In an effort for the United States to become fiscally competitive on the world stage, the new US Tax Reform included provisions to move towards a territorial tax system by imposing a “toll tax” on undistributed profits on US-owned foreign corporations. Its purpose is particularly meant to stimulate the economy by motivating corporations to repatriate cash generated from previously untaxed profits abroad to invest in the economy and create jobs.
The following comments will provide a high level overview of the adverse and unfortunate effects US individual shareholders of foreign corporations will endure from the new toll tax and GILTI rules in comparison to US corporate shareholders.
Effective for the last taxable year of a foreign corporation that begins before January 1, 2018, the “toll tax” is a one-time tax of 15.5% on aggregate cash balances and 8% on all other undistributed profits earned since 1987 on the balance sheet of a foreign corporation as of December 31, 2017 or November 2, 2017, whichever is higher. Consequently, future dividend distributions to its US parent will be free from US taxes thus achieving the “territorial tax regime”.
Many of us may have read the headlines on how this toll tax, also referred as the Repatriation Tax, affects US corporate shareholders of foreign corporations, (e.g. Goldman Sachs, Apple: news article) However, the toll tax also applies to US individual shareholders of a foreign corporation that is a Controlled Foreign Corporation (a “CFC”).
A foreign corporation is a CFC if US shareholders own more than 50% of the total combined voting power of its stock or more than 50% of the stock’s total value. For this purpose, the law defines a US shareholder as any US person who owns 10% or more of a foreign corporation, including a US citizen, a green card holder or an individual who meets the physical presence test (or elects) to be considered as a tax resident of the United States. These rules also apply if a US person resides outside the United States due to the preservation of the worldwide tax regime for US individuals.
The method to arrive at the toll tax liability is relatively complex. The 15.5% and 8% effective rates are in fact prescribed as “equivalent percentages”. A deduction based on the US corporate tax rates is used to arrive at these effective rates. To the extent the toll tax is due for a CFC as of December 31, 2017, the deduction is based on the 2017 corporate tax rate of 35% (max) rather than the individual rate of 39.6% (max) and US individuals will have to follow that same corporate rate deduction mechanism using the 35%, not the individual rate. Hence, US individual shareholders of a CFC will bare a higher toll tax burden than that of a US corporate shareholder. While this provision provides for partial foreign tax credits to decrease the net toll tax due of US corporate shareholders, individuals are not allowed to claim foreign tax credits to reduce their net toll tax liabilities. In addition, US individuals will continue to pay US taxes on future dividend income, not previously taxed, received from their CFCs as the new dividend exemption only applies for US corporate shareholders.
An election to pay the toll tax liability in installments over an 8-year period is available and if such election is made, the first payment is due by the original due date of the shareholder’s 2017 US tax return determined without regard to any extension i.e. April 15, 2018 for a calendar year taxpayer. To date, it is unclear if individual US shareholders residing abroad will be allowed the regular automatic extension until June 15, 2018 to make their first toll tax payment.
Also included in the US Tax Reform are the GILTI implications. Going forward, applicable for the first tax year of a CFC beginning after December 31, 2017, the US will also require individual shareholders of the CFC to include in their annual taxable income a “global intangible low-taxed income” or GILTI; which notwithstanding its name, is not limited to intangibles nor low-taxed income. Prior to the GILTI rules, CFCs with active business income used to qualify for deferral from US taxes and received qualified dividend treatment (preferential tax rates if from a treaty country) at the time profits were distributed to their US shareholders.
The GILTI rules practically eliminate the active business income deferral. The treatment for US corporate shareholders is again different from that of a US individual. While a 50% deduction will be allowed to reduce the annual taxable GILTI including an available 80% deemed foreign tax credit against the GILTI tax for US corporate shareholders, US individuals subject to the GILTI tax will not benefit from such deduction nor the foreign tax credit. Accordingly, it is strongly recommended that the current organizational structure, involving a CFC with a 10% or more US individual shareholder (resident in or outside the United States), is carefully reviewed under the new rules all the while exploring certain available elections permitted by the IRS.
Every circumstance is different and the new rules are extremely complicated. Although US tax practitioners are still waiting for more guidance from the IRS and how it will particularly impact their clients, it is uncertain if the impact on individuals will be addressed further. It is crucial for US individual shareholders of foreign corporations to work closely with their advisors to consider potential planning opportunities on how they can reduce, or prepare for, these additional tax burdens.
If you have any questions or wish to discuss, our US tax experts at PwC in Switzerland are available to assist.
Richard Barjon, CPA
PwC | US Tax Director
+41 58 792 13 53