Tag: tax

#IndiaU.S.TaxSeries Ep. 1: What are Tax Treaties?

Posted on by Peter Harper

This refreshing entry of the #AsenaTaxBlog series on tax treaties focuses on the US and India tax treaty framework. The first blog presents a brief history that might interest my readers, who are curious to learn about the application of tax treaties and their interplay with domestic legislation to determine how beneficial provisions impact their cross-border tax planning needs. In doing so, there is a list of questions that you should discuss with your advisor to ensure your tax compliance is in order. 

Background

A tax treaty is an agreement or a convention between two countries. For instance, an income tax treaty is an agreement primarily concerning the taxation of income, prevention of double tax, and evasion. There can be various reasons for a country to negotiate and enter a tax treaty with another country.  

Post the First World War, the League of Nations began developing model tax conventions, which were taken over by the Organization for Economic Co-operation and Development (OECD) and later the United Nations. The United Nations was essential in establishing the United Nations Economic and Social Council (ECOSOC) to address the needs of the developing countries to formulate a model tax convention promulgating the manner to negotiate a tax treaty that is focused on addressing the sourcing country’s taxing. In 2003, the United Nations’ Department of Economic and Social Affairs published a revised edition of the Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries. It noted that “the twin goals of a tax treaty are, firstly, to encourage economic growth by mitigating international double taxation and other barriers to cross-border trade and investment, and secondly, to improve tax administration in the two Contracting States by reducing opportunities for international tax evasion.”  

US Tax Treaty Framework

In the US Constitution’s Article II, Section 2, Clause 2 confers the President to make treaties and lays out how to enforce a treaty. The US has signed the Vienna Convention on the Law of Treaties (Vienna Convention) but considers many of its provisions concerning the application of international law to the law of treaties. 

The US has entered into income tax treaties with several foreign countries. The US concluded the first income tax treaty with China in 1932 to foster trade relations between the US and France. As more developing countries seek to achieve foreign investments, the bilateral income tax treaties could be a guidance tool for taxation of income, avoidance of double taxation, and evasion of taxes.  

The US has below types of treaties dealing with tax matters:

  1. Double tax avoidance income tax treaties;
  2. Estate and gift tax treaties; 
  3. Tax information exchange agreements (TEIAs); 
  4. Social security agreements or Totalization agreements; and 
  5. Multilateral Convention on Mutual Assistance in Tax Matters.

The list of countries with which the US has an income tax treaty is provided on the IRS’s official website. Countries included are Armenia, Australia, Austria, Azerbaijan, Bangladesh, Barbados, Belarus, Belgium, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Georgia, Greece, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Korea, Kyrgyzstan, Latvia, Lithuania, Luxembourg, Malta, Mexico, Moldova, Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russia, Slovak Republic, Slovenia, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Tajikistan, Thailand, Trinidad, Tunisia, Turkey, Turkmenistan, Ukraine, Union of Soviet Socialist Republics (USSR), United Kingdom, United States Model, Uzbekistan, Venezuela, and Vietnam.

India Tax Treaty Framework

Article 253 of the Indian Constitution confers the Parliament of India to make treaties and lays out how to enforce a treaty. However, India is not an official signatory to the Vienna Convention. Still, how the courts (Ram Jethmalani v. Union of India (2011) 8 SCC 1 and various high courts in India) have acknowledged and embraced the customary international law provisions is a small step towards encouraging an integrated framework. 

India has below types of treaties dealing with tax matters:

  1. Double tax avoidance income tax treaties including comprehensive, limited bilateral, limited multilateral, and other agreements (DTAs);
  2. Tax information exchange agreements (TEIAs); 
  3. Social security agreements (SSAs); and 
  4. Multilateral Convention on Mutual Assistance in Tax Matters.

India has entered into 96 comprehensive and eight limited bilateral income tax treaties. These include Armenia, Australia, Austria, Bangladesh, Belarus, Belgium, Botswana, Brazil, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Ethiopia, Finland, France, Georgia, Germany, Greece, Hashemite Kingdom of Jordan, Hungary, Iceland, Indonesia, Ireland, Israel, Italy, Japan, Kazakhstan, Kenya, Korea, Kuwait, Kyrgyz Republic, Libya, Lithuania, Luxembourg, Malaysia, Malta, Mauritius, Mongolia, Montenegro, Morocco, Mozambique, Myanmar, Namibia, Nepal, Netherlands, New Zealand, Norway, Oman, Philippines, Poland, Portuguese Republic, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovenia, South Africa, Spain, Sri Lanka, Sudan, Sweden, Swiss Confederation, Syrian Arab Republic, Tajikistan, Tanzania, Thailand, Trinidad and Tobago, Turkey, Turkmenistan, United Arab Emirates, UAR (Egypt), Uganda, United Kingdom, Ukraine, United Mexican States, United States of America, Uzbekistan, Vietnam, and Zambia. 

The Indian tax legislation prescribes the availability of tax treaty benefits subject to certain procedural compliance and poses a challenge for taxpayers. For example, a non-resident Indian (NRI) is required to obtain a Tax Residency Certificate (TRC) from the tax authorities of a country of which he/she/they are a resident, in addition to filling out a self-declaration form. 

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India-US Income Tax Treaty Framework

Forms of tax treaty agreements between India and the US: India and the US have only two bilateral tax agreements, namely:

  1. The Convention Between the Government of the United States of America and the Government of the Republic of India was made for the avoidance of double taxation and the prevention of fiscal evasion concerning taxes on income 1989, which came into effect on 1 January 1989 (India-US DTA), and the protocol and technical explanation to guide for that.  
  2. The Agreement between the Government of the Republic of India and the Government of the United States of America for improving the international tax compliance and to implement the Foreign Account Tax Compliance Act (FATCA). This agreement was entered on 9 July 2015 in terms of Article 28 relating to the exchange of information for tax purposes on an automatic basis and put into effect from the period beginning 1 January 2017.

There is no gift, inheritance, nor estate tax treaty between India and the US. Therefore, a taxpayer is required to be governed and comply with the domestic tax legislation of the country where the citizenship/residence/domicile is established at the time of the taxing event.

