While the focus of today’s post is how the United Arab Emirates (UAE) forthcoming Corporate Tax (CT) may impact US persons who are shareholders in a so-called Controlled Foreign Corporation (CFC) or Passive Foreign Investment Company (PFIC), the analysis applies equally to other jurisdictions which impose tax on the corporate entity. We examine today the impact on the US shareholder (whether an individual or US corporation) of a foreign country’s tax imposed on the foreign corporation in which shares are held covering the so-called GILTI tax, CFC rules, PFIC/QEF rules, and foreign tax credit (FTC).
United Arab Emirates Corporate Tax
As discussed in my first blog post in this series, on January 31, the UAE Ministry of Finance announced the introduction of a federal corporate tax on UAE businesses, to be implemented in June 2023. Many American citizens and green card holders have businesses in the UAE. Last week’s blog post looked at the US tax issues for Americans running a business through a sole proprietorship or through a UAE corporation for which a “check-the-box” election had been made to treat the corporation as “disregarded” as separate from its sole owner.
Business is also conducted in the UAE through a UAE corporation that is not treated as a “disregarded” entity for US tax purposes, perhaps by establishment of a so-called “free zone” entity or a UAE corporation doing business on the mainland.
As you will see, the US tax issues become far more complex when participation in business is through ownership in a UAE corporation.
First, it must be determined if the corporation is to be classified as a “controlled foreign corporation” or a “passive foreign investment company“. Classification will impact many tax issues for the US shareholder. Second, one must look to the shareholder – is the shareholder a US corporation or an individual?
- Controlled Foreign Corporation
A CFC is a foreign (non-US) corporation with so called “United States shareholder(s)” owning, directly or indirectly, more than 50 percent of its stock by vote or value. It sounds simpler than it actually is, so tax advice should be sought to determine if the foreign entity with US owners qualifies as a CFC.
The CFC tax regime is designed to prevent deferral of US taxation by abuse of offshore corporations. The CFC rules require that any “United States shareholder” (generally, a 10% or greater shareholder) of the CFC include in the shareholder’s current-year taxable income so called “Subpart F” income of the CFC (comprised predominantly of “passive” income) regardless whether such income is actually distributed to the shareholder in the current year. Subpart F income is explained in greater detail here.
There are various exceptions to the Subpart F inclusion rules. These exceptions generally cover situations that do not involve tax deferral or avoidance. One example, is the “high-tax exception”. Under this exception, income of a CFC that is subject to tax in the foreign jurisdiction at a rate that is at least 90% of the US corporate tax rate will not be subject to Subpart F inclusion.
The “high tax” exception would not be available for the US shareholder of a UAE CFC since the UAE CT is imposed at 9% . The exception applies if there is at least an 18.9 percent foreign country tax rate (based on the current US corporate rate of 21 percent x 90%).
Who is the Shareholder?
If the US shareholder is a corporation as opposed to an individual, three important tax attributes will lessen the US tax impact of the CFC and GILTI regimes.
- Lower Tax Rate: Corporations are taxed at a maximum 21% US federal tax rate; whereas the individual’s top tax rate is 37%.
- GILTI Deduction of 50%: GILTI will be discussed in more detail, but for now it is important to understand how a corporate shareholder fares so much better than the individual shareholder when it comes to GILTI. The corporate shareholder is generally entitled to deduct one-half of the GILTI it would otherwise have to include as taxable income. The individual shareholder receives no such deduction.
- “Indirect” Foreign Tax Credits: A corporate shareholder of a CFC may take an “indirect” FTC for up to 80% of the foreign tax that is paid by the CFC on its items of GILTI. This further reduces the effective US tax rate. An individual shareholder does not get the benefit of any such “indirect” foreign tax credits.
Section 962 Election for Individual Shareholder
If the UAE corporation is a CFC and the US individual shareholder makes a so-called Section 962 election under the Internal Revenue Code, the individual will be treated for tax purposes as a “corporation”. This provides several unique benefits. The individual shareholder (i) will be taxed at more beneficial US federal corporate tax rates (flat rate of 21%, versus the maximum 37% individual tax rate); (ii) can take a personal FTC to reduce his personal US income tax by a portion of the foreign income tax paid by the CFC itself. The US taxpayer owning a UAE CFC who makes the Section 962 electioncan claim the FTC, however, it will be limited to 80% of the total foreign tax (here, the UAE CT) that was paid by the CFC.
The individual taxpayer can change the decision to make the Section 962 election from year to year. Since the election is made only when the individual’s tax return is filed (several months after the taxable year has ended), the shareholder can carefully evaluate if is it favorable to make the election. This is a particularly important analysis and professional guidance should be taken.
If the taxpayer does not make the Section 962 election, the CT paid by the UAE corporation will only reduce the CFC’s income at the corporate level. This will in turn, impact the corporate earnings and profits (thus reducing the US shareholder’s possible Subpart F income) and GILTI tax exposure.
