The Tax Cuts and Jobs Act (the Act), signed into law on Dec. 22, 2017, heralded the most significant changes to the U.S. international tax system since the Tax Reform Act of 1986.
With respect to multinational corporations, the Act introduced a number of provisions, including a participation exemption regime, that move the U.S. closer to a territorial tax system, along with new sourcing rules, reduced tax rates on foreign-derived intangible income and a number of new anti-abuse measures to prevent the shifting of profits offshore. However, there are a number of equally significant—and in some cases much less favorable—provisions that have a direct impact on planning for international private clients.
In Part I, we explored how the Act may affect non-U.S. individual taxpayers with U.S. holdings. Now, we’ll explain how changes in foreign anti-deferral rules and other provisions will affect U.S. individuals and trusts with offshore holdings, as well as offshore structures established for the benefit of U.S. persons. Some of these changes may require the reorganization of existing structures. Others may inform how U.S. and non-U.S. individual taxpayers choose to structure their holdings both in the United States and abroad going forward.
The Act substantially overhauled the rules governing the taxation of foreign income for individuals and corporations alike. A discussion of all of these provisions is beyond the scope of this article. However, what may have the greatest direct impact on many individual private clients are those provisions affecting the tax treatment of controlled foreign corporations and their U.S. shareholders. Affected individuals may face an unexpected phantom income charge for the 2017 tax year and other phantom income inclusions in future years, where there otherwise would have been none. Further, many existing structures set up by nonresident aliens for U.S. beneficiaries may need to be modified in light of these new rules.
Overview of Controlled Foreign Corporations and Subpart F Regime
In general, a foreign corporation is a controlled foreign corporation, or CFC, if U.S. shareholders—defined as U.S. persons who own 10 percent of the stock of the foreign corporation (by vote before the Act and by vote or value going forward) directly, indirectly or by attribution—together own more than 50 percent of the stock, by vote or value. If the foreign corporation earns income under Subpart F, such income may be taxable to U.S. persons who are U.S. shareholders on the last day of the CFC’s tax year as phantom income in proportion to their direct or indirect ownership, with certain adjustments, whether or not such income is actually distributed. Subpart F income includes most types of passive income from investments and capital gains from the sale of securities. It generally doesn’t include active business income of a CFC, other than certain types of related party sales and services income.
Participation Exemption and Forced Repatriation Tax on U.S. Shareholders
The Act introduced a new participation exemption regime, a 100 percent dividends-received deduction, for U.S. corporations receiving eligible dividends from 10 percent foreign-owned subsidiaries. The participation exemption is only available to U.S. corporations. U.S. individuals and trusts will continue to be taxed on dividends from U.S. and foreign corporations alike.
To prevent companies from receiving a windfall on previously untaxed earnings under the new participation exemption regime, Congress also imposed a one-time repatriation charge on existing U.S. shareholders (10 percent owners by vote under the old rules) of CFCs and certain other foreign corporations. Unlike the participation exemption, however, the toll charge is imposed on both corporate and noncorporate taxpayers alike. For the last taxable year of the foreign corporation beginning before Jan. 1, 2018, the affected U.S. taxpayers will be required to include their pro rata shares of the foreign corporation’s post-1986 deferred foreign income that wasn’t previously subject to U.S. tax. Earnings and profits that were accumulated before the foreign corporation became a CFC or otherwise became a “specified foreign corporation” are excluded, but affected taxpayers can still be taxed on earnings accrued before they themselves became shareholders. Specified foreign corporations subject to the repatriation charge also include foreign corporations that aren’t controlled foreign corporations if at least one (10 percent) U.S. shareholder is a domestic corporation. Generally, the deemed repatriation amount is taxed at a 15.5 percent rate to the extent of earnings attributable to the U.S. shareholder’s share of the foreign corporation’s “cash position” and at an 8 percent rate for earnings attributed to other assets, with adjustments for earnings deficits when multiple companies are involved. The tax may be paid over an 8-year period.
We note that earnings subject to the repatriation charge should be treated as “previously taxed income” under existing ordering rules for CFCs, meaning that future distributions of those earnings, which otherwise would be taxed as dividends, should be tax-free to U.S. shareholders who were subject to the repatriation charge. The Internal Revenue Service has promised more detailed guidance on the mechanics of these rules and how repatriated earnings would be credited, as well as other aspects of the transitional repatriation regime.
Changes to Rules Governing CFCs
There were a number of modifications to the CFC rules, but we’ve focused on three key changes that will likely affect most taxpayers: (1) the elimination of the 30-day threshold for Subpart F income inclusions; (2) a change in the definition of U.S. shareholder; and (3) a change in the attribution rules.