Snapshot of the Articles covered under the India-US DTA

Broadly, the articles under the India-US DTA can be categorized as under:

Category

Article
Scope and Taxes Covered Article 1: General scope;

Article 2: Taxes covered;

Article 30: Entry into force;

Article 31: Termination
Definition Article 3: General definition;

Article 4: Residence;

Article 9: Associated enterprises
Individual Income  Article 6: Income from immovable property;

Article 10: Dividends;

Article 11: Interest;

Article 12: Royalties and fees for technical services;

Article 13: Gains; Article 15: Business personnel services;

Article 16: Dependent personnel services

Article 17: Director’s fees;

Article 18: Income earned by entertainers, and athletes;

Article 21: Payments received by students. and apprentices;

Article 22: Payments received by professors, teachers, and research scholars;

Article 23: Other income;

Article 29: Diplomatic agents, and consular officers
Business Income Article 5: Permanent establishment;

Article 7: Business profits;

Article 8:  Shipping and air transport;

Article 14: Permanent establishment tax
Pension Income Article 19: Remuneration and pensions in respect of government services;

Article 20: Private pensions, annuities, alimony, and child support
Other Provisions Article 24: Limitation on benefits;

Article 25: Relief from double taxation;

Article 26: Non-discrimination;

Article 27: Mutual agreement procedure;

Article 28: Exchange of information and administrative assistance

The interpretation of the articles covered under the India-US DTA needs deep analysis, and a cross-border tax advisor should be consulted to apply the tax treaty to the facts and circumstances of your situation.

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Key Questions to Discuss with Your Advisor Concerning the DTA While Tax Planning or Compliance: 

  1. Whether the DTA is effective or in force?
  2. What is the nature of the DTA in force – comprehensive or limited?
  3. Does the scope of the DTA cover me?
  4. What is the basis for determining my residential status under the DTA?  
  5. Does the “saving clause” under the DTA apply to me?
  6. What types of income are covered under the DTA?
  7. Does my business activity in a country establish a “permanent establishment” status?
  8. Do I have an option between applying the DTA and domestic tax legislation? 
  9. Is the application of the DTA more beneficial than domestic tax legislation? How do they interact? 
  10. What are the relevant provisions for the elimination of double taxation?
Our team of international tax specialists at Asena Advisor has in-depth knowledge of interpreting international tax treaties and ascertaining their applicability to your specific circumstances. Please contact Janpriya Rooprai, Head of the US-India Tax Desk, for more information.

Janpriya Rooprai

Peter Harper

Entity Classification Election

Posted on by Peter Harper

Entity Classification Election

Following our previous discussion about entity changes with check-the-box regulations, let’s go into another process that entrepreneurs and executives are likely to consider with the tax season fast approaching: the entity classification election.

What is the Purpose of Entity Classification Election?

The purpose of the entity classification election is to enable business entities to avoid the default tax classification applied by the IRS for federal income tax purposes. Business entities receive a default tax classification, which can result in paying for more federal taxes than necessary. If your entity is eligible to use the entity classification election form, you can change your tax election status and potentially lower your tax liability.

For example, a U.S. corporation can avoid double taxation by using the CTB regulations, and it also benefits foreign eligible entities by avoiding potential double taxation. For example, an entity in India could be classified and taxed differently in the U.S. than in India, such as a tax treaty or an income tax treaty. The CTB rules, therefore, provide the entity in India to elect its entity classification for U.S. tax purposes with that said tax treaty. 

The entity set up in India can also use the tax treaty, along with any treaty benefits included, to qualify for lower dividend withholding taxes if it elects to be taxed as a corporation in the U.S. 

A Parent company in the U.S. can also use the CTB rules to benefit from the tax treaty with India and avoid double taxation. 

What Is A Business Entity Classification?

A business entity is any entity that is recognized for federal tax purposes that is not correctly classified as a trust under Regulations section 301.7701-4 or otherwise subject to special treatment under the Code regarding the entity’s classification. A business entity is classified as either a C-Corporation, partnership, or disregarded entity for federal tax purposes. 

Here is how you can remember:

Association – For purposes of the CTB regulations, an association can be an eligible entity that’s taxable as a corporation by election or under the default rules for foreign eligible entities, as discussed below.

Business entity – A business entity is any entity recognized for federal tax purposes that is not accurately classified as a trust under Regulations section 301.7701-4. Or they are otherwise subject to special treatment under the Code regarding the entity’s classification. 

Corporation – For federal tax purposes, a corporation is any of the following: 

    • A business entity is organized under a federal or state statute or a federally recognized Indian tribe statute if that same statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic. 
    • An association.
    • A business entity is organized under a state statute if the statute describes or refers to the entity as a joint-stock company or joint stock association. 
    • An insurance company. 
    • A state-chartered business entity that is conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act or a similar federal statute. 
    • A business entity that is wholly owned by a state or any political subdivision or is wholly owned by any entity described in Regulations section 1.892-2T, such as a foreign government.
    • A business entity that can be taxable as a corporation under a provision of the Code other than section 7701(a)(3). 
    • A foreign business entity as listed on page 7 of Form 8832. 
    • An entity is created or organized under tax laws of more than one jurisdiction (an example can be a business entity that has multiple charters) if the entity will be treated as a corporation with respect to any of the jurisdictions. For examples, see Regulations section 301.7701-2(b)(9).

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What is an Entity Classification Form?

This federal tax form allows certain businesses to select whether they want to be taxed as a corporation, partnership, or disregarded entity for future tax purposes and protected under tax law. 

What is IRS Form 8832?

You can use IRS form 8832 to choose to have:

      • A corporation with more than one owner is treated as a partnership for tax purposes.
      • A corporation with a single owner is treated as a ‘disregarded entity for tax purposes.
      • A partnership is treated as a corporation for tax purposes.
      • A ‘disregarded entity is treated as a corporation for tax purposes.

Which Businesses Can Use Form 8832?

