How tax reform is affecting US expat owners of a foreign business
By James Debate, Corporate Senior Tax Associate at US Tax and Financial Services
On 20th December 2017, Congress passed H.R. 1, the Tax Cuts and Jobs Act of 2017 (“TCJA”). This was signed into law by President Trump and will enact significant changes to the US tax code with the potential to affect US individuals and businesses, both at home and abroad.
In particular, the legislation provides for new provisions which affect investment by US persons into non-US businesses. Any expat who currently holds or plans on making investments outside the United States may be affected and these changes could require action as soon as the upcoming spring tax deadline.
The source of the concern is the two new provisions relating to certain foreign companies known as controlled foreign corporations (“CFC”). In short, these are non-US corporate entities which are greater than 50 percent owned by US shareholders, each of whom owns at least 10 percent. The IRS has historically been concerned by the potential for US citizens to defer taxation by allocating their income abroad and imposes a special regime of compliance. Under the new law, two additional forms of taxation will apply to such investments – a Deemed Transition Tax potentially starting with the 2017 tax year, and a new minimum tax on foreign earnings which is applicable for tax years 2018 onwards.
Deemed Transition Tax
Before the enactment of the TCJA, US corporations were taxed on their worldwide income. To make the US more competitive, along with a substantial drop in the US corporate tax rate, Congress decided to move to a more territorial system of taxation for corporations. As a result, most foreign income earned by corporations will no longer be taxed when it is repatriated to the US.
Therefore, to address the substantial amount of untaxed earnings and profits that has been sitting offshore, the new tax law contains a one-time repatriation provision. For corporate shareholders, the tax rate is 15.5 percent on cash and cash-equivalent assets and 8 percent on non-cash assets. Based on the calculation (which uses corporate tax rates), individual shareholders of a CFC could have higher effective tax rates on both categories of assets.
Although the transition tax was meant to help corporations “adjust” to the new territorial system of taxation, this provision of the new law, as written, is also applicable to individuals (who will still be taxed on their worldwide income).
This transition tax becomes applicable on the CFC’s last taxable year which begins before January 1, 2018. This means that for CFCs with a December 31 year end, the deemed transition tax is applicable for the 2017 tax year and will need to be paid by April 17, 2018. For CFCs with fiscal year ends, it appears that the transition tax is applicable for 2018 and will not be “payable” until April 15, 2019. However, we would generally expect that CFCs with individual shareholders to have calendar year ends, in which case such investors will need to determine if they are affected as soon as possible.
Fortunately, the new law permits a US shareholder to elect to pay this liability over a period of up to eight years, without any interest charge. If the election is made, the US shareholder will pay 8 percent of the net tax liability in each of the first five instalments, 15 percent of the net tax liability in the sixth instalment, 20 percent of the net tax liability in the seventh instalment, and 25 percent of the net tax liability in the final instalment. Although the election is made on the individual’s income tax return, the initial payment will be due by April 15th (as noted earlier, for the 2017 tax year, the payment will be due on April 17, 2018).
Minimum Tax on Foreign Earnings – GILTI
Global Intangible Low-Taxed Income (“GILTI”) is an entirely new category of income that requires the recognition of a certain amount of untaxed foreign earnings each year, as determined by reference to what is defined as the “deemed tangible return.” Applicable for tax years after December 31, 2017 (thus, 2018 onward), this is essentially a new minimum tax on foreign earnings of a CFC.
The calculation of the tax on GILTI is somewhat complex, but it essentially starts with the foreign corporation’s gross income (excluding US income, other already-taxed income, and certain exemptions) and then reduces the gross income by the foreign corporation’s deductions, including taxes. The remainder is reduced by a deemed 10 percent return on the historic tax basis of depreciable tangible property (minus any relevant interest expense). This becomes the GILTI amount that the US shareholder must pick up as income. For individuals, this will be taxed at the individual’s marginal rate for the year.
US corporate shareholders can reduce the amount of the GILTI inclusion by 50 percent (37.5 percent after 2025) and may claim a foreign tax credit of up to 80 percent of the foreign taxes incurred during the year. Although individual shareholders of a CFC cannot normally claim a foreign tax credit for taxes paid by the foreign corporation, they can elect to be taxed as a corporation on the GILTI income, which would allow them to claim the foreign tax credit. However, it does not appear that they would be allowed the deduction of 50 percent on the GILTI inclusion.
The result of these provisions is that it has become less attractive for a US person to set up a foreign corporation. While the deemed transition tax is a one-time event, the GILTI regime will become an annual occurrence that requires action from the affected investors. Equity investment is a standard practice of wealth management. But for expats, investing in non-US businesses just became more complicated.
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