Classifying Your Company
It is important to keep in mind in this regard that the classification of companies under the tax law of your country may not agree with the classification for U.S. tax purposes. For instance, entities that are not considered corporations under foreign law may be considered corporations for U.S. tax purposes and thus may fall within the U.S. tax rules related to foreign corporations (e.g., Australian unit trusts).
The Internal Revenue Code contains two principal anti-deferral regimes that may impose tax on a U.S. taxpayer on a current basis when its foreign subsidiaries generate income. The two regimes are the:
- Controlled Foreign Corporation (“CFC”) regime; and
- Passive Foreign Investment Company (“PFIC”) regime
The Tax Cuts and Jobs Act, signed at the end of 2017, made several important changes to the rules applicable to U.S. persons owning foreign companies, including the imposition of a one-time mandatory repatriation tax on previously untaxed earnings of certain foreign companies (applicable for the 2017 tax year) and a new anti-deferral regime referred to as the Global Intangible Low-Taxed Income (GILTI) regime (applicable for the 2018 tax year and onward). These changes are discussed more fully below.
What is a CFC?
Under U.S. tax law, if a foreign corporation is a “Controlled Foreign Corporation” (“CFC”), then a “United States Shareholder” who owns stock in the corporation on the last day of the taxable year is required to include in its gross income for the taxable year certain “deemed” income, primarily – such person’s pro-rata share of the corporation’s “Subpart F” and "GILTI" income for such year.
For expats, this means that if your corporation has earnings and is classified as a CFC, you may have to automatically include those earnings in your personal income for the taxable year.
Additionally, other code provisions are relevant under the CFC regime, including Section 956, relating to investments in U.S. property (which include, importantly, loans to U.S. shareholders) by CFCs that can trigger a current inclusion in a U.S. Shareholder’s gross income.
A CFC is technically defined as any foreign (i.e., non-U.S.) corporation, if more than 50% of (i) the total combined voting power of all classes of stock of such corporation entitled to vote; or (ii) the total value of the shares in such corporation, is owned in the aggregate, or is considered as owned by applying certain attribution rules, by United States Shareholders on any day during the taxable year of such foreign corporation. A “United States Shareholder” is any U.S. person who owns, or is considered as owning, by applying certain attribution rules, 10 percent or more of the total voting power or the total value of shares in the foreign corporation.
CFCs and the Subpart F Rules
As discussed above, the Subpart F rules attempt to prevent deflection of income from the United States into another jurisdiction, particularly one which has a preferential tax regime. Thus, these rules generally target types of income that are easily deflected to another jurisdiction or that are earned in certain transactions between related parties that can easily direct the flow of income between entities in different jurisdictions. These types generally include passive income and income that is split off from the activities that produced the value in the goods or services generating the income.
Subpart F income inclusion has several limitations. For instance, Subpart F income of any CFC for any taxable year is generally limited by the amount of such corporation’s earnings and profits (“E&P”) for such taxable year, but is subject to recapture as Subpart F income in future years to the extent that Subpart F income exceeds current E&P. Furthermore, it does not include income of a CFC subject to an effective rate of income tax imposed by a foreign country that is more than 90 percent of the maximum U.S. corporate income tax rate (the “high tax exception”), i.e., 18.9% (calculated as 90% of the corporate tax rate of 21%).
CFCs and the New GILTI Rules
Starting with the 2018 tax year, a U.S. shareholder of any CFC has to include in gross income the CFC’s global intangible low-taxed income (“GILTI”) in a manner generally similar to inclusions of Subpart F income as described above. Whereas the Subpart F rules are aimed at a CFC's passive (e.g., dividends, interest, royalties) income, the GILTI rules are aimed at a CFC's active (e.g., business, trading) income.
In general, GILTI is computed as the income of the CFC (aggregated for all the CFCs owned by the U.S. shareholder) that is in excess of a 10% return on certain tangible property of the CFC. GILTI does not include income effectively connected with a U.S. trade or business, Subpart F income, Subpart F income qualifying for the high-tax exception, or certain related party payments.