Only businesses that are considered eligible entities can use Form 8832. The following are regarded as eligible entities:

      • Partnerships
      • Single-member LLCs
      • Multi-member LLCs; and
      • Certain types of foreign entities

Not every type of business can use Form 8832 to change their business’s tax classification. The following can be considered businesses eligible for filing Form 8832:

      • Partnerships
      • Single-member LLCs
      • Multi-member LLCs
      • Explicit types of foreign entities (Page 5, Form 8832)

The above entities can use Form 8832 to elect to be taxed as a C corporation, partnership, or sole proprietorship.

If you’re currently a limited liability company (LLC) taxed as a corporation, you can use Form 8832 to revert to a previous tax classification.

Eligible businesses that don’t fill out the form will be taxed based on their default tax status. If you are content with your current or default tax classification, do not fill out Form 8832.

Remember that your business can only change its tax classification once every five years.

Who is Not Eligible to File Form 8832?

Sole proprietors, domestic corporations, and foreign corporations are listed in IRS Regulations 301.7701-2(b)(8). 

How Do You Fill Out Form 8832?

Form 8832 is a straightforward form to fill out and only requires the entity’s name, address, and tax identification number, followed by making an election by checking the relevant box and the signature of the entity’s eligible owner, member, partner, or officer.

Before you begin filling out your form, you need to gather some information. Take a look at what to have handy for Form 8832:

      • Business name, address, and phone number
      • Employer Identification Number (EIN)
      • Owner’s name and Social Security number (if the business only has one owner)

There are two parts to the form: Election Information (Part I) and Late Election Relief (Part II). Part I asks a series of questions on your tax status election. Depending on your answers, you may be able to skip some lines.

Part II is for businesses seeking late election relief only. To be eligible for late election relief, all of the following must apply:

      • The IRS denied a previous Form 8832 filing because you didn’t file on time.
      • You haven’t filed your taxes because the deadline hasn’t yet passed, or you’ve filed your taxes on time.
      • You have reasonable cause for not filing your form on time.
      • It has been less than three years and 75 days from your requested effective date.

Is Form 8832 Complicated?

No. The required information you need to know is: 

        • The name of your business
        • The phone number and address of your business
        • The employer identification number (EIN)

Who Must File Form 8832?

Keep in mind that it is not a mandatory form at all. It provides eligible entities the option to change their default classification should they wish. 

What Information is Required?

        • The name of your business
        • The phone number and address of your business
        • The employer identification number (EIN)
        • Owner’s name and Social Security number if the business only has a single owner

Where Should It Be Filed?

        • The form can not be filed electronically. 
        • If you are living as either a resident or non-resident in the U.S., you will have to mail it to the appropriate IRS office in your state.
        • If you are a resident or non-resident in a foreign country, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.

Where Do You Send the Form?

This will depend on the location your entity is residing in a domestic or foreign location:

        • If you live in the U.S., you’ll mail it to the appropriate IRS office in your state.
        • If you live in a foreign country as a resident or non-resident, you will need to mail the form to the Department of the Treasury, Internal Revenue Services, Ogden, UT 84201-0023.

Once your specific office receives your form, they will notify you immediately whether it has or hasn’t been accepted. A final determination notice of the election change will be sent to you within 60 days of the acceptance decision.

What’s the Form 8832 deadline?

Because Form 8832 is not mandatory, it doesn’t have a deadline per se. It can be filed at any point by an eligible entity. There are, however, specific but basic rules to take note of. When you file the form, you can include the date the change will take effect. 

Broadly, an election specifying an eligible entity’s classification will not take effect more than 75 days before the election is filed, nor can it take effect later than 12 months after the election is filed. However, an eligible entity may be able to apply for an exemption and receive a late election relief in certain circumstances.

How Long Does It Take to Prepare?

The IRS estimates that 17 minutes are required to prepare the form. However, this doesn’t take into account the time it will take to learn and understand the applicable tax law.

What Else Should I Know About Form 8832?

It is essential to know the difference between Form 8832 and Form 2553. Both forms allow certain businesses to request a new tax classification. However, the major difference is the type of tax classification you request.

Form 8832 authorizes businesses to request to be taxed as a corporation, partnership, or sole proprietorship, whereas Form 2553 is the form corporations and LLCs use to elect S-Corp tax status. 

The check-the-box regulations authorize entities to elect to change their U.S. tax classification, though a change in tax classification, no matter how achieved, has tax consequences. This applies to U.S. and International business owners.

Essentially there are three ways to accomplish a classification change:

        • An elective classification change by filing IRS Form 8832.
        • An automatic classification change, wherein an entity’s default classification changes as a result of a change in the number of owners.
        • An actual conversion, wherein an entity merges into, or liquidates and forms, an entity that has the desired classification.

Suppose a corporation elects to be classified as a partnership. In that case, it will be deemed to have distributed all its assets and liabilities to shareholders in liquidation. The shareholders are considered to contribute all the distributed assets and liabilities immediately after that to a newly formed partnership. An entity will be deemed to have liquidated under §331 or §332, and the deemed liquidation will be treated like it were an actual liquidation for tax purposes.  

An entity not regarded as eligible will first need to convert into an eligible entity before making the check-the-box election. 

Lastly, an actual conversion can be implemented.

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Why to Use Form 8832

Businesses receive a default tax classification, which can result in paying more business taxes than necessary. If you’re eligible to utilize the entity classification election form, you can change your tax election status and potentially lower your liability on a tax return, saving you money and building more tax credit.

Why Comply?

Even though this form is not mandatory, this will be an advantage for some taxpayers to decide whether their entity will be taxed as a partnership (one with multiple owners), as a corporation, or disregarded for tax purposes (single owner entity) and taxed like a proprietorship.

What is the Best Tax Classification for an LLC?

An ideal tax classification for a limited liability company (LLC) will depend on if you’d like your business profits should be taxed at your personal income tax or corporate tax rates. If you would rather use your personal tax rates instead, you can classify it as a disregarded entity or as a partnership. If not, you can classify it as a corporation instead.

