Written by: Peter Harper and Janpriya Rooprai
Illustrations by: Janpriya Rooprai
Peter heads CST Tax Advisors in North America and a member of the global executive of CST International. Janpriya is the head of the US-India practice and US Operations Head with CST Tax Advisors.They can be reached directly at email@example.com and firstname.lastname@example.org.
Tax Reforms brought in by the Trump administration has introduced sweeping tax reforms for individuals, corporates and pass-through entities.The impact of the US Tax Reforms on individuals has been described as “turbocharge inequality in America” and making the US “more and more like a rentier society.”1 The tax policy changes for foreign corporate entities is also supportive of this position. With certain key amendments having retroactive effect, the policy makers have undeniably rung the bell on foreign corporations leaving foreign businesses and multinational corporations with no time to consider the impact of the reforms and make sound tax planning decisions to address the changes.
In a quest to understand the consequences that the Tax Reforms will have on the international business landscape, in this article we will focus our analysis on two key questions: what do the Tax Reforms mean for foreign corporations planning to enter US markets, and what is in store for existing corporate entities?
Initial analysis that we have undertaken for our clients has shown that the Tax Reforms can result in burdensome and costly compliance requirements even in situations where no further tax may be due. Careful and diligent planning should be undertaken with respect to the Tax Reforms when addressing international tax planning for foreign business owners and investors to avoid unintended and costly results. Foreign investors who are in the process of exploring US markets should be vigilant of the possible tax exposures that can impact their global business.
Concepts underpinning the Tax Reforms
In order to understand the intentions and impact of the Tax Reforms it is perhaps best to first define the underpinning concepts and how they have changed.
Controlled foreign corporation (CFC)2 : A CFC is a foreign corporation with US shareholders owning more than 50% of the stock value or voting power.
The definition of CFC has been expanded via the concept of constructive ownership so that a US person who owns 10% or more of the total combined stock value or voting either directly, indirectly or constructively of all classes of stock of a foreign corporation can be a CFC. This is because foreign subsidiaries of a foreign parent can be considered to be constructively owned by a US subsidiary.
Subpart F income3 :The earnings of a foreign corporation are not taxed in the US until dividends are paid from the foreign corporation to US shareholders. Where the foreign corporation is a CFC for US purposes, Subpart F provides an exception to this “deferral” of tax by attributing certain income of the foreign company to the US shareholders.
Generally, Subpart F income consists of categories of “passive” income such as interest, rent, dividends, royalties etc.
Although the Tax Reforms have not directly changed the definition of Subpart F income, by broadening the scope of who is considered a US shareholder and therefore subject to attribution under the CFC rules and expanding the definition of CFC to include certain foreign corporations, more US taxpayers and foreign corporations will therefore be subject to Subpart F.
Global Intangible Low Tax Income (GILTI)4 : GILTI is defined as a CFC’s income that exceeds 10% of qualified business asset investment excluding intangible assets. GILTI is computed by a CFC’s net tested income (NTI) that exceeds 10% of qualified business asset investment (QBAI). GILTI is computed in the same manner as subpart F income.The formulae of GILTI unlike its name does not include the intangibles owned by business.The tested income of a CFC generally includes CFC’s income not included as subpart F income.
Foreign Derived Intangible Income (FDII)5 : FDII is the portion of intangible income determined on a formulaic basis that is derived from a CFC. This is indeed the intangible component in GILTI which is excluded from its computational provisions.
Dividend Received Deduction (DRD)6 : DRD is a deduction for dividends received from foreign corporations(and other specified 10% owned foreign corporations) after December 31, 2017.
With the introduction of the DRD allowing US corporate shareholders of foreign business to deduct dividends received, Base Erosion and Anti-Abuse Tax7 (BEAT) was introduced to deter US corporations from eroding the US tax base by paying tax-deductible expenses to foreign affiliates then distributing profits tax-free. BEAT is essentially a form of “alternative minimum tax” and applies to US companies with annual average gross receipts of US$500 million for the past 3 years and with a base erosion percentage of 3%.
Key changes of the Tax Reforms
President Trump in a tax reform rally on December 5, 2017 said, “our tax plan is anti-offshoring and 100 percent worker…100 percent pro-America.” But with an economy that fosters large volumes of international trade and encourages business to come to the US, the Tax Reforms appears to be an expensive vaccine shot that is unlikely to encourage a pro-America approach.
Expanded scope of enterprises classified as CFC
Prior to the Tax Reforms, a US shareholder of a CFC was defined as a US person owning at least 10% of a foreign corporation’s voting stock. This definition has expanded its scope to include a US person owning at least 10% in voting stock or value of a foreign corporation.
The expanded scope not only broadens the net for who is considered a US shareholder of a CFC but also checks foreign entities that may be considered CFCs for US tax purposes with the inclusion of indirect ownership. This is an important change in which those with multinational structures should err with caution and carefully manage.
For a foreign corporation to be a CFC,its US owners may be direct, indirect or constructive owners. A direct or indirect ownership is simple flow of ownership from top to bottom as exhibited below:
The laws that determine constructive ownership of a CFC by a US shareholder of a foreign corporation twirls like a snake (refer paragraph above) and creates ownership where there is no direct or indirect flow of ownership. A constructive ownerwith no US shareholder is exhibited below:
This constructive ownership rules of a foreign subsidiary have been extended.8 Prior to the Tax Reform, the provisions specifically excluded a foreign subsidiary held by a foreign holding corporation from being considered a CFC. The expanded definition now includes hybrid indirect ownership. Per the diagram above, we have a situation where a foreign parent company (For Co) has a foreign subsidiary company (For Sub) and a US subsidiarycompany (US Sub).Under the expanded definition, For Sub is now considered a CFC of US Sub with applicationbeginning January 1, 2018.