A U.S. corporate shareholder of a CFC is entitled to a 50% deduction to offset GILTI plus an 80% foreign tax credit for foreign tax paid at the CFC level. As a result, the corporate shareholder will be taxed at a maximum 10.5% rate (50% x 21% corporate tax rate), and there will be no additional tax if the GILTI was subject to foreign tax of at least 13.125%.
A U.S. individual, on the other hand, will be taxed at the ordinary tax rate on such GILTI (37% is the maximum rate) with no 50% deduction and no foreign tax credit for the foreign tax paid at the CFC level. For this reason, an individual U.S. shareholder who holds at least 10% of the CFC should consider making a so-called “962 election” to be taxed as a corporation on the GILTI (i.e., taxed at the 21% corporate rate with the 80% indirect foreign tax credit and 50% deduction). Such an election can have complex and varied tax consequences, and a tax advisor should be consulted to fully understand its merits.
The GILTI "high-tax exception" exempts a CFC from the GILTI rules if the company is taxed locally at a rate higher than 18.9% (calculated as 90% of the corporate tax rate of 21%).
CFCs and the Reporting Rules
Individuals who own CFCs must include Form 5471 with their federal tax return.
There are also several other similar categories of filers that must file this form. Special attribution rules (which include attribution between spouses) may apply to expand the scope of taxpayers that fall within these categories. It is important for U.S. individuals who own shares in a foreign corporation to determine if they fall into any of such categories.
In general, Form 5471 assists the IRS with gaging the scope of a U.S. taxpayer’s foreign holdings that may facilitate U.S. tax deferral. The form is useful for keeping track of the earnings and profits of U.S.-owned foreign corporations, determining whether a foreign entity is a CFC generating Subpart F or GILTI income, and tracking possible IRC Section 956 inclusions.
The following penalties, among others, may apply for failure to accurately file Form 5471:
- Civil penalty of $10,000 for each year’s failure. If the information is not filed within 90 days after the IRS has mailed a notice of the failure to the U.S. person, an additional $10,000 penalty (per foreign corporation) is charged for each 30-day period, or fraction thereof, during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000 for each failure.
- 10% reduction in any foreign tax credits claimed from the relevant foreign corporation.
- Failure to file keeps the audit statute of limitations open indefinitely when information is required to be reported
- Criminal penalties may also apply in certain circumstances.
What is a PFIC?
Technically, a PFIC is a foreign corporation that has one of the following attributes: (i) At least 75% of its income is considered “passive” (e.g., interest, dividends, royalties), or (ii) At least 50% of its assets are passive-income producing assets. A U.S. person that holds any interest in a PFIC, directly or indirectly, is subject to the PFIC rules.
Unbeknownst to many expats, most foreign mutual funds fall within the definition of a PFIC. This can be the case even if such funds are held through a tax-deferred savings account (e.g., U.K. individual savings accounts (“ISAs”) and Canadian tax-free savings accounts (“TFSAs”)) or a non-qualified pension and retirement account (as is the case with most foreign pensions).
PFIC Punitive Tax Rates
PFIC investment income resulting from a distribution from a PFIC or a sale of a PFIC interest is generally subject to highly punitive U.S. federal tax rates, namely the highest marginal tax rate that can be imposed on an individual taxpayer (regardless of whether capital gains tax rates would normally apply). A non-deductible penalty interest charge can also compound regularly while holding an interest in a PFIC. Losses in PFICs generally cannot be used to offset gains in non-PFIC investments.
Several elections are available to mitigate the more onerous aspects of PFIC taxation (e.g., a so-called “QEF election” or “mark-to-market” election). Special rules apply if such elections are not made for the first year of PFIC stock ownership.
When a shareholder makes a QEF election, he will be required to include each year in gross income the pro rata share of earnings of the QEF and include as long-term capital gain the pro rata share of net capital gain of the QEF.
Under the mark-to-market election, shareholders must include each year as ordinary income, the excess of the fair market value of the PFIC stock as of the close of the tax year over its adjusted basis in the shareholder´s books. If the stock has declined in value, an ordinary loss deduction is allowed, but it is limited to the amount of gain previously included in income.