An LLC can be taxed in several ways for the business and its owner to save on taxes. Below are ways how an LLC can be taxed, how your business can benefit from being taxed as an S corporation or as a corporation, and how you can elect this tax option:

An LLC can be considered as a disregarded entity, similar to the way sole proprietorships are treated, or can be taxed as a partnership if it has multiple members. Those are the most usual classification for LLCs, with each case having the profits ultimately taxed as a part of every member’s personal income.

It’s also possible for an LLC to be considered a corporation. If so, the entity will have to pay corporate taxes instead of passing profits through to each member’s personal income tax return.

To be taxed as a corporation, use the entity classification election or IRS Form 8832. The election for being taxed as a new entity will go into effect on the date entered on line 8 of Form 8832. However, the election cannot take effect over 75 days before the date the election is filed, nor will it take effect any later than 12 months after it is filed.

The form includes a consent statement that may be signed by all or one member on behalf of all other members. If one member does sign, there needs to be some record in a company membership meeting that all members have approved this specific election.

For single-member LLCs, you will need to provide the name(s) and owners’ Social Security number. The same will be applied for multi-member LLCs, but with an Employer ID Number instead of Social Security number. 

You can fill out an IRS Form 2553 in order to be taxed as an S corporation, also known as an election by a Small Business Corporation. To start a new tax classification for a year, you will need to file by March 15, which will be effective for the entire year. You must also include all necessary information about each shareholder: name and address, Social Security number, the date the owner’s tax year ends, shares that they owned, and a consent statement.

For any change to a corporation, you must note the following: when your election to corporate status goes into effect, the IRS will determine that any and all liabilities and assets from the previous business (whether it was a partnership or a sole proprietorship) will be added to the corporation in exchange for shares of the corporate stock.

By default, the IRS can tax a multi-member LLC as a partnership since LLCs don’t have a separate IRS tax category.

If you want to convert your LLC’s tax status from a partnership to a corporation while not changing the LLC’s legal form, you will only need to file an IRS Form 8832 (taxed as a C corporation) or an IRS Form 2553 (to be taxed as an S corporation). 

Note that once an LLC has elected to change its classification, it cannot elect again to change its classification for the 60 months after the election’s effective date. 

Any election for changing a partnership classification to a corporation shall be treated like the partnership provided all of its liabilities and assets to the corporation in exchange for stock. The partnership is then immediately liquidated by distributing the stock to its partners.

IRS Form 8832: Q&As

If you have any further questions about Form 8832 and if this is the best decision for your business, please feel free to contact us at Asena Advisor for a private consultation or check out the IRS’ entity classification election page, which will have a digital copy of the form. Click here to check the latter.

Speak with one of our consultants to learn more about how Entity Classification Election can help you.

Shaun Eastman

Peter Harper

Check-The-Box Regulations

Posted on by Peter Harper

Check-The-Box Regulations

Also known as the Regulations, the Check-The-Box regulations (CTB) is a classification process that allows an entity, if they so choose for U.S. tax purposes, to be recognized as a corporation or partnership. Entities that can be considered for CTB are those that have already been incorporated under federal or state law, associations, insurance companies, joint stock companies, state-owned entities, banks, publicly traded partnerships, and certain foreign entities.

When Did Check-The-Box Regulations Come Out?

The IRS declared in Notice 95-14 its intention to simplify the entity classification process. Final entity classification regulations under Internal Revenue Code 7701 and treasury regulations sections 301.7701-1 through 301.7701-3, also known as Check-the-Box or CTB regulations, went into effect on January 1, 1997, for all, whether they are domestic or foreign eligible entity. The regulations allow a qualified (or not automatically classified as a corporation) entity to be classified as a corporate (association) or a flow-through (partnership or an entity disregarded from its owner (DRE)) for U.S. income tax purposes if they wish so.

What Is A “Check-The-Box” Election (IRS Form 8832)?

A CTB election is an entity classification election for federal tax purposes made on Form 8832 – Entity Classification Election. The process can be relatively straightforward; you will need to select the appropriate box and the date that the election will become effective. 

What Is The Effect Of A Check The Box Election?

Regulations under a Check-The-Box election allow an eligible (i.e., not automatically classified as a corporation) entity to be classified as a corporation (association) or as a flow-through (a partnership or entity that is disregarded from its owner (DRE)) for U.S. federal tax purposes.

The CTB regulations permit U.S. investors to create limited liability partnerships (LLP) or companies to incorporate business entities in foreign countries, particularly civil law countries. That way, all members would enjoy limited liability, which would be treated as a corporation under foreign limited liability and could be treated as a partnership or disregarded entity under U.S. tax law. 

However, the entity cannot change its classification again for five years, with this limitation applying only to changes made by an election. Accordingly, a new eligible entity that elects from its default classification may change its classification by election at any time. 

The Benefits Of The US Check-The-Box Regulations

Now that we have defined what the CTB is, let’s go into more detail about the benefits that come with it:

Benefits Of Check-The-Box Regulations For Entities With Two Or More Members

In a domestic entity with two or more members, the default classification (if no CTB election is made) is that of a partnership. 

Some of the benefits of making a CTB election are:

    • A corporation, such as C Corporations, is considered a separate legal entity and continues in perpetuity. 
    • As a U.S. corporation, it can benefit from various Double Tax Treaties the U.S. has in force. 
Benefits Of Check-The-Box Regulations For Entities With One Member

The Default classification of a domestic entity with a single member is that it will be treated as a disregarded entity and, therefore, as a sole proprietorship. The same benefits will apply if an election is made to be taxed as a corporation.

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Considerations On Whether To Check-The-Box For Foreign Subsidiaries

Following the benefits of CTB, the following are factors to take into mind before making a final decision:

Deferral And Timing Of Income

Due to U.S. taxpayers being taxed on a worldwide basis, U.S. owners of a transparent foreign entity are not able to defer or time the amount of U.S. tax on their foreign income. U.S. tax is payable when the income is earned, regardless of whether they repatriate the cash. 

Making a CTB election for your foreign subsidiary to be classified as a corporation gives the U.S. shareholder more flexibility on whether and when they want to receive a dividend from the foreign subsidiary. U.S. tax is only payable once the cash is distributed to the U.S. owner. 

