Tax Reform and Deferred Foreign Income: What You Must Know by April 15, 2018
Tax reform legislation substantially changes how U.S. individuals and businesses are taxed on worldwide income.
Prior to the Tax Cuts and Jobs Act, U.S. citizens, U.S. resident alien individuals, and domestic corporations were required to report and pay tax on both domestic and foreign income. But the new law eliminates this system of worldwide taxation for certain domestic corporations.
It is replaced with a territorial/participation exemption system that permits a 100 percent deduction for certain dividends received by domestic corporations from 10 percent-owned foreign corporations. The toll charge for transitioning to a participation exemption regime is a federal income tax on the deemed repatriation of so-called “offshore earnings” held by foreign corporations. Here are answers to many of the questions you may have about the deemed repatriation tax.
For the last taxable year beginning before January 1, 2018, a U.S. shareholder of a specified foreign corporation (SFC) must include (as Subpart F income) the pro rata share of the undistributed, non-previously taxed, post-1986 foreign earnings (foreign deferred income) of such SFC.
A U.S. shareholder includes U.S. citizens; U.S. resident alien individuals; and domestic corporations, partnerships, trusts, and estates that directly, indirectly, or constructively own 10 percent or more of a specified foreign corporation’s voting stock.
This is a foreign corporation that is either:
- A controlled foreign corporation as defined under IRC Section 957, or
- A foreign corporation that has at least one domestic corporate U.S. shareholder
A foreign corporation that meets the definition of a passive foreign investment company under IRC Section 1297 is excluded from treatment as an SFC.
An SFC’s foreign deferred income balance is determined as of November 2, 2017, or December 31, 2017, whichever is higher.
Foreign earnings generally exclude earnings that are:
- Previously taxed income as defined under IRC Section 959
- Attributable to income that is effectively connected with the conduct of a trade or business in the United States and subject to U.S. income tax
- Subpart F income (determined without regard to the foreign deferred income inclusion) included in the gross income of a U.S. shareholder
The federal income tax rate on foreign deferred income inclusions of a U.S. shareholder that is a Subchapter C corporation is:
- 15.5 percent with respect to amounts attributable to an SFC’s cash assets
- 8 percent with respect to amounts attributable to all other assets.
- The effective tax rate on individual U.S. shareholders is approximately 17.53% on an SFC’s cash assets and 9.05% on all other assets.
A U.S. shareholder that is a domestic Subchapter C corporation may offset the federal income tax due on deferred foreign income inclusions with foreign tax credits. The amount of foreign tax credit allowed is pro-rated to account for the lower tax rate on foreign deferred income inclusions. Approximately 55.7 percent of the foreign tax credit is disallowed when computing the 15.5 percent tax due attributable to cash assets, and 77.1 percent of the foreign tax credit is disallowed when computing the 8 percent tax attributable to all other assets.
When computing the deemed repatriation tax due, a U.S. shareholder may in some cases offset the accumulated earnings and profits (E&P) deficits of one SFC against the foreign deferred income balance of another SFC.
U.S. shareholders that owe federal income tax on their foreign deferred income inclusions can elect to defer payment of such tax based on the installment schedule (below) rather than pay the full amount due with the return on which the inclusion income is reported.
- In each of years one through five: 8 percent of net tax liability due on inclusion income
- Year six: 15 percent
- Year seven: 20 percent
- Year eight: 25 percent
For U.S. shareholders with tax years ending on December 31, 2017, the first installment tax payment is due on April 15, 2018.
If an SFC is owned by a Subchapter S corporation, then each S corporation shareholder may elect to defer payment of federal income tax due on his or her share of foreign deferred income inclusions until certain triggering events have occurred.
Triggering events include:
- A change in the status of the corporation as an S corporation
- The liquidation, sale of substantially all corporate assets, termination of the S corporation or end of business, or similar event, including reorganization in bankruptcy
- A transfer of shares of stock in the S corporation by the electing taxpayer, whether by sale, death, or otherwise, unless the transferee of the stock agrees with the secretary to be liable for net tax liability in the same manner as the transferor
If the triggering event is the change in status of the corporation or a transfer of shares, the affected S corporation shareholder may elect to pay the federal income tax liability in accordance with the eight-year installment schedule (above). If the triggering event is due to the liquidation, sale, etc., the election to defer the payment of the federal income tax liability may only be made with IRS consent. If an election to defer payment of the federal income tax is made, the S corporation and the shareholder are jointly and severally liable for the payment and any penalty or additional amount.
No. As a general rule, the U.S. shareholder would treat the receipt of previously taxed foreign deferred income inclusions as nontaxable return of capital.
Every situation is different, depending on your specific set of facts, but this simplified scenario will help illustrate the how the new law may apply.
Facts: Joe is a U.S. citizen and 10 percent shareholder in XYZ S-Corp. XYZ S-Corp owns 100 percent of the stock in Cayman Widgets Ltd., a controlled foreign corporation. As of December 31, 2017, Cayman Widgets had deferred foreign earnings and profits of $10 million. Cayman Widgets’ balance sheet consists entirely of non-cash assets.
Analysis: Cayman Widgets is a specified foreign corporation because it is a controlled foreign corporation. XYZ S-Corp is a U.S. shareholder in Cayman Widgets because it is a domestic corporation. XYZ S-Corp must report Cayman Widgets’ $10 million of deferred foreign earnings as Subpart F income on its 2017 Form 1120S, because XYZ S-Corp is a U.S. shareholder that owns at least 10 percent voting stock in Cayman Widgets, an SFC. Joe must report and pay federal income tax on his share (i.e., $1 million) of XYZ S-Corp’s Subpart F income. Joe may elect to defer payment of this tax to the IRS until the tax year in which a triggering event occurs, at which time he may elect to pay the tax in installments over an eight-year period. The federal income tax rate on the income inclusion would be 8 percent because all of Cayman Widgets’ assets are non-cash assets.
We strongly encourage you to review your legal entity structure for potential direct, indirect, or constructive ownership in foreign corporations. The deemed repatriation tax that is imposed on a U.S. shareholder’s portion of an SFC’s deferred foreign income is mandatory and applies even if the SFC distributes the underlying cash or property in a subsequent tax year. Failure to report the deferred income inclusion and elect to defer payment of the corresponding federal income tax under the eight-year installment period could result in a substantial, one-time federal income tax liability, plus interest and penalties.
Domestic corporations that are affected by this tax law should consider E&P studies to determine whether foreign tax credit pools are available to offset federal income tax due on deferred foreign income inclusions.
How we can help
CLA’s global tax professionals can work with you to assess the new law’s applicability for your business and personal tax situation. We can help you devise a strategy that suits your particular facts and needs.