Elimination of 30-day requirement. Until the new law, there was no Subpart F income inclusion for U.S. shareholders if a foreign corporation wasn’t a CFC for an uninterrupted period of at least 30 days during its tax year. However, the 30-day threshold has been eliminated for tax years of foreign corporations beginning after Dec. 31, 2017. Accordingly, even if a foreign corporation is a CFC for only one day, there potentially can be significant phantom income inclusions for U.S. shareholders. The elimination of the 30-day rule has significant ramifications for common estate planning structures created by nonresident individuals for U.S. beneficiaries:
- Noncitizen nondomiciliaries will often invest in U.S. situs assets, such as stock in U.S. companies, through foreign blocker corporations held by revocable trusts that may have one or more U.S. beneficiaries. During the grantor’s lifetime, the grantor is considered the owner of the foreign blocker for U.S. income tax purposes under the grantor trust rules, thereby preventing the foreign blocker from becoming a CFC and the U.S. beneficiaries from being taxed on its income. However, the blocker may become a CFC after the grantor’s death if enough of the beneficiaries are U.S. persons who own 10 percent or more of its stock, including under attribution rules that can attribute ownership through foreign trusts. Until it was repealed, the 30-day rule provided a post-mortem window during which the executor or trustee could safely “check the box” to treat the blocker corporation as a disregarded entity, resulting in a deemed liquidation that would step up the basis of the underlying securities without generating what would otherwise be taxable Subpart F income. As long as the trust was structured to allow for a step-up with respect to outside basis on the grantor’s death, the deemed liquidation of the foreign blocker a few days later wouldn’t generate significant income at the trust level either.
- Under the new law, checking the box even a couple of days after the death of the grantor could generate significant amounts of phantom income if the underlying securities are highly appreciated. This income could be taxable to the U.S. beneficiaries. Making the election effective prior to death would solve the Subpart F issue, but could expose the non-U.S. decedent to estate tax because she would be considered to have died owning U.S. situs assets through a disregarded entity.
- It’s still possible to reorganize existing structures by creating a two-tiered holding company structure allowing for successive check-the-box elections (or liquidations) of both the lower tier blocker and the upper tier companies to step up the basis of the underlying assets without generating significant amounts of Subpart F income. The key is to put the new structure in place while the foreign grantor is still alive because one can’t create this structure retroactively after the grantor’s death. Another option is to increase the amount of turnover within the underlying investment portfolio so that the amount of unrealized gain at any given point is kept to a minimum. However, one would have to consider whether this was consistent with the long-term investment strategy.
Change in definition of U.S. shareholder. Prior to the new law, a U.S. person wasn’t a “United States shareholder” unless she owned 10 percent or more of the voting stock of the foreign corporation. Potentially, this allowed a U.S. person to own significant amounts of nonvoting stock in a foreign corporation without being subject to the Subpart F rules, although there were anti-abuse rules under the existing Treasury regulations that limited one’s ability to do so. Under the new law, a U.S. person is a U.S. shareholder for tax years of the CFC beginning after Dec. 31, 2017 if she owns 10 percent or more of the stock by vote or value. In other words, one can’t avoid U.S. shareholder and CFC status solely through the use of nonvoting stock. This also eliminates the potential argument that a U.S. beneficiary of a foreign nongrantor trust shouldn’t be considered to own shares of a foreign corporation owned by the trust under the attribution rules if she doesn’t have any control over the trust.
Downward attribution. The CFC rules provide for attribution of ownership through related entities and individuals. However, there’s no family attribution to a U.S. individual from relatives who are nonresident aliens and, until the new law went into effect, a U.S. corporation, partnership, trust or estate wouldn’t be considered to own stock in a foreign corporation owned by a non-U.S. shareholder, partner or beneficiary, respectively. This second limitation on downward attribution to U.S. entities has been eliminated, which will cause some U.S. entities that didn’t previously have foreign information on filing obligations to file Form 5471 to report their constructive ownership of CFCs. However, the provision blocking family attribution from nonresident aliens remains intact, so U.S. relatives of nonresident aliens with interests in closely held foreign corporations won’t be considered U.S. shareholders solely on account of their foreign relatives’ ownership.
The Act also introduced a new foreign anti-deferral regime that operates in tandem with the Subpart F rules for CFCs for tax years beginning after Dec. 31, 2017. Under this new regime, a U.S. shareholder of a CFC must include in gross income for a taxable year such shareholder’s ratable share of the CFC’s global intangible low-taxed income, or GILTI, in a manner similar to inclusions under the Subpart F rules. As with the repatriation charge discussed above, the actual calculations can be highly complex, but in the bigger picture, the GILTI regime can result in phantom income inclusions to the extent that a CFC’s adjusted gross income exceeds a benchmark return of 10 percent of the CFC’s adjusted basis in certain tangible depreciable property used in a trade or business. An important takeaway is that operating income or gains from the sale of business assets that would be considered “good” income under the Subpart F rules (thus, not currently taxable to U.S. shareholders of the CFC) potentially could still give rise to phantom income inclusions under the GILTI regime. Further, individuals are taxed at a much higher rate than corporations —both because of lower corporate tax rates and a further deduction on foreign-derived intangible income that’s only available to corporations—and don’t receive any credit for foreign taxes paid by the foreign corporation. There are some exceptions, including for certain types of “high-taxed” income. Although, in certain extreme cases, it actually could cost more for an individual to own a CFC directly than to own the same CFC through a fully taxable C corporation.
A number of questions remain regarding the scope and mechanics of this new regime. We hope to see more detailed guidance from the IRS in the coming months.