Rate Differential

Suppose you decide to treat a foreign eligible entity as transparent. In that case, the U.S. owner is considered to be earning the entity’s income directly and, therefore, taxable at the U.S. owner’s marginal rate, which could be as high as 37%.

If you make an election to treat the foreign subsidiary as a corporation and separate entity, the tax rate would be 21% in the U.S. 

There are various tax planning opportunities available.

Use Of Foreign Losses

A US taxpayer may prefer a transparent entity initially to realize the current tax savings that foreign losses can provide.

Foreign Tax Credit Regime

This regime prevents U.S. taxpayers from paying U.S. tax on income that a foreign jurisdiction already has taxed. 

U.S. citizens and domestic corporations may credit income taxes paid to foreign countries (subject to limitations). Generally, a U.S. person may only claim a credit for the foreign income tax if they paid. 

However, Section. 902 allows domestic corporations to claim a credit for taxes paid by underlying foreign corporations as if the U.S. taxpayer paid these taxes directly. U.S. shareholders will then claim this deemed-paid credit in the same year the undistributed income is taxed. 

Can An LLC Check-The-Box?

Yes, an LLC can apply CTB regulations. Limited Liability Companies have the advantage of the flexibility and limited liability for their owners. However, from a tax and accounting perspective, it will take on the complexity of the box it checks. An LLC can therefore make a CTB election.

New Check-The-Box Rules Simplify Entity Classification

The new regulations simplify entity classification. These new rules divide business entities into three groups:

  • Those automatically classified as corporations – such as insurance companies, banking organizations, state-owned companies, and specific listed organizations formed outside of the U.S.
  • Those that may elect to be classified as partnerships or corporations – include all other business entities with at least two members.
  • Those that may elect to be classified as corporations or be disregarded for tax purposes – entities that may elect to be classified as corporations or be disregarded, include all business entities not in the group automatically classified as corporations with only a single owner.

Classifying Business Entities Under The Check-The-Box Regulations

If you already have a business, whether an LLC or Corporation, here are some ways to determine if it falls under CTB regulations.

Determining If a Separate Entity Exists

U.S. Federal tax laws are applied to determine whether a separate entity (S.E.). Local law will not be the determining factor. 

If a business entity, for example, has more than a single member, and if participants were to carry on a trade, financial operation, business, or venture, followed by dividing the resulting profits, an S.E. is considered to exist (even if one is or isn’t considered to exist under an applicable state law). A mere expense-sharing collaboration or mere co-ownership of an asset, however, does not create an S.E.

Automatic Classification as Corporation

Below are the following entities that are automatically classified as corporations:

    • A business entity is arranged under federal or state statute (or under the statute of a federally recognized Indian tribe) if that said statute should describe or refer to the entity as incorporated or a corporation, body corporate, or body politic. 
    • An association as determined under Regs. Sec. 301.7701-3, where an unincorporated entity that elects to be taxed as a corporation.
    • A business entity is arranged under a state statute if that same statute describes or refers to the entity as a joint-stock association or company.
    • A business entity is taxable as an insurance company.
    • A state-chartered business entity that is conducting banking activities, if any of its deposits are insured under the Federal Deposit Insurance Act. It is also amended or a similar federal statute.
    • A business entity that is completely owned by a state or political subdivision. Also, a business entity is completely owned by a foreign government.
    • Any business entity that can be taxable as a corporation under a provision of the Code other than Sec. 7701(a)(3). For example, include a publicly traded partnership, real estate investment trust, tax-exempt entity, or regulated investment company.
    • A foreign entity designated explicitly as a corporation (see Regs. Sec. 301.7701-2(b)(8) for a list).
    • A business entity with multiple charters and is treated as a corporation in any one of the jurisdictions.
Classifying unincorporated domestic single-owner entities

A newly formed domestic single-owner entity that cannot be automatically classified as a corporation — including a single-member limited liability company or an LLP is, by default, classified as a disregarded.

Classifying unincorporated domestic multi-owner entities

A newly formed domestic entity that has two or more owners, which is an eligible entity, is classified by default rules as a partnership.

The IRS ruled in Rev. Rul. 2004-77 that if an eligible entity has two members under local law. Still, suppose one of the members is a disregarded entity owned by the other member. In that case, the eligible entity cannot be classified as a partnership and be taxed as a disregarded entity or also elect to be taxed as a corporation.

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Beware Of Tax Consequences Of Classification Changes

Taxpayers need to understand the tax treatment when an entity’s classification changes. If that entity changes its classification from a corporation to a partnership or a disregarded entity, the resulting tax consequence of that transaction will often be treated as a taxable liquidation.

Although it may be straightforward to file Form 8832 to change the classification of an entity, the tax exposure can be significant and immense.  

What Does It Mean When an LLC Checks The Box?

The IRS provides the following summary regarding the default rule:

  • A Limited Liability Company is an entity created by state statute.
  • Depending on elections made by Limited liability companies and the quantity of members, an LLC will be treated by the IRS as either a corporation, partnership, or a piece of the owner’s tax return (as a “disregarded entity”).
  • A domestic LLC that has, at minimum, two members is classified as a partnership for federal income tax purposes. That would apply unless the members decide to file Form 8832 and elects to be treated as a corporation.
  • For income tax purposes, limited liability companies that have a singular member will be treated as an entity that isn’t separate from its owner unless it files Form 8832 and affirmatively elects to be treated as a corporation. However, an LLC that only has a singular member is still considered a separate entity for employment tax and certain excise taxes.
For any more information on Check-The-Box regulations, contact Asena Advisors.

 

Shaun Eastman

Peter Harper

How to Avoid the Net Investment Income Tax

Posted on by Peter Harper

How to Avoid the Net Investment Income Tax

Ever since the net investment income tax, or NIIT, was introduced by the IRS, taxpayers have tried to understand this tax and at the same time try to avoid it. What follows is an introduction of what this tax entails, how it is triggered, the types of income that are and are not included, how to calculate it and, strategies for how to avoid or minimize it. 

What Is The Net Investment Income Tax?

This is a tax that is not widely understood by many people, but is a very important concept to learn about, especially if a large part of one’s income is derived from investments. 

