Private Clients - 12 Mar 2018
Much has been written of the headline grabbing reduction in the US corporate tax rate from a previous high of 35% to a more globally competitive 21%. In addition, at the corporate level at least, the US is moving to what they are considering, a ‘territorial’ system of taxation, with the introduction of a dividend received deduction.
What has made fewer headlines is that, in making this transition to a ‘territorial’ tax system, the provisions put in place for US parent corporations also equally impact US individual shareholders. Individual shareholders continue to be exposed to tax on worldwide income and gains. In addition, the rules applying with respect to the ‘repatriation’ of offshore funds held in non-US corporations apply equally to individual shareholders and not just US corporates. Individuals are also exposed to new and ongoing anti-avoidance rules designed to ensure income derived from intangible property is subject to a minimum level of tax. The legislation is far-reaching and results in some very unexpected consequences for individuals with a 10% or greater interest in a non-US company.
In this area, tax reform has most certainly not simplified matters - which apparently was one of the main goals of the administration. The controlled foreign company rules were already quite complex and have now become even more so.
The changes can be broadly split into 2 categories: the ‘transition’ into the new rules and the ‘new rules’ themselves. There have also been some related technical changes that will impact US shareholders. The following covers each of these at a high level:
1. THE ‘TRANSITION’ – 2017 OR 2018
In moving to what is being termed a ‘territorial’ system, there is a need to manage the US tax treatment of previously untaxed retained earnings and profits that are held in Specified Foreign Corporations (SFCs).
An SFC includes all Controlled Foreign Corporations (CFCs) – i.e. foreign companies controlled by US shareholders and any foreign corporation where a US corporation is a US shareholder; a ‘US shareholder’ being a US person with a 10% or greater voting interest.
A US shareholder of an SFC will become subject to a potential inclusion of income in the ‘transition’ year. This will be either 2017 or 2018 depending on the year end of the company. The amount that will be subject to US tax in the appropriate year will be determined by the net accumulated earnings and profits (E&P) within the foreign company as of either 2 November 2017 or 31 December 2017 (the greater of). Each US shareholder will need to include the amount of accumulated E&P less the amount of deficit E&P (i.e. losses) that corresponds to their shareholding in each CFC in which they hold an interest.
If there is a net amount to include this will then be subject to what the IRS may consider to be favourable rates – essentially applied to ‘clean up’ the past, as any subsequent distributions of the amounts taxed under the transitional provisions will not suffer US tax again. The headline top rates for US parent corporates are 15.5% on taxable E&P up to the value of cash or cash equivalents held by the company and 8% on any taxable E&P in excess of the ‘cash or cash equivalents’.
For US individual shareholders, the top rates will unfortunately be greater. Essentially, the computation to reach the applicable US tax rate is calculated by taking a deduction against the income so that the effective tax rate (for corporate taxpayers) is 15.5% / 8%. However, this deduction is made with reference to the US corporate tax rate of 35% in 2017 and 21% in 2018. As such, the deduction required to create an effective 15.5% / 8% rate for a US corporate is lower than an individual who may pay tax at up to 39.6% or 37% in those years. Therefore, any individual US shareholder that has an inclusion under this ‘transition’, and who ordinarily suffers US tax at the top Federal rate will in fact be subject to tax charges at 17.54% on cash profits and 9.05% on non-cash profits includible in 2017 or 27.31% on cash profits and 14.1% on non-cash profits includible in 2018 (see table on next page). This is far higher than the ‘headline rates’.
The payment of tax on this income may be made in instalments over eight years but it does require a first instalment being paid by 17 April 2018. If this is not paid in time, then the ability to make payment in instalments over eight years is lost and the full amount is potentially due immediately.
Obviously the above gives US individuals who are exposed to this regime a cash flow concern as well as a need to act quickly, given the potential need to pay the first instalment imminently. It also raises concern over the interaction of tax credits where tax may be due in the local country (i.e. the UK) at a different point in time – such as upon receipt of a distribution or dividend. This could lead to real double taxation.
2. THE ‘NEW RULES’ - GLOBAL INTANGIBLE LOW TAXED INCOME (GILTI) – 2018 ONWARDS
GILTI is an expansion of the existing anti-deferral regime under Subpart F. Subpart F attributes certain income within a CFC to US shareholders and subjects that income to tax at the individual level as it arises in the company, as opposed to on receipt of distributions or dividends. This has the potential to accelerate the point at which income is charged to US tax but may also create double tax issues where the eventual distribution/dividends of the profits are subject to income tax in the local country (e.g. in the UK). The US foreign tax credit system often requires the US tax charge and the local tax charge to be aligned in order to achieve a credit and the timing differences that result from the subpart F regime often present a barrier to this alignment.
In the broadest sense, the GILTI inclusion is the annual profits realised in a CFC over a certain allowable threshold. The threshold is computed with reference to 10% of the cost basis of its tangible assets. Any amounts over this are attributed to the US shareholder and subject to US tax in the current year, irrespective of any distributions being made.
We will see this legislation impacting a number of industries, including those who do business as a consultant through a company or those in the service industry who often hold very little in the way of tangible assets. These taxpayers may have historically deferred the US tax charge until the point at which they extract funds. The way in which those types of business organise themselves and strategically withdraw funds may change in light of this.
3. OTHER CHANGES
There are some further changes to US legislation in this sphere which will apply from 2018 onwards, including an expansion of the definition of ‘US shareholder’ to include shareholders with a right to the value or economics of an entity despite holding no (or minimal) voting powers.
In addition, certain beneficial planning techniques concerning the timing of execution of certain events may no longer be available as the definition of a CFC moves from being an entity controlled for at least 30 days in a year to an entity that is controlled at any point in the year.
Finally, there are additional attribution rules where there are US entities in the structure – we expect that this will mean more US taxpayers (individuals and corporates) will become exposed to the historical Subpart F legislation but also the new GILTI regime.
HOW WE CAN HELP
At Frank Hirth we have extensive experience of advising on the US tax implications of doing business overseas, at both the corporate and individual shareholder levels. With dedicated teams focussing on advising entities as well as individuals with privately owned businesses, we are able to provide advice and guide clients through the complex new rules for 2017 and beyond, as well as the necessary associated US tax filings.
In addition, as dual US and UK tax advisors, we are able to help you navigate through the UK/US interactions should you have a UK company - including the withdrawal of profits in the most tax efficient way. Looking forward, it may be that the way in which a business might organise itself where there is a US connection or US shareholding will change. We can help advise upon and implement the most appropriate structure in light of the new legislation and the lower corporate tax rates that may be available (including the use of certain US tax elections).
Our senior leadership team and subject matter experts have been digesting the changes under US tax reform since its release – we recommend that anyone who may think they are caught by any of the above changes reach out to discuss their situation to better understand how they may be impacted:
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