By Anthony Diosdi
The Tax Cuts and Jobs Act of 2017 dramatically changed the way U.S. businesses plan outbound foreign investments. This article will compare and contrast the different entities available for outbound tax planning. Prior to the enactment of the 2017 Tax Cuts and Jobs Act, U.S. taxpayers had two main entity choices when engaging in outbound foreign tax planning: flow through structures (i.e., disregarded entities or partnerships) and corporate structures. Each had its relative costs and benefits.
A. Tax Entities Used in Outbound Foreign Tax Planning Prior to the Enactment of the 2017 Tax Cuts and Jobs Act
1. Flow Through Entities
Individuals that utilized flow through entities in outbound tax planning were subject to one layer of taxation. The flow through entities provided for one level of tax at a top individual U.S. federal tax rate generally of 39.6 percent and 23. 8 percent on capital gains (20 percent capital gains taxes + 3.8 percent net investment income tax). In addition, from a U.S. federal income tax perspective, flow through entities recognize capital gain treatment on the sale of certain assets. From a U.S. federal income tax perspective, distributions were subject to one level of tax. To the extent that the foreign entity paid local country tax, that tax was eligible to be claimed by the U.S. individuals as a U.S. foreign tax credit against U.S. federal income tax equal to the amount of the foreign taxes paid.
2. Corporate Structures
Before the 2017 Tax Act, the top effective tax rate for corporations was 35 percent with no preferential capital gains tax rate. Dividends paid to U.S. individual shareholders by C corporations or qualifying foreign corporations were subject to a second level of tax of 23.8 percent. Thus, the aggregate tax rate was about 50.5 percent. These C corporate entities made sense prior to the 2017 Tax Cuts and Jobs Act because in certain situations C corporations were able to defer the recognition of U.S. taxation.
The Changes the 2017 Tax Cuts and Jobs Act Made to the Taxation of Foreign Source Income
The 2017 Tax Cuts and Jobs Act made seven major changes in the way international outbound transactions are taxed. These changes are as follows:1) reduced tax rates for individuals, partnerships and corporations; 2) the enactment of the transition tax; 3) global intangible low tax income regime; 4) foreign intangible income deduction; 5) the new provisions of the Internal Revenue Code involving the taxation of foreign goodwill and going concern value; and 5) the rules exempting from taxation dividends paid to U.S. corporate parents of foreign CFC’s; 6) the corresponding rules exempting from taxation sales of stocks held by U.S. parents; and 7) anti-abuse rules limiting deductions for certain situations concerning hybrid entities and hybrid debt/equity instruments. These changes resulted in major changes in the way outbound international structures are planned. Below, please find a more detailed discussion of each aforementioned change.
1. Federal Tax Rates Reduced
The 2017 Tax Cuts and Jobs Act reduced the marginal tax brackets across the board for individual and corporate taxpayers. The highest tax bracket for individual taxpayers was reduced from 39.6 percent to 37 percent. Internal Revenue Code Section 199A reduced the income tax rates by an additional 7.4 percent to 29.6 percent for income received through pass through entities such as S corporations or partnerships. However, these reductions do not apply to international outbound tax planning. Finally, one of the central items of the Tax Cuts and Jobs Act was the reduction in the U.S. corporate income tax rate from 35 percent to 21 percent.
2. A Transition Tax Imposed Foreign Source Income That Was Previously Deferred
The 2017 Tax Cuts and Jobs Act enacted imposed the transition tax. The transition tax was promulgated under Internal Revenue Code Section 965. Internal Revenue Code Section 965 imposed a one-time transition on a U.S. shareholder’s share of deferred foreign income of certain foreign corporations. Section 965 effectively taxes a U.S. shareholder’s share of a foreign corporation’s share of cash, cash equivalents, or certain short-term assets at 15.5 percent and an individual U.S. shareholder at 17.54 percent. Internal Revenue Code Section 965 imposes a tax on cash assets at 8 percent and 9.05 percent for corporate and individual shareholders respectively.
Individual shareholders of an S corporation could defer payment of the transition tax indefinitely by making an election under Internal Revenue Code 65(i)(1), until a trigger event occurs. A trigger event with respect to a Section 965 liability is whichever the following occurs first: 1) such corporation ceases to be an S corporation; 2) a liquidation or sale of substantially all the assets of such s corporation; or 3) a transfer of any share of stock in the S corporation.
3. Global Intangible Low Taxed Income (“GILTI”) Imposed on Certain Classes of Income
Effective for controlled foreign corporations’ (CFC) first taxable years beginning after December 31, 2017, in addition to subpart F inclusions, Internal Revenue Code Section 951A requires the U.S. shareholders of a CFC to include in the U.S. shareholder’s income an amount of its CFC’s income determined to be in excess of a specified return on the CFC’s investment in depreciable tangible property. GILTI was intended to impose a current year tax on income earned from intangible property and impose a tax on a 10 percent return on a CFC’s investment in tangible depreciable assets. However, GILTI is not limited to income from intangibles. GILTI taxes most foreign earnings at a rate of 13.125 percent. Under currently established authorities, the GILTI lower tax rate is based upon a 50 percent tax rate reduction that applies only to subchapter C corporations. The amount can be reduced to the extent that the entity has significant tangible property in its CFC. The GILTI also is eligible for an 80 percent foreign tax credit. Thus, a 13.125 percent credible foreign income tax offsets the 10.5 percent GILTI.