Simply put, the NIIT is a 3.8 percent tax that is applied on certain investment income. For the purposes of calculating net investment income (NII), the IRS looks at income derived from investments (before any applicable taxes are applied) such as bonds, stocks, mutual funds, annuities, and loans (minus properly allocable expenses). 

The other way to think about this tax is that it is a surtax imposed on certain unearned income. The tax equals 3.8 percent of the lesser of the taxpayer’s NIIT, or the excess of the taxpayer’s modified gross income (MAGI) over a certain threshold (discussed later in this article). 

The tax applies to estates, trusts, families and individuals. However, certain income thresholds need to be met before the tax takes effect. 

When Did The Net Investment Income Tax Take Effect?

As is the case with all taxes, the main purpose for including NIIT as part of the Health Care and Education Reconciliation Act, was to raise revenue. In this case, this surtax was used to help pay for the Affordable Care Act. The official name of this tax is actually “Unearned Income Medicare Contribution Tax,” which would logically imply that it is used to fund Medicare. However, this is not the case. The surtax is effective for tax years beginning after December 31, 2012.

What Triggers Net Investment Income Tax?

In the case of individual taxpayers, section 1411(a)(1) of the tax code imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to a tax rate of 3.8 percent of the lesser of the individual’s NII for that tax year, or the excess (if any) of the individual’s MAGI for that tax year, over the threshold amount. We will discuss the calculations behind this tax, later in this article.

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What Counts As Net Investment Income?

Net Investment Income Includes:

For the purposes of calculating this tax, net investment income includes short and long-term capital gains (as well as gains from the sale of investment real estate, and gains from the sale of interests in partnerships and S corporations to the extent the partner or shareholder was a passive owner), taxable interest income, rental and royalty income, qualified and non-qualified dividends, passive income from investments, business income from trading financial instruments or commodities, and taxable portion of non-qualified annuity payments (for example, Roth IRAs). 

It Doesn’t Include:

In general, NII does not include wages, unemployment income, operating business income from a non-passive activity, Social Security Benefits, alimony, tax-exempt interest, self-employment income, municipal bonds, Alaska Permanent Fund Dividends and distributions from certain qualified plans (those described in sections 401(a), 403(a), 403(b), 408, 408A or 457(b) of the tax code), such as qualified annuities.

What Is Exempt From NIIT?

The NIIT does not apply to any portion of a gain that is excluded from regular income tax. Therefore, gains from sale of a principal residence are excluded from the NIIT unless the gain exceeds the principal residence exclusion amount of $250,000 (for a single filer) or $500,000 (if filing jointly with your spouse).

In addition, non-resident aliens (NRAs), who are individuals that are neither U.S. citizens nor U.S. residents, are not subject to this tax. The U.S. Treasury regulations state that in the case of a U.S. citizen or resident who is married to a non-resident alien individual, the spouses will be treated as married filing separately for purposes of section 1411. The U.S. citizen or resident spouse will be subject to the threshold amount for a married taxpayer filing a separate return, and the non-resident alien spouse will not be subject to the NIIT.

Who’s Subject To The Net Investment Income Tax?

All individuals who file tax returns, except NRAs, are subject to NIIT if they have NII and MAGI over the aforementioned taxable income thresholds. 

Trusts and estates that have undistributed NII and an AGI greater than the highest tax bracket applicable will be subject to this tax. 

Is Your MAGI Greater Than The Threshold?

For the purposes of meeting the threshold to be subject to this tax, the MAGI amounts are:

  • Married filing jointly — $250,000
  • Married filing separately — $125,000
  • Single or head of household — $200,000 or
  • Qualifying widow(er) with a child — $250,000

How To Calculate The NIIT?

The tax itself is computed on Form 8960 of one’s U.S. tax return. Individual filers report and pay the tax on Form 1040, while trusts and estates report and pay this tax on Form 1041. 

For purposes of calculating NII, modified adjusted gross income is a household’s AGI, with certain deductions and tax-exempt interest payments, such as contributions from individual retirement accounts (IRAs), included again. The relevant deductions for purposes of AGI are listed on Schedules 1, 2, and 3 of Form 1040. If your MAGI is higher than the thresholds for your filing status, you will need to pay NIIT.

The next step is to calculate your NII based on the included income stated above. Before you can calculate your NII, however, you first need to ascertain what your gross investment income is. This is the amount prior to considering any eligible deductions (which are discussed later in this article). 

Once you arrive at the gross investment income, it will be reduced by deductions allowed against the income tax which are properly allocable to those items of gross income or net gain to arrive at the NII. 

Finally, the amount that will be subject to NIIT at a rate of 3.8 percent will therefore vary as follows: 

  • If your NII is higher than the amount by which MAGI surpasses the threshold, the tax applies to your MAGI
  • If your NII is lower than the amount by which MAGI surpasses the threshold, the tax applies to your NII

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Will I Have To Pay Both The 3.8% Net Investment Income Tax And The Additional .9% Medicare Tax?

You may be subject to both taxes, but not on the same type of income, as these two taxes apply to different types of income. The 0.9 percent additional Medicare tax applies to individuals’ wages, compensation, and self-employment income over certain thresholds, but it does not apply to income items included in NII.

Can Tax Credits Reduce My NIIT Liability?

Indeed, any tax credit that is allowed to offset a tax liability imposed by subtitle A of the tax code may be used to offset the NII. However, if the tax credit is only allowed to be offset against tax imposed by Chapter 1 of the tax code, such as regular income tax, that credit may not reduce the NIIT. For instance, foreign tax credits may not be used to reduce NIIT exposure in the U.S., as they are only allowed to offset a tax liability on regular income tax. Further, foreign tax credits are only allowed against taxes imposed by IRC Chapter 1. 

Strategies To Avoid Or Reduce The Tax

There are various strategies and planning opportunities to either reduce your NII or reduce your MAGI, which will result in reduced taxable income. No blanket strategy or planning tool exists, and due to the complex nature of the NIIT, it is advisable to consult professionals such as your tax advisor or CPA on possible mitigation. The IRS will not be lenient if these regulations are willfully avoided. This is why it is so important to get advice from a tax advisor who has experience dealing with these sorts of matters.

