It is usually very quick and easy to set up a foreign corporation – say, one in Belize or in the Cayman Islands. What is not so easy is working one’s way through the quagmire of required Internal Revenue Service (IRS) reporting and US tax obligations simply because you are a US person owning shares in a non-US company — even if the company has not transacted any business. That’s right! Welcome to the IRS Quicksand….despite all the hyped-up advertising by the incorporating agent about “absolute confidentiality” by setting up your company in the Cayman Islands, Belize or wherever, you are legally required to report these companies to the IRS. If you don’t, you can be subject to heavy fines, and possibly worse. Today’s blog post provides an introduction to the downsides of owning a foreign corporation. More details will be forthcoming in a follow up post.
I will remind readers on a point that is often overlooked: any entity that is not created under US law is treated as “foreign” for purposes of the US tax rules. This remains so even if it is an entity created in the country where you may reside or run your business, or of which you may also be a citizen.
The US Tax Downside of Foreign Corporations
Depending on the particular facts, US shareholders of closely-held foreign corporations may be subject to tax on some or all of their pro-rata share of corporate earnings even before they are distributed out to the shareholder; in other instances, a pay out from the foreign corporation or disposition of the shares can result in imposition of very harsh penalty taxes and compounded interest charges. These results are attributable to US tax rules that are commonly referred to as “anti-deferral provisions.”
The anti-deferral provisions are contained in two separate tax regimes: those for so-called “Controlled Foreign Corporations” (CFC) and those for so-called “Passive Foreign Investment Companies” (PFIC). One of the major differences between the PFIC and CFC rules is that there is no minimum level of stock ownership required by a United States person in order to subject the person to the PFIC rules. In fact, surprisingly enough, many foreign public companies that earn significant investment income or have large cash reserves and other passive assets may be treated as PFICs under the US tax rules.
Further Complications with the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (“TCJA”) heralded numerous changes to the US tax law. One of TCJA’s changes implemented new Internal Revenue Code Section 965, bringing the “deemed repatriation” or “transition tax” to the table. This new provision is intended to help convert the US international tax system into what is called a “territorial system”, with the goal being to enhance the US as a jurisdiction to do business in such a way that US corporations will not be taxed when receiving future distributions of profits from their overseas subsidiaries. In “transitioning” to this new model of taxation, US shareholders of certain foreign corporations (including CFCs) must pay a one-time “deemed repatriation tax” on the past earnings that have been accumulating over the years by the foreign corporations in which they hold shares. Because the tax is a “deemed” tax, it will apply even though the earnings are not actually distributed to the US shareholder (note, however, that no tax will again be due when the earnings are actually paid out to the shareholder).
You can learn all about the “deemed repatriation” or “transition tax” here.
Another very significant change wrought by TCJA was the introduction of the so-called “GILTI” tax, effective for taxable years beginning after December 31, 2017. GILTI stands for “Global Intangible Low Tax Income”. It is a new category of income that is not good to have! This is so because GILTI income is deemed repatriated in the year earned (therefore taxed in the year earned even if not distribution has been made by the corporation to the shareholder). The GILTI tax is applicable to US shareholders that own 10% or more of a CFC and essentially impose a minimum level of US tax on foreign profits. GILTI will impact the shareholders of CFCs having low levels of depreciable assets as compared to income. This means the impact will be felt most harshly by tech companies and service providers which typically have a significant amount of intangible assets and low levels of fixed and depreciable assets. Since the UAE does not impose tax on (most) corporations, GILTI will be a significant issue for US persons owning CFCs in the United Arab Emirates.
Get Advance Tax Planning to Minimize US Taxes
US shareholders in such corporations can minimize the tax bite if proper planning is undertaken. Perhaps this can take the form of structuring ownership or operations. Perhaps it can be through the use of Treaty benefits or by making certain tax elections. Sometimes, proper use of the so-called “check the box” election can prevent the corporation from ever being classified as a CFC or a PFIC. Expert advice is needed to ensure the most efficient tax result.
Posted October 22, 2018
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