The retroactive application of these changes highlights the draconian nature of the rules that apply tocompanies and corporate groups for which these rules will apply.
In effect, the number of entities in a structure designated as a CFC will increase considerably. As will the quantum of income that may be included in the US shareholder’s income. It is however, important to note constructive rules of ownership are limited to the determination of a CFC and that attribution of income to a US shareholder requires ownership in CFC.
This is seen in the above diagram. The For Sub is a CFC because it is constructively owned by the US Sub and 10% of its GILTI or subpart F income will be attributable to the shareholder who is a US shareholder.
As well as potentially increasing the Subpart F income attributable to US shareholders, the Tax Reform increases reporting compliance requirements for direct, indirect or constructive shareholders of a CFC, even if no income is included on a US shareholder’s tax return. A US shareholder of a CFC is required to report9 its Subpart F inclusions and certain information concerning CFCs. The Tax Reforms further requires a US person who is an officer or director of a foreign corporation in which a US person owns more than 10% of the total combined voting power of all classes of stock of such corporation entitled to vote or total value of stock of such corporation to comply with reporting requirements on form 5471.
It is important to analyze the application for CFC rules now as the foreign corporation is not given 30 days at the end of the year to determine how it should be classified. Now the CFC rules apply to foreign corporation if its owned either directly, indirectly or constructively “on any day during the taxable year” of such foreign corporation.10
Transition tax and moving to territorial regime for corporations
Prior to the Tax Reforms being introduced, US based multinational enterprises could be taxed only on profits distributed from their foreign subsidiaries. Post these reforms, foreign corporations repatriating dividends to US parent companies are exempt from US corporate tax on profits derived after 1986.
As part of the transactional measures from the old rules to the new rules, a territorial tax system to cover undistributed profits including cash and earnings of a deferred foreign income corporation (DFIC) to be taxable to a US shareholder.11 DFIC is either a CFC or a foreign corporation that has a US corporation (thus is not a passive foreign investment company) as a US shareholder.12 Foreign earnings of a DFIC held in the form of cash and cash equivalents are taxed at 15.5%, and the remaining earnings are taxed at 8%, which may be paid in installments over the prescribed period.13 A US shareholder of DFIC includesits pro-rata share of the income in sub-part F income for the DFIC’s last taxable year beginning before January 1, 2018.14
Interplay between Sub-part F Income and GILTI
Sub-part F income generally includes foreign base company and insurance income. GILTI is an additional tax for US shareholders on CFC’s income and included in the same manner as subpart F income.
Unlike an individual or flow-through entity who is a shareholder of a CFC, a corporate shareholder can claim a deduction of 50% of GILTI and 37.5% of FDII.15 A 50% deduction results in reducing the effective tax rate to 10.5%. A 37.5% deduction for FDII for deemed intangible deduction reduces the effective tax rate to 13.125%. The effective tax rates may reduce further for US corporate shareholders who can claim foreign tax credits in addition to the deductions.
The computational provisions of GILTI exclude prescribed percentages of specified tangible property. In a way it excludes tangible assets of a CFC which seems unnecessary. It supports the Trump administration’s story that this is a tax on foreign owned intellectual property.
As a general rule, GILTI taxes any low tax income that is not caught under subpart F income. For example, subpart F income excluding profits which are taxed in a foreign country not classified within the definition of subpart F income and taxed at a rate greater than 90% of the maximum US corporate tax rate, they are included in GILTI basket.16 This means that any foreign income is effectively taxed to US corporate shareholders at a minimum rate of 10.5% and taxed at rates as high as 37% which is attributed to US individual shareholders.
The engaging discussion for foreign founders here is to evaluate how they continue to own foreign corporations and what form of entity they should consider for doing business in the US.With a temporary reduction of personal tax rates from 39.6% to 37%and a deduction of up to 20% for income derived by individuals directly or through flow through entities, individuals entering US with no foreign business interests may find the tax reform alluring. But individuals owning foreign corporations and coming to the US have to be watchful of the applicability of subpart F and GILTI.
As the OECD/G-20 lead Base Erosion Profit Shifting (BEPS) initiative is gaining more traction worldwide and strongly supported with participation from both developed and developing countries like Australia and India, the USis making its domestic tax reporting system more robust with additional reporting compliances of a CFC. The scope of reporting requirements for direct, indirect and constructive US shareholder and inclusive list of anti-avoidance conditions is vicarious to the idea of doing business for global entrepreneurs.
The Tax Reforms are promoted as atransition from worldwide taxation to territorial taxation system for domestic corporations. These reforms are effectively capturing the income of foreign corporations classified as CFCs under different baskets, namely GILTI and transition tax in addition to what was already included as Subpart F income. For large US and foreign corporations, BEAT adds to an already burdensome tax cost for doing business in the US. With this approach, scrutinizing foreign corporations under downward attribution CFC rules will be dissuading US subsidiaries in foreign business structures.
It is therefore imperative for foreign founders moving to the US and becoming US residents to be cautious of their move if they hold interests in foreign businesses. There may be additional costs that their move can place on the business as there is no set off against the income attributable under CFC rules – no deduction and no foreign tax credit. This calls for foreign founders to reexamine their existing structures and undertake diligent planning before entering the US market as the Tax Reforms may result inadditional tax and reporting for a US shareholder.The Tax Reforms in my opinion are likely designed to affect the US business adversely rather than positively.
8 Repealed section 958(b)(4)
10 Section 957
16Section 954 read with section 951A(c)(2)(III)