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The Federal Anti-Deferral Rules For Foreign Income

Table of Contents

    When U.S. companies do business abroad, they often create foreign subsidiary corporations to conduct their affairs in foreign countries. Under pre 2017 tax law, a significant tax advantage of using a foreign corporation to conduct foreign operations was income tax deferral. Under prior tax law, U.S. tax on the income of a foreign corporation was generally deferred until the income was distributed as a dividend or otherwise repatriated by the foreign corporation to its U.S. shareholders. This is known as tax deferral. Currently however, under changes made by the Trump Administration, tax deferral is ordinarily overridden by provisions accelerating the imposition of U.S. tax on U.S. shareholders of foreign corporations. As a result, income is often taxed before a dividend is distributed. Our experienced International Tax Attorneys and CPAs at the Tax Law Offices of David W. Klasing understand the two major anti-deferral regimes in the U.S. and can help advise our clients about whether their cumulative prior tax deferrals related to their foreign holdings was overridden by Trump’s changes and what deferred profits therefore need to be repatriated, and what to do if they failed to do so back in 2018 if you were required to do so.

    Subpart F Provisions

    The “Subpart F” provisions of the U.S Tax Code serve to prevent deferral of taxation on some categories of foreign income. They do this primarily by taxing certain U.S. persons on their pro-rata share of such income earned by a qualifying controlled foreign corporation (CFC). In order to qualify as a CFC, stock representing more than 50% of either the total combined voting power or the total value of shares of the foreign corporation must be owned, directly, indirectly, or by attribution, by “U.S. shareholders” on any day during the foreign corporation’s taxable year. A “U.S. shareholder” is, in turn, defined as any person, corporation, partnership, estate, or trust holding stock representing 10% or more of the total voting power of all classes of the foreign corporation’s stock that is entitled to vote.

    Broadly speaking, any “Subpart F income” earned by a CFC that is not distributed or otherwise taxed for the tax year in which it was earned is considered constructively repatriated. As such, U.S. persons must report the pro-rata share of any such income as part of their gross income on their yearly returns, meaning it will be subject to U.S. taxes. “Subpart F income” is generally movable income with little or no economic relation to the CFC’s country of incorporation. However, the definition of what does and does not count as “Subpart F income” is very complicated and contains many narrow exceptions and other confusing issues. If you have investments in foreign companies, you should always speak with a skilled tax lawyer and CPA like those at the Law Offices of David W. Klasing before filing your returns so we can take a close look and help you understand what does and does not qualify as Subpart F income that needs to be included in your gross income total.

    Passive Foreign Investment Companies

    In addition to CFCs, passive foreign investment companies (PFICs) are also subject to a sort of anti-tax deferral scheme. Unlike the rules in Subpart F, these rules apply to all U.S. investors in a PFIC, not just those with a certain amount of ownership stake. Again speaking in the broadest sense, a PFIC is a foreign corporation that has, during the tax year, at least 75% passive income, meeting what is known as the “income test,” or an average percentage of assets that produce passive income of at least 50%, meeting what is known as the “asset test.” If a foreign company meets the standards of either of these tests, its U.S. shareholders become subject to the anti-deferral rules of the PFIC regime.

    Like with CFCs and Subpart F income, what does and does not qualify as “passive income” for the purposes of this section is a very fact and situation-intensive calculation that should not be done without the help of an experienced tax attorney and CPA like those at the Tax Law Offices of David W. Klasing. For example, while most foreign investment companies will qualify, only certain personal services firms will. In some cases, the tax and interest imposed under these rules may exceed the amount of the distribution. In such an instance, we may encourage you to forego deferral voluntarily and to include the income as if the PFIC were tax transparent.

    Transition Repatriation Tax

    Under the 2017 Tax Cuts and Job’s Act, (TCJA) the U.S. now generally exempts earnings from active business carried out through foreign subsidiaries even if the profits are repatriated via a new 100% dividends received deduction. To prevent a windfall profit to U.S Corporations with foreign subsidiaries any accumulated but unrepatriated offshore earnings are taxed as if the offshore earnings were repatriated but at preferred tax rates.   Generally starting in 2018, foreign unrepatriated earnings held in cash and cash equivalents were taxed at 15.5% and those not held in cash or cash equivalents were taxed at 8%. The TCJA permitted this tax to be paid in installments over eight tax years.

    Global Intangible Low Taxed Income (GILTI) regime

    Starting in 2018, the GILTI tax regime now applies to income earned by foreign affiliates of U.S. companies from intangible assets like patents, trademarks and copyrights. To prevent the shifting of profits from these types of assets to foreign subsidiaries in low tax offshore jurisdictions because of the new 100% dividends received deduction, a 10.5% minimum tax on GILTI assets was added under the TCJA.  U.S. businesses are required to include GILTI minimum tax in income annually. GILTI is calculated as the total active income earned by a U.S. companies foreign affiliates that exceeds 10% of the firm’s depreciable property.  A U.S. Corporations can generally deduct 50% of the GILTI and claim a foreign tax credit for 80% of the foreign taxes paid on GILTI assets.  If the foreign tax rate is zero, the effective tax rate on GILTI will be 10.5% or ½ of the 21% corporate rate because of the 50% deduction.   If the foreign tax rate is 13.125% or higher there will be no U.S. tax after the 80% credit for foreign taxes.

    If You Are Concerned Your 2018 & 2019 Tax Returns May be Misstated Because of a Misunderstanding of the new Federal Anti-Deferral Rules, Contact Our Experienced International Tax Attorneys and CPAs Today

    Many of the tax deferral benefits of creating foreign subsidiary corporations to do business have been reduced or eliminated under the TCJA if the company and its shareholders are subject to one of the above anti-deferral tax regimes. Whenever you are thinking of investing in or creating a foreign subsidiary company, you should first consult with an experienced dual licensed International Tax Attorney and CPA like those at the Tax Law Offices of David W. Klasing. We can help you understand whether the anti-deferral rules are likely to apply to your situation and whether this may mean the investment is not worth it.

    More Questions and Answers About International Tax

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