4. Foreign-Derived Intangible Income (“FDII”) Imposed on the Sale of Goods and/or Services to Foreign Customers
For U.S. subchapter C corporations that sell goods and/or provide services to foreign customers, there is a deduction pursuant to Internal Revenue Code Section 250 that reduces the effective tax rate on qualifying income to 13.125 percent.
5. Taxation of Foreign Goodwill and Going Concern Valuation
The transfer of foreign goodwill and going concern to a foreign corporate subsidiary is now fully taxable and the applicable tax utilizes the “aggregate method” that takes into account the aggregate and combined value of the transferred goodwill. The GILTI tax rate is in effect at 13.125 percent for such transfers.
6. Dividends and Stocks Sales Exemption for Subpart C Corporations Owning CFCs
For choice of entity purposes, the favorable GILTI tax rate of 13.125 percent is now paired up with a favorable exemption on dividends from CFCs to U.S. corporate parents. This second level tax level payable on dividends by subchapter C corporations to U.S. individuals can be deferred indefinitely. Where funds are held in a U.S. C corporation, the personal holding company income tax does need to be addressed. Also, sales of stock by U.S. C corporations in CFC stock can be exempt from U.S. federal income tax under rules mirroring the foregoing dividend rules.
6. The Hybrid Provisions of the 2017 Tax Cuts and Jobs Act
Internal Revenue Code Section 245A(e) denies the dividends received deduction under Section 245A with respect to hybrid dividends and Internal Revenue Code Section 267A denies certain interest or royalty deductions involving hybrid transactions or hybrid entities. With respect to Section 267A, Congress was concerned with arrangements that exploit differences in the tax treatment of a transaction or entity under the laws of two or more tax jurisdictions to achieve double non-taxation, including long-term deferral. As for Section 245(e), it prevents double non-taxation by disallowing the 100 percent dividends received deduction for dividends received from a CFC, or by mandating subpart F inclusions for dividends received from a CFC by another CFC, if there is a corresponding deduction or other tax benefit in the foreign country.
A. Internal Revenue Code Section 245A(e)
The proposed regulations define the term hybrid to mean an amount received from a CFC for which a deduction would be allowed under Internal Revenue Code section 245(a) and for which the CFC received a deduction or other tax benefit in a foreign country. Hybrid dividends between CFCs with a common shareholder are treated as subpart F income.
B. Internal Revenue Code Section 267A
Internal Revenue Code Section 267A denies a deduction for any disqualified related party amount paid or accrued as a result of a hybrid transaction or by, or to, a hybrid entity. The statute defines a disqualified related party amount as any interest or royalty paid or accrued to a related party where there is no corresponding inclusion to the related party in the other tax jurisdiction or the related party is allowed a deduction with respect to such amount in the other tax jurisdiction. A “related party” includes any individual, corporation, partnership, trust, or estate, that directly or indirectly, controls or is controlled by the payor (or is controlled by the same person that controls the payor). Control is ownership of more than 50 percent (by vote or value) of the corporation’s stock or more than 50 percent (by value) of the beneficial interests in a partnership, trust, or estate.
The statute’s definition of a hybrid transaction is any transaction where there is a mismatch in tax treatment between the U.S. and other foreign jurisdiction. Similarly, a hybrid entity is any entity which is treated as fiscally transparent for US tax purposes but not for purposes of the foreign tax jurisdiction, or vice versa.
One favorable limitation on the no deduction rule is an exception that applies under the newly proposed regulations where the interest or royalty payment is fully taxable in the recipient jurisdiction at the applicable rate. The result is that the payment that is taxable at normally applicable tax rates in a relatively low income tax jurisdiction is not subject to reduction. Thus, given the 13.125 percent GILTI rate, a relatively low rate (e.g. 12.5 percent in Ireland) can be comparable with the new anti-hybrid rules. See IRC Sections 267A(a) and (b)(1)(B).
Choice of Entity Options After the 2017 Tax Cuts and Jobs Act
This section of this article will compare and contrast structures available for use in outbound investments after the enactment of the 2017 Tax Cuts and Jobs Act. I will then show how the basic tax changes discussed above has dramatically changed the way outbound tax structures are planned.
Flow Through Entities
Individuals investing offshore can still utilize flow (e.g. partnerships or disregarded entities) through entities as an investment vehicle. Operational profits are taxed immediately. The new top tax rate for outbound investments is 37 percent. Foreign income taxes generally are permitted as foreign tax credits that directly reduce taxes to individual owners on a dollar for dollar basis subject to the limitations under Internal Revenue Code Section 904 (which requires foreign sourcing of income). Just as before the 2017 Tax Cuts and Jobs Act, if eligible for capital gains treatment, a sale of assets or foreign equity interests will be taxed at 23.8 percent in the U.S. This amount generally may be offset by foreign tax credits for foreign taxes. Taxable sales of capital gain assets can potentially deferred through tax-free restructurings under Internal Revenue Code Sections 351 (for contributions to corporations) or 731 (for contributions to partnerships).