PFIC Reporting Rules
Aside from the high taxation rates associated with PFICs, there are specific reporting rules associated with PFICs. There is a specific form, Form 8621 for reporting your PFIC ownership interests. A separate Form 8621 must generally be filed for each PFIC in which stock is held directly or indirectly.
Internal Revenue Code Section 1298(f) provides the basic reporting requirement that all shareholders of a PFIC must file the Form 8621 each year.
Good recordkeeping is essential for properly reporting PFIC information on the Form 8621. Performing PFIC computations for corporations and shareholders that have not been collecting the required information from the beginning can be very challenging, if not impossible, depending on the information available.
Unlike other information returns, Form 8621 does not carry a penalty for not filing the form. However, failing to file the form does leave open the statute of limitations on all tax matters for that tax year indefinitely. Also, with FATCA, the IRS is receiving masses of information from the foreign financial institutions about the investments of U.S. persons, which could include information about your foreign mutual fund. A mismatch between reports can lead to an IRS audit of your entire return.
Effect of Trump Tax Reform
The Trump Tax Reform (formally known as the "Tax Cuts and Jobs Act" or "TCJA"), signed into law at the end of 2017, made a number of important changes to the U.S. tax code that affect the treatment of foreign companies.
In another of the more dramatic changes to the U.S. tax system under the new tax reform, the TCJA provides for a complete exemption for foreign income (which is non-Subpart F income and non-GILTI income) earned by certain U.S. corporate taxpayers via a foreign subsidiary. Technically, the exemption is provided for by means of a 100% dividends received deduction (“DRD”) for the foreign-source portion of dividends received from a “specified 10-percent owned foreign corporation” by domestic corporations that are U.S. 10% shareholders of those foreign corporations. This new rule, often referred to as the "participation exemption" rule, is intended to encourage companies to repatriate their active income to invest in the U.S. economy.
Under revised Internal Revenue Section 965, as part of the transition to the participation exemption system, the TCJA uses the mechanics under Subpart F to impose on U.S. shareholders owning at least 10% of a foreign subsidiary a one-time mandatory “repatriation tax” or “transition tax” on the undistributed, non-previously taxed post-1986 foreign earnings and profits (“E&P”) of a “specified foreign corporation.” A specified foreign corporation is defined as (i) any CFC, and (ii) any foreign corporation with respect to which one or more domestic corporations is a 10% United States shareholder. The portion of the E&P comprising cash or cash equivalents is taxed at the rate of 15.5%, while any remaining E&P is taxed at the rate of 8%.
Section 965 does not distinguish U.S. corporate shareholders from other U.S. shareholders, so the transition tax potentially applies to any U.S. person (including an individual) owning at least 10% of a foreign subsidiary. The transition tax rates can be slightly higher for U.S. individual shareholders whose effective tax rate was higher than 35% for the 2017 tax year.
Section 965 specifies, importantly, that the transition tax applies to the greater of the accumulated post-1986 deferred foreign income (essentially the previously untaxed earnings and profits) of the foreign corporation determined as of November 2, 2017 or as of December 31, 2017. In order to prevent pre-transition tax avoidance planning, the section adds that E&P is determined by essentially ignoring dividends distributed during the 2017 taxable year (other than dividends distributed to another specified foreign corporation).
Other aspects of Section 965 that could potentially ease the pain of the transition tax including the following:
- U.S. shareholders can elect to pay the transition tax over a period of up to eight years.
- In the case of foreign corporations held via an S corporation, U.S. shareholders can elect to maintain deferral on the deferred foreign income.
- Deferred earnings of a U.S. shareholder are reduced (but not below zero) by the shareholder’s share of deficits from other specified foreign corporations.
- The transition tax does not apply to previously-taxed earnings and profits.
- The portion of earnings subject to the transition tax does not include E&P that were accumulated by a foreign company prior to attaining its status as a specified foreign corporation.