (E&P) year after year. Once the dividend was paid out, the E&P would be adjusted downward and the U.S. shareholder would pay tax on the dividend income through their U.S. tax return.
The new Section 965 transition law requires any U.S. shareholder to include income that consists of post-1986 Earnings & Profits as taxable income beginning with their 2017 U.S. tax return and pay tax retroactively (but only for those years when the corporation was a “Specified Foreign Corporation”). Fortunately, the tax rates for these repatriated earnings are discounted and U.S. shareholders can pay the balance owed in installments over an 8-year period and without interest.
Furthermore, to the tax jargon referring to active income of a foreign corporation, the new Tax Reform law introduced another term - GILTI (Global Intangible Low Tax Income). Similar to Subpart F income, a foreign corporation’s profits from normal business operations must now be recognized and taxed by the U.S. government in the year in which they are earned. Thus, most U.S. shareholders’ future tax returns will contain income that they have not had to include on previous years’ returns and pay taxes to the U.S. government regardless of whether the profits have already been taxed at a corporate level outside the United States.
According to the GILTI rules, once taxed, the profits “move” to the “previously taxed income” category. Any dividends paid by the Specified Foreign Corporation out of this income category would then be income tax free to the U.S. shareholder.
When and where the new rules apply, here are a few examples:
Example 1:
A U.S. Person 1 (USP1) and a U.S. Person 2 (USP2) each hold 15% of stock of the foreign corporation (FC1). The remaining 70% is held by another foreign corporation (FC2) unrelated to either USP1 or USP2. Neither U.S. Person is required to tax the income.
Example 2:
Now, assume USP1 and USP2 have the same ownership, FC2 holds 55%, and the remaining 15% is held by a U.S. corporation. The U.S. corporation ownership qualified the foreign company to become a Specified Foreign Corporation. As a result, both USP1 and USP2, as well as the U.S. corporation, must all report and tax their pro rata share of income on each of their U.S. tax returns.
Example 3:
Assume a U.S. shareholder owns a percentage interest in both a profitable Specified Foreign Corporation and a loss-making Specified Foreign Corporation. In this case, the shareholder reduces their pro rata income of the profitable foreign corporation by the pro rata share of the loss-making foreign corporation.
Section 962 election and tax minimization
A possible strategy to minimizing or eliminating the GILTI and Subpart F tax, especially if the foreign company operates in a high tax jurisdiction, is to make a Section 962 election. As long as the business profits have been taxed in the foreign jurisdiction at a rate higher than 21% (the new corporate tax rate enacted by the 2017 Tax Reform), the individual taxpayer may be able to elect to be taxed as a corporate entity and fully offset the U.S. tax calculated on the current earnings of the Specified Foreign Corporation with the business income taxes paid in the foreign jurisdiction.
The biggest detriment of the Section 962 election lies in the distributions of previously taxed income to the U.S. shareholder. Such distributions would be subject to tax at a U.S. shareholder level creating a second layer of taxation typical to corporations in the normal flow of events. However, given that the U.S. shareholder has been taxed on the distributions in the foreign jurisdiction, foreign taxes would be credited against the U.S. taxes calculated on the amount.
The Section 962 election is made on a year-by-year basis with the U.S. Person’s U.S. tax return filed for that year. While the election adds another layer of complexity when it comes to filing such U.S. tax returns, it is viewed as a solution for many business owners operating and residing in high tax jurisdictions.
Net Investment Income Tax
The Net Investment Income Tax (NIIT) applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts. A U.S. Person will owe the tax if they have Net Investment Income as well as have a modified adjusted gross income over the following filing status income thresholds:
- Married Filing Jointly: $250,000
- Married Filing Separately: $125,000
- Single or Head of Household: $200,000
The modified adjusted gross income for most U.S. Persons living abroad is their total world-wide income (not counting the Foreign Earned Income Exclusion). The Net Investment Income Tax is neither imposed on Subpart F nor GILTI income. But bear in mind whenever a U.S. Shareholder receives a dividend payout from the previously taxed income, even if not subject to income tax, such a distribution would be subject to NIIT presuming the income thresholds are met. NIIT cannot be offset with foreign tax credits and must be paid to the U.S. government.
Applicable tax rates and foreign tax credits summary
Retroactive tax on deferred earnings from foreign corporations must be calculated using a set of formulas. However, for most U.S. shareholders the rate is around 15.5% as a guide. Again, the resulting tax may be spread out and paid over an 8-year period starting with 2017 U.S. returns. The payments are not subject to interest if made timely. Foreign tax credits are not allowed at the individual shareholder level.
In addition, relevant tax consequences would be:
Current Subpart F income and GILTI (for 2018 and future U.S. tax returns) are taxed at ordinary individual tax rates 0%-37%; and, foreign tax credits are not allowed at the individual shareholder level;
Subpart F income and GILTI under Section 962 election are taxed at a corporate rate 21%; and, foreign tax credits may be used to offset the tax liability;
Distributions out of the previously taxed income (in the absence of Section 962 election) are tax free;
Distributions out of the previously taxed income (Section 962 election) are taxed at ordinary individual tax rates (0%-37%) or capital gains rates (0%-20%); and, foreign tax credits may be used to offset the tax liability;
NIIT rate on distributions from the previously taxed income is 3.8% as long as income thresholds are met; and, foreign tax credits are not allowed.
Disclaimer: In applying the provisions of this and any other tax article, it is important to understand the impact of applicable tax laws will vary between individual tax filers. Please consult your tax adviser to determine how the tax laws discussed may affect your particular U.S. tax situation.
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