The major advantage of flow through entities is they are relatively easy to set up. However, there are significant drawbacks if a U.S. person intends to hold shares of a CFC through a flow through entity. U.S. shareholders of CFCs must include GILTI as ordinary income. As discussed above, the current federal rate applicable to an individual is 37 percent and the current highest federal tax rate applicable to C corporations is 21 percent. In addition to a significantly lower corporate tax rate, corporate shareholders of CFCs are provided one other significant benefits that are not afforded to non-corporate shareholders: C corporations can deduct 50 percent of any GILTI inclusion. By holding CFC shares through a flow through entity, the owners of such a structure will likely pay significantly more federal taxes compared to options.
Corporate Structure with U.S. Subchapter C Corporate Parent
The subchapter C corporation option is the principal alternative to the above discussed flow through model. It avoids the immediate high taxation of earnings under GILTI and may achieve deferral of certain items income for U.S. federal tax purposes where foreign taxes are at least 13.125 percent. Dividends generally will not be taxed to shareholders until distributed.
As indicated above, C corporate structures can be utilized to reduce federal tax on GILTI inclusions. In general, the GILTI tax regime is considered to be a net income tax for all income exceeding a 10 percent return on foreign tangible personal property. This net income is eligible for an 80 percent foreign tax credit so that a 13.125 percent foreign income tax can offset the otherwise applicable 10.5 percent U.S. income tax on GILTI. Based upon the foregoing, corporations will have an incentive to reduce their effective CFC tax rate to 13.125. Since all CFCs are subject to the same 13.125 percent GILTI, companies will want to direct deductible interest and royalty payments to low tax jurisdictions (e.g. Ireland at 12.5 percent). Thus, moving intellectual property offshore (including foreign good will and going concern value that is now taxable) will be a viable tax planning strategy.
Non-Corporate U.S. CFC Shareholders Making a 962 Election
Internal Revenue Code Section 962 allows an individual U.S. shareholder of a CFC to elect to be subject to the corporate income tax rates (under Sections 11 and 55) on amounts that are included in his or her gross income under Internal Revenue Code Section 951(a) (Subpart F income) and Internal Revenue Code Section 951A (GILTI tax regime). Section 962 also allows individuals making a Section 962 election to claim a 50 percent deduction under Internal Revenue Code Section 250 as to their GILTI income. The attractiveness of Section 962 elections has changed dramatically with the enactment of the 2017 Tax Cuts and Jobs Act. This is because corporate rates fell to 21 percent and the effective tax rate that U.S. C corporations pay on their GILTI income is only 10.5 percent (after accounting for the 50 percent Section 250 deductions such corporations are permitted to take. U.S. individuals holding CFC shares who do not make Section 962 elections on the other hand will pay up to 37 percent tax on GILTI income and are not permitted to claim a 50 percent Section 250 deduction. A Section 962 election treats the non-corporate U.S. shareholder as a corporation solely for purposes of subpart F inclusions and GILTI inclusions. If the non-corporate shareholders were to sell the CFC stock, the shareholders therefore would not be subject to tax on such sale as if the shareholder was a corporation. Thus, there would not be two layers of federal tax upon such sale.
Anyone considering making a Section 962 election must understand there are some complexities when making this election. For example, if the individual U.S. shareholder makes a Section 962 election, a later distribution of previously-taxed earnings to that shareholder is, under Internal Revenue Code Section 962(d), again subject to tax as dividend income. See Treas. Reg. Section 1.962-3(d)(1).
S Corporation Ownership
S corporate structures are taxed for U.S. outbound taxation purposes similar to flow through entities. On its own, a structure were an S corporation holds CFC shares is generally not considered an effective way to reduce subpart F or GILTI inclusions. However, holding CFC shares through an S corporation may provide an extremely effective way to defer the recognition of the transition tax. Individual shareholders of an S corporation are able to defer the transition tax indefinitely by making a Section 965(i)(1) election, until a trigger event occurs. A trigger event with respect to a Section 965 liability is whichever the following occurs first: 1) such corporation ceases to be an S corporation; 2) a liquidation or sale of substantially all the assets of such an S corporation, a cessation of business by such S corporation, such corporation ceases to exist, or any similar circumstances; 3) a transfer of any share of stock in such S corporation by the taxpayer.
Any shareholder of an S corporation with with deferred foreign source income must carefully proceed to ensure that a trigger event does not take place.
The above discussed examples demonstrates the complexities involved in outbound international tax planning. There is no one size fits all solution. Individuals involved in outbound international tax planning should consult with an international tax attorney to consider all of the benefits and burdens of each above discussed structure.
The tax attorneys at Diosdi Ching & Liu, LLP represent clients in a wide variety of domestic and international tax planning and tax controversy cases.