The Tax Cuts and Jobs Act of 2017 brought sweeping changes to the US taxation of US shareholders of Controlled Foreign Corporations (CFCs). If you were a US shareholder of a CFC in 2017 then you will have already been affected by the Repatriation/Transition tax, whereby an inclusion had to be made on your tax return in respect of retained earnings and profits of the company as of 2nd November 2017 or 31st December 2017 (whichever was higher). In most circumstances, the US Federal tax due on these inclusions was able to be covered by available foreign taxes paid.
To refresh your memory regarding the above definitions:1. Controlled Foreign Corporation Defined . A controlled foreign corporation is any foreign corporation in which more than 50 percent of the total combined voting power of all classes of stock entitled to vote is owned directly, indirectly, or constructively by U.S. shareholders on any day during the taxable year of such foreign corporation or more than 50% of the total value of the stock is owned directly, indirectly or constructively by U.S. shareholders on any day during the taxable year of the corporation.
2. A U.S. shareholder is a U.S person (US citizen, Greencard holder, US resident, etc) who owns directly, indirectly, or constructively 10 percent or more of the total combined voting power of all classes of stock entitled to vote in a foreign corporation. “
You do not need to consider the contents of this note if you are the sole shareholder of a foreign corporation which is treated as a disregarded entity for US tax purposes.
The Tax Cuts and Jobs Act included further changes to the way US shareholders of CFCs are taxed in 2018 and going forward. The Act introduced the Global Intangible Low-Taxed Income (GILTI) Tax. Although the Act was originally published on 2 November 2017 and was intended to affect the taxation of corporate taxpayers, the changes were ill-thought-out and have had the effect of also impacting individual taxpayers.
On 13th September 2018 the IRS and Treasury released proposed regulations providing general rules for determining a US shareholder’s GILTI inclusion. These proposed regulations did not include rules relating to foreign tax credits, or the Section 250 deduction (discussed later). On 28th November 2018 the IRS and Treasury updated the proposed regulations confirming that foreign taxes paid, and foreign tax credit carry-forwards cannot be used to offset tax due on GILTI, and that GILTI has its own foreign tax basket. On 4th March 2019, the IRS and Treasury issued additional proposed regulations providing guidance on both the computation of the deductions available under section 250.
It is important to note that these remain proposed regulations. The IRS does not intend to issue final regulations until 22 June 2019. This note is therefore based on the proposed regulations, and it is advisable not to submit your 2018 US Federal tax return until after that date, as an amendment may be required.
Although there are other issues that can affect a CFC (e.g. Subpart F), this note is designed to focus solely on the GILTI tax, and how these changes may impact you.
GILTI is your share of the net profit of the company, whether or not distributed to you in the tax year. GILTI cannot be reduced by dividends distributed to you in the tax year. On the face of it, therefore, this law change could impose a costly US tax charge on individuals, with no credit for taxes paid on that income to the foreign country.
This note will now set about explaining the various options which may be available to you if you are caught by the new GILTI tax. This is based on our current understanding of the Tax Cuts and Jobs Act and proposed regulations. With the exception of the option to treat the company as a US corporation, none of these actions can be taken retroactively.
Is your spouse a non-resident alien?
A non-resident (NRA) alien is an individual who is not a US citizen, Green Card Holder or US resident. GILTI does not apply constructive ownership of an NRA spouse’s shares to you when testing whether the company is a CFC; constructive ownership is where you are deemed to own the shares of another individual by virtue of your relationship with them. As such, a gift of some of the shares of the company to an NRA spouse can reduce your shareholding such that you are no longer a shareholder in a CFC. There are several things to consider here:
- Your spouse’s own exposure to home (foreign) country taxes
- Home country company and gift tax implications of such a gift
- US income and gift tax implications when gifting an asset to an NRA, and whether the US lifetime gift and estate allowance is available
Make an election to change the entity’s classification with the IRS
This is what is commonly known as the “check-the-box” election, and the following options could be considered:
- If you are the sole owner/shareholder of the company you could elect to treat the company as a “disregarded entity”. This would then make the company transparent for US tax purposes. Although you would still report the net profit of the company annually on your US tax return, you would be able claim a credit for UK (or foreign country) tax paid on salary and dividend distributions, as well as UK (or foreign) corporation tax.
- If you are not the sole owner/shareholder, elect to treat the company as a partnership for US tax purposes. This again would make the company transparent for US tax purposes, and the above foreign tax credits would also be available. Please note that this election would affect all US shareholders so the decision would need to be made at company-level.
Other considerations here:
- Has the company made an entity classification in the previous 5 years? If so, it’s classification cannot currently be changed.
- If you’re the sole owner/shareholder, have you revoked the Foreign Earned Income Exclusion in the previous 5 years? This exclusion will form an integral part of any planning.
- Both of these scenarios would require recognising a deemed sale of the entity (including goodwill), which may or may not have US tax implication based on how the company was treated in tax years prior to 2019.
Can I close the company and set up a new one?
This concept is currently being referred to as “phoenixing”. It will require careful planning, and a timely filed “check-the-box” election for the new entity (within 75 days of incorporation).
There will be many considerations here:
- The home (foreign) country tax treatment when closing the company, and taxation of retained earnings:
- Will the retained earnings be taxed as a capital gain or a dividend when distributed? There are generally specific rules on this if you will be setting up an identical company to replace it.
- If I am withdrawing these as dividends, what is the best strategy for withdrawing the funds to manage my home country tax bill
- Will there be a US tax charge if the company has not previously paid the Repatriation tax; again, depending on how company was treated in tax years prior to 2019
- Have I previously revoked the Foreign Earned Income Exclusion?
Shall I distribute everything as salary or a bonus?
Salary and bonuses will reduce your net profit in the company for that financial year and so reduce the amount subject to GILTI tax. This will reduce your home country corporation tax liability. However, it will likely increase your home country personal tax liability. In the UK, for example, the salary and bonus payments will be subject to income tax rates rather than dividend tax rates. These amounts will also be subject to Class 1 Employee National Insurance. Further, the company will also be required to make Class 1 Employer National Insurance contributions.
Elect to treat the company as a US corporation
An election can be made under IRC section 962 to treat the foreign company as a US corporation. Again, although the net profit of the company is reportable:
- An IRC section 250 deduction is available (for corporations and individuals) of 50% of the profits.
- US corporation tax is assessible on this 50% profit figure at 21%
- A credit is allowed for the UK corporation tax paid on 80% of the net profits (the UK corporation tax rate is currently 19%)
For UK-based companies, it is envisaged that taking this approach will not create a US tax liability in the majority of cases, although this is unlikely to be a long-term solution to GILTI. The section 962 election is made on a year-by-year basis.
All of these options will need to be carefully considered on a case-by-case basis, and this note is only designed to give you a background knowledge of the issues involved. It is important to note again that at this stage the regulations are only proposed, and the final regulations have not yet been issued.
Please be aware that this article is only intended to provide information on GILTI and the options available to shareholders of foreign controlled corporations. This article should not be taken as tax advice. Please contact us directly for more information.