Tips For Managing Your Investments

As stated previously, no blanket strategy or planning tool exists, due to the complex nature of this tax. However, if you do have investment income and if you think you will be subject to this tax, there may be deductions available for you to take advantage of.

Some examples of deductions which may be properly allocable to gross investment income include brokerage fees, investment advisory fees, tax preparation fees, fiduciary expenses (which only apply to estates and trusts), interest expense, investment advisory fees, expenses incurred in relation to royalty and rental income, and state and local income taxes. 

If the deductions are not properly allocable to gross investment income, then they will not be allowed. For instance, brokerage fees that are not properly allocable will not be allowed as a deduction. The instructions to Form 8960 provide examples of deductions that are not deductible for NII purposes; for example, deductions for contributions to IRAs or other qualified plans. 

Additionally, special rules apply for traders of financial instruments and commodities regarding the deduction of expenses in relation to self-employment income.

 

If you have further questions or want to begin the process, reach out to one of our Asena consultants.

Arin Vahanian

Peter Harper

US-AU DTA: Article 18 – Pensions, Annuities, Alimony and Child Support

Posted on by Peter Harper

Background

The background of this week’s blog is a bit different from the previous ones due to the unique nature of the topic. This week we will be looking at Article 18 of the DTA – Pensions, Annuities, Alimony, and Child Support, which affects a much broader demographic than other articles. The background focuses more on the global economy and financial markets, but there is a reason for this.

Most people start saving for their retirement when they earn their first salary. Contributions are made monthly (either by yourself or on your behalf) towards a Pension Fund (IRA, 401k, super, etc.) and are invested in various classes of assets. We diversify investments to reduce risk and maximize continuous growth, and it gives people a sense of comfort and security to invest in their future via a Pension Fund. 

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In recent months, the world has contended with the emergence of the Omicron variant, central bank policy tightening, and persistent inflation. And most recently, Russia’s invasion of Ukraine has ignited a geopolitical crisis that is shaking global financial markets to their core.

As tensions continue to mount in Eastern Europe, the concern about what is to come has led to some people impulsively cashing out their retirement portfolios or reviewing them. 

I’ve always been a great admirer of Warren Buffet and his quotes on investments. 

So just to lay the foundation for this week’s blog, I thought I would share two relevant quotes about the current economic climate.

“The most important quality for an investor is temperament, not intellect.” 

“Uncertainty actually is the friend of the buyer of long-term values.”

Humans are, by nature, irrational beings and are often tempted to make trades when they think the market is working against them, whereas in contrast, it is the well-tempered investor that learns not to watch the market. This person ultimately ends up reaping the most rewards over the long term. 

Their investment philosophy is that you don’t need to have an extremely high I.Q. to build more wealth, but rather that you should be more disciplined with your reaction toward the market’s irrationality. 

Now to link the background with the rest of the blog to follow, if you are a U.S. resident with an Australian pension or vice versa, prior to considering whether to cash out your pension or not, make sure you take a step back and instead make sure you understand the potential adverse tax implications of having an international pension fund. 

Introduction

The purpose of the Australian treaty is to prevent double taxation and fiscal evasion.

Because the U.S. does not tax contributions or accumulated earnings, and Australia does not tax the distribution of benefits, a U.S. resident could perceivably relocate from the U.S. to Australia and never pay income tax on contributions, accumulated earnings, or the payment of pension benefits that accrued while the employee worked in the U.S. To prevent this issue, the two countries formed a double taxation agreement.

Interpreting Article 18 of The DTA – Pensions, Annuities, Alimony, and Child Support

Article 18 addresses the taxation of cross-border pensions and annuities. Subject to Article 19, pensions and other similar remuneration paid to an individual who is a resident of one Contracting State in connection with past employment shall be taxable only in that State. 

Article 18(4) 

defines the term’ pensions and other similar remuneration, as used in this Article, to mean ‘periodic payments made by reason of retirement or death, in consideration for services rendered, or by way of compensation paid after retirement for injuries received in connection with past employment.’ 

Article 18(5) 

defines the term ‘annuities,’ as used in this Article, to mean ‘stated sums paid periodically at stated times during life, or during a specified or ascertainable number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered or to be rendered).’ 

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Article 18 is critical to any U.S. person who is a beneficiary of an Australian Superannuation Fund for the following reasons:

  • The U.S. has taxing authority over vested Australian superannuation benefits pursuant to Article 18 of the DTA; and
  • In the absence of a specific Article dealing with contributions and the annual income derived by pension schemes (as exist in the U.K. treaty), the U.S. retains the right under Article 1 of the DTA to tax contributions and accumulated earnings under its domestic tax laws.

In terms of the IRC, most foreign retirement plans are not considered “qualified plans” under Section 401(a), which means the plans generally do not qualify for tax-deferral treatment. 

For a pension plan to be tax-exempt, the plan must satisfy the requirements contained in § 401 Internal Revenue Code 1986 (IRC). Section 401(a) IRC specifically provides that, for a pension plan to be a “qualified plan” (and therefore exempt from tax under § 501 IRC), it must be organized in the U.S. Accordingly, this means that no Australian superannuation plan (whether retail or self-managed) can be a “qualified plan.” (Read our Whitepaper on Taxation of Foreign Pensions for more details)

There are essentially three phases of U.S. tax treatment that need to be looked at when dealing with the taxation of an Australian superannuation plan. I will provide a brief summary of the three phases for this blog, but please review our Whitepaper for more information.

Phase 1 – Contributions 

Suppose contributions are made to an Australian superannuation fund after an Australian citizen becomes a U.S. person (or a U.S. citizen becomes an Australian resident). In that case, the contributions will be taxable in the U.S. under § 402(b)(1) IRC. 

Phase 2 – Earnings Derived Within A Superannuation Plan After An Australian Citizen Becomes A U.S. Person

Subchapter J contains the general rules concerning estates, trusts, beneficiaries and decedents, specifically the grantor trust rules. While it is critical that an individual assessment of the circumstances of every taxpayer be undertaken, most superannuation plans (or portions thereof) in Australia could be classified as grantor trusts for U.S. tax purposes. 

