By Anthony Diosdi
As a result of the Section 965 “transition tax,” few controlled foreign corporations (“CFCs”) have untaxed offshore earnings and profits (“E&P”). With that said, there are still a number of strategies available to CFCs to defer offshore E&P. In certain cases, these strategies leave CFC shareholders with large pools of untaxed offshore E&P. This article will discuss how untaxed offshore E&Ps is taxed when a CFC shareholder disposes of such stock.
Under Section 1248(a) of the Internal Revenue Code, gain recognized on a U.S. shareholder’s disposition of stock in a CFC is treated as dividend income to the extent of relevant accumulated E&P while the stock was held. When a corporation sells shares of a CFC, the conversion of gain into a dividend typically results in an exemption from federal tax pursuant to a Section 245A dividends received deduction. (Section 245A provides a 100 percent deduction to domestic corporations for certain dividends received from foreign corporations after December 31, 2017). Thus, the conversion of gain into dividend income may be beneficial from a federal tax point of view for certain corporate shareholders.
As one would probably expect, the result is different for individual CFC shareholders.
When an individual CFC shareholder sells stock in the CFC, the conversion of gain into dividend results in a recharacterization under Section 1248(a). This recharacterization reclassifies accumulated E&P from long-term capital gains rates to ordinary rates. Taking into consideration the Net Investment Income Tax (“NIIT”), the maximum federal rate for long-term capital gains is 23.8 percent. The maximum ordinary rate including NIIT is 40.8 percent.
At first glance, it appears that Section 1248(a) taxes the conversion of reclassified CFC dividend income at a maximum marginal rate of 40.8 percent. However, Section 1248(b) provides a ceiling on the tax liability that may be imposed on the shareholder receiving a Section 1248(a) dividend if the taxpayer is an individual and the stock disposed of has been held for more than one year. The Section 1248(b) ceiling consists of the sum of two amounts. The first amount is the U.S. federal income tax that the CFC would have paid if the CFC had been taxed as a domestic corporation, after permitting a credit for all foreign and U.S. tax actually paid if the CFC had been taxed as a domestic corporation, after permitting a credit for all foreign and U.S. tax actually paid by the CFC on the income (the “hypothetical corporate tax”). For example, let’s assume that CFC incorporated in the British Virgin Islands and has $1,000 of income. Let’s also assume the same CFC pays $0 of foreign taxes. Assuming that the CFC would be in the 21 percent corporate tax bracket for tax purposes, the hypothetical corporate tax would be $210. ($1,000 x 21% = $210).
Under the second part of the formula, the taxpayer’s U.S. federal income tax for the year that results from including in gross income as long-term capital gain an amount equal to the excess of the Section 1248(a) amount over the hypothetical corporate tax (the “hypothetical shareholder tax”). Assuming the same facts as above,the hypothetical shareholder tax would be 23.8 percent of $790 ($1,000 Section 1248(a) amount less the hypothetical corporate tax of $210), or $188.
The next step is to add together the hypothetical corporate tax and the hypothetical shareholder tax. For the above example, this would result in a yield of $398.00. ($210 + $188 = $398) or a 39.8 percent effective tax rate.
Since the CFC in this example is not a resident in a treaty country. (The United States does not have a tax treaty with the British Virgin Islands), the amount of taxable gain that can be reclassified as a dividend under Section 1248(a) is $1,000. Because the maximum marginal effective tax rate for ordinary income is 40.8 percent, the tax rate would be $408. This amount is greater than the $398 ceiling amount discussed above. Therefore, in this example, the U.S. shareholder would be subject to U.S. federal tax of $398 on the sale of his or her CFC shares.
As demonstrated above, Section 1248(b) calculation will typically reduce a tax liability associated with retained E&P converted to dividends. It should be noted that as the foreign tax rate increases, the Section 1248(b) calculation may become more favorable.
Conclusion
If you are selling stock in a CFC, it is important to determine if the foreign corporation has untaxed accumulated E&P. If the CFC has accumulated untaxed E&P, that E&P may be reclassified as a dividend. For individual shareholders, this dividend could be taxed subject to a federal tax up to 40.8 percent under Section 1248(a). However, in most cases, Section 1248(b) can lower the tax liability that would have been imposed under Section 1248(a).
Anthony Diosdi one of the international tax attorneys at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. As an international tax attorney, Anthony Diosdi advises clients in areas of international tax planning and international tax compliance throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.