Income earned by a U.S. taxpayer from foreign operations conducted by foreign corporate entities generally is only subject to U.S. federal income tax when the income is distributed as dividends to U.S. shareholders. Until that time, U.S. federal income tax is generally deferred, subject to the “Tax Cuts and Jobs Act” signed into law on December 22, 2017 by President Trump. Nevertheless, anti-deferral regimes, such as the controlled foreign corporation (“CFC”) rules under Subpart F and the passive foreign investment company rules may cause U.S. shareholders of a foreign corporation to be taxed on a current basis in the U.S. with respect to certain income, regardless of whether the income has been distributed. To deal with the perceived abuses arising from the alleged misuse of this deferral principle, Congress created a number of complex rules that impact most taxpayers in the international investment area.
The first regime, specifically aimed at limiting deferral by U.S. persons earning income through foreign corporations, was the personal holding company provisions. These provisions were enacted to prevent the avoidance of U.S. income tax by a concentrated group of individuals through channeling passive investment income and certain other income into a corporation.
Second, Congress enacted the Subpart F provisions of the Internal Revenue Code. These provisions use the constructive dividend provisions of the Internal Revenue Code with respect to certain so-called controlled corporations. Under Subpart F, only U.S. persons holding a percentage in a foreign corporation’s voting power count in determining whether the foreign corporation is a CFC and only such shareholders are subject to constructive dividend treatment.
The Subpart F rules of the Internal Revenue Code are extremely complicated. At Diosdi Ching & Liu LLP, we understand the complexities of the Subpart F rules and plan accordingly.
Below are a few examples of Subpart F planning that our attorneys were involved in planning:
Deferral of U.S. Income Tax on Foreign Developed Software
Company A was a medium sized software manufacturer based in the U.S. It was wholly owned by U.S. shareholders. Company A also developed software overseas. Company A planned to export the software developed overseas. Company A also wanted to defer the U.S. income tax from the sale of the software developed overseas. Our international attorneys were involved in assisting Company A to defer the U.S. tax consequences of its foreign source income.
Utilizing Malta to mitigate Subpart F Income
Company B, a U.S. software developer wished to expand its operations outside the United states and wished to mitigate its exposure to the Subpart F provisions of the Internal Revenue Code. Company B wanted to establish a CFC outside the U.S. In this case, our international tax attorneys assisted Company B in becoming a tax resident of Malta. Internal Revenue Code Section 954(b)(4) provides that a U.S. shareholder of a CFC may exclude from base foreign company income an item of income earned by a CFC if the taxpayer can demonstrate that the foreign income was subject to an effective tax rate greater than 90 percent of the maximum tax rate specified in Internal Revenue Code Section 11. At the time of the planning, the maximum rate of tax specified in Internal Revenue Code Section 11 was 35 percent. This meant that in order for the high-tax exception to apply, the income earned by the CFC must be subject to an effective foreign tax rate of at least 31.5 percent (90 percent x 35 percent = 31.5 percent).
For purposes of this provision, the effective tax rate equals 1) the foreign income taxes paid, accrued, or deemed accrued with respect to the net item of income, divided by 2) the net item foreign base income. The amount of foreign income taxes paid, accrued, or deemed accrued with respect to an item of income is generally the amount a taxpayer would be deemed to have paid under Internal Revenue Code Section 960 if the item of income were included in gross income under Subpart F.
The regulations under Internal Revenue Code Section 954(b)(4) provide that the amount of foreign income taxes paid, or deemed accrued with respect to an item of income will not be affected by a subsequent reduction in foreign income taxes attributable to a distribution to a shareholder of all or part of such income. Further, a regulation dealing with the “high-tax kick out” exception under the foreign tax credit rules of Internal Revenue Code Section 904 specifies that if the effective foreign tax rate imposes on a foreign corporation is reduced under foreign law upon the distribution of that income, the rules of Internal Revenue Code Section 954(b)(4) are applied without regard to the possibility of a subsequent foreign tax reduction.
An example in the Internal Revenue Code Section 904(d) regulations illustrate this concept: S, a CFC, is a wholly owned subsidiary of P, a domestic corporation. P and S are calendar year taxpayers. In 1987, S’s only earnings consist of $200 of income earned in foreign country X. Under country X’s tax system, the corporate tax on particular earnings is reduced on distribution of those earnings and no withholding tax is imposed. In 1987, S pays $100 of foreign tax. P elects to apply the Internal Revenue Code Section 954(b)(4) high tax exception to S’s income that is Subpart F income. In 1988, S distributes $150 to P. The distribution is a dividend to P because S has $150 of accumulated earnings and profits (the $100 of earnings in 1987 and the $50 refund in 1988). The example concludes that the $200 of foreign income will be eligible for the Internal Revenue Code Section 954(b)(4) high tax exception of Subpart F income, even though the effective foreign tax rate is reduced from 50 percent to 25 percent (which was less than the 31.5 percent needed to qualify at the time) as a result the $50 tax refund received in 1988.
Company B earned income through a CFC that was a tax resident of Malta which excluded Subpart F income. This is because at the time of planning, Malta’s corporate income tax rate was approximately 35 percent. Even though Malta’s corporate tax was 35 percent, under Malta’s “imputation system,” the corporate income tax paid by a company may be refunded to the shareholders upon distribution of dividends.
When the Maltese company in question earns active income, the shareholders were entitled to claim refunds of 6/7 of the Maltese corporate income tax paid. This resulted in an effective corporate income tax rate of 5 percent. The refunds were payable within 14 days from the last day of the month in which the request was made to the Maltese tax authorities. This tax planning resulted in avoiding the Subpart F taxing regime of the Internal Revenue Code and thus Company B was able to defer its foreign source income from U.S. taxation.
Passive Foreign Investment Company Provisions (“PFIC”)
In the case of a U.S. person owning a small interest in a widely held “offshore” investment company not controlled by U.S. persons or a CFC, Congress enacted the Passive Foreign Investment Company (“PFIC”) provisions. The PFIC tax computations impact U.S. taxpayers who hold foreign mutual funds. Congress was concerned that owners of these foreign financial accounts were not properly disclosing the investment income generated from foreign mutual funds or foreign financial accounts and enacted the PFIC provisions of the Internal Revenue Code.
In these provisions, a different technique for eliminating the benefits of deferral was adopted. Instead of treating the U.S. shareholder as having received a share of the undistributed income of the foreign investment company for the tax year as a constructive dividend, the PFIC provisions eliminate the economic benefit of deferral by imposing additional U.S. tax when the U.S. person owning stock in the PFIC disposes of the PFIC stock at a gain or receives a so-called “excess distribution” from a PFIC, tax is imposed at that time which is increased by an interest charge based on the value of the tax deferred.
The only way to avoid or mitigate the PFIC computations stated in the Internal Revenue Code is to make a qualified fund or mark to market election.
If you hold an interest in a foreign financial account or are considering investing in a foreign investment such as a mutual fund, the complicated PFIC rules and harsh tax consequences may impact you. If you do not properly plan for the PFIC taxing regime, the federal tax consequences could easily exceed your foreign investment. Let the international tax attorneys at Diosdi Ching & Liu, LLP review your foreign portfolio to determine if PFIC planning is available to you. Contact us now for a FREE consultation!