Phase 3 – Distribution of benefits 

In our opinion, there are two possible ways in which accrued Australian superannuation benefits (contributions and earnings) may be taxed in the U.S.

The first is that Australian superannuation benefits of a U.S. person will be taxable upon such a person attaining 60 years of age (the Australian retirement age). The taxpayer will first be liable for tax in Australia, but receive foreign tax credits in the U.S. (creditable only against U.S. federal income tax) for the Australian tax paid (which will be nil if the account is in the benefits phase). In the event of any shortfall, they will pay further federal, state, and city income tax (where applicable).

The second view (the alternate view) concerns highly compensated employees (HCE) and the application of § 402(b)(4) IRC. If an employee is a highly compensated U.S. person who is also a member of a foreign pension plan (i.e., an Australian superannuation plan), technically, on a literal reading of § 410(b)(3)(C) IRC, there is a high likelihood that the foreign pension plan will fail the minimum coverage tests because contributions made in favor of non-resident aliens with no US-source income are not included for the purposes of determining whether the coverage tests have been satisfied.

Conclusion

Both Australia and the U.S. recognize the need for their citizens to be able to self-fund their retirement and the importance of having a globally mobile workforce. This is evident when looking at the concessional tax treatment for individuals who maximize superannuation and pension contributions, and the current impact government-supported pension plans have on federal and state budgets.

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The inadequacies in the DTA arise because it approaches Australian superannuation and U.S. pensions as though they are only taxed at one point, which is on distribution.

Unfortunately, unless Article 18 is amended, the adverse tax implications of U.S. migration on a taxpayer’s superannuation benefits may become a determining factor in whether an executive migrates between Australia and the U.S.

So, the current global economic turmoil might be the perfect opportunity to focus on reviewing the tax exposure of your pension fund instead of considering cashing it out.

 

Our team of International Tax specialists at Asena Advisors will be able to assist you with these complex tax rules that could apply to your pension fund. In times of adversity, you need proper guidance to your specific needs, and our Multi-Family Office will help you find opportunities in uncertain times. 

Shaun Eastman

Peter Harper

US-AU DTA: Article 17 – Entertainers

Posted on by Peter Harper


INTRODUCTION

In this week’s blog we will be discussing Article 17 of the US/Australia DTA which relates to entertainers and how they are taxed from an international perspective. 

In general, Article 17, provides that if a resident of one country derives income in the other country as an entertainer or sports person, some of the income earned may be protected from tax in that other country, but usually not to the same degree as other individuals who are not entertainers or sports person.

What distinguishes entertainers and sportspersons from other individuals who receive income from employment is that by the nature of their work, some entertainers and sportspersons may have the opportunity to earn a large amount of income in a very short period of time.

INTERPRETING ARTICLE 17 OF THE DTA – ENTERTAINERS

Article 17 states that income derived by visiting entertainers and sportspersons from their personal activities as such will be taxed in the country in which the activities are exercised, irrespective of the duration of the visit. 

However, where the gross receipts derived by the entertainer from those activities, including expenses reimbursed to the entertainer or borne on the entertainer’s behalf, do not exceed $10,000 or its equivalent in Australian dollars in the year of income, the income will be subject to tax in accordance with Article 14 or Article 15, which deals with independent or dependent personal services, as the case may be.

It should be noted that income derived by producers, directors, technicians and others who are not artists or athletes is taxable in accordance with Article 14 or 15, accordingly. The commentary to the OECD Model Convention indicates that the word “entertainer” extends to activities which involve a political, social, religious or charitable nature, provided entertainment is present. 

It does however not extend to a visiting conference speaker or to administrative or support staff. The commentary acknowledges that there may be some uncertainty about whether some persons are entertainers or not, in which case it will be necessary to consider the person’s overall activities.

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Article 17(2) is a safeguarding provision to ensure that income in respect of personal activities exercised by an entertainer, whether received by the entertainer or by another person, is taxed in the country in which the entertainer performs. This is irrespective of whether or not that other person has a “permanent establishment” or “fixed base” in that country. 

If it is however established that neither the entertainer nor any person related to him/her participates in any profits of that other person in any manner, the relevant income accruing to that other person shall be taxed in accordance with the provisions of Article 7, 14 or 15, dealing respectively with business profits and income from independent or dependent services, as the case may be.

A legislative instrument has removed the PAYG withholding requirement in relation to entertainers and sportspersons who are US residents when working in Australia. This only applies where the payments relate to entertainment or sports activities carried on in Australia and where the combined payments do not exceed $10,000 or its equivalent in Australian dollars in the year of income.. 

This legislative instrument applies from 3 April 2014 until 1 October 2024.

A US entertainer who fulfils the contractual obligations of a US employer by performing in Australia, for a salary paid by the employer, is considered to derive “income from personal activities”, within Article 17 of the US/Aus DTA. This is irrespective of the fact whether or not the entertainer is at arm’s length from the US employer. Where the entertainer is paid an annual salary, an apportionment will be necessary to determine the amount applicable to the period of time spent in Australia.

Where the contract for the personal services of a US entertainer in Australia is made between a US resident and an Australian resident, and Article 17(2) of the DTA applies, both the US resident and the entertainer may be taxable in Australia. 

The US resident will be liable to tax under Article 17(2) on the taxable income derived by it, and the entertainer may be taxed under Article 17(1) on remuneration derived from the US resident in respect of the personal activities in Australia.

CONCLUSION 

For any person interested in tax planning, Article 17 could be a good motivator to start exercising to ensure this Article applies to you. However, that is easier said than done. 

Our team of International Tax specialists at Asena Advisors, will be able to assist you with your international tax planning needs to ensure that Article 17 is adhered to by entertainers. Lastly, we will never say no to an autograph.

Our team of International Tax specialists at Asena Advisors, will be able to assist you with submitting the relevant forms in the US and Australia to get access to these relief measures.  

Shaun Eastman

Peter Harper