The Global Intangible Low-Taxed Income or so-called “GILTI” provisions were enacted in 2017 by the Tax Cuts and Jobs Act. GILTI turned the world of international taxation on its head for CFCs. GILTI income was introduced as a brand new category of income for shareholders of a CFC; it is separate and distinct from Subpart F income.
GILTI is income that is deemed repatriated in the year it is earned. In other words, the tax law “pretends” that the GILTI income is paid out to the CFC’s US shareholder, even though no actual distribution has been made. Of course, just like the case of Subpart F income, the US shareholder of the CFC must pay US tax on this “pretend” income distribution.
Thus, even if a CFC earns no Subpart F income, the US shareholder of the CFC can be hit with the GILTI tax. It is computed in a special way, with the current rate at 10.5%. US shareholders of CFCs in the UAE can definitely be subject to GILTI. Let’s look at the impact of the UAE CT on the GILTI tax.
No “High Tax” Exception
The UAE CT should reduce any GILTI tax since the tax is based on the CFC’s so-called “tested income”. This is computed initially by looking at the CFC’s taxable income, just as if the CFC were a US corporation (this would permit foreign taxes to be deducted). Additional items are then subtracted out from “tested income” including for example, income that otherwise qualifies as Subpart F income and also, income that is not Subpart F income because it is subject to an exception for income that is considered “highly taxed” by the foreign country.
The “high tax” exception would not be available for the US shareholder of a UAE CFC to reduce its GILTI “tested income”. In order to claim the exception, the taxpayer must show that the foreign corporation pays tax at a 90% or greater rate than the highest US corporate tax rate. As discussed, a foreign country tax rate of at least 18.9% would be required to meet the exception and the UAE CT is imposed only at a 9% rate.
Section 962 Election and GILTI
Making the Section 962 election, however, may rescue the UAE shareholder. Section 962 permits the individual American taxpayer with an overseas business that is covered by the GILTI regime (such as the US shareholder owning a UAE CFC), to receive a deduction of 50% on their business income that is defined as “GILTI” income. It will be recalled that making the election permits the individual taxpayer to be treated as a “corporation” and Congressional intent in enacting the Section 962 election was to ensure that an individual taxpayer’s tax burden with respect to its CFC’s undistributed foreign earnings would not be any greater than if the individual owned such CFC through a domestic corporation (which is permitted the 50% deduction). In other words, the election allows the American expat shareholder of a CFC to reduce the amount of GILTI income on which the individual would otherwise have had to pay the GILTI tax.
3. Passive Foreign Investment Company
The PFIC regime is highly complex. This discussion is a broad overview of how the regime may apply to the US shareholder of a UAE corporation that qualifies as a PFIC.
At the outset it should be noted that the CFC regime takes precedence over the PFIC regime with regard to those investors who meet the definition of a “United States shareholder” of the CFC. In other words, generally, only one tax regime will apply to the shareholder, not both; and the CFC regime has top priority!
An important point is that the classification of the corporation as a CFC or a PFIC occurs on a shareholder by shareholder basis. A foreign corporation can be a CFC for some shareholders, but a PFIC for others. How can this be? The different classification most commonly occurs when the US person owning shares holds less than 10% of the corporation’s total value or voting stock. Falling short of the 10% threshold means that person will not meet the definition of a “United States shareholder” under the CFC rules. If the person is not a “United States shareholder”, the CFC regime cannot apply to them, but they can be subject to the PFIC rules.
PFIC problems can easily arise for US persons holding minority interests in a company – regardless how small the percentage of ownership. It comes as a surprise to many US owners of foreign corporations with an active business that the corporation can still be classified as a PFIC for US tax purposes. For example, the PFIC regime might apply to an active services business that does not have hard assets, but has a large cash reserve (think of a consulting business or a website development business).
The PFIC rules embody a harsh penalty regime that taxes gains and so-called “excess distributions” at the highest income tax rate (currently, this is 37%; no capital gains tax rates apply). In addition to the tax, an interest charge is imposed on what is viewed as the deferral period (i.e., the time period income was accumulating in the PFIC and not paid out to the shareholder). The harsh PFIC tax results occur when the shareholder either receives an “excess distribution” from the PFIC (which can be a dividend), or at the time the taxpayer disposes of the PFIC shares.
PFICs, QEFs and the UAE CT
The simplest way to think of PFIC’s is that, as applied to the US shareholder, the Code Section 1291 PFIC regime functions net of tax borne by the corporation-PFIC. In other words, if the shareholder gets a dividend from the PFIC, which is a possible “excess distribution”, it will naturally already be net of the CT paid by the corporation.
A US shareholder can make a special election to get out of the Section 1291 regime of PFIC taxation. If the UAE corporation is a PFIC for which the US shareholder makes a so-called “qualified electing fund” election (QEF), the US shareholder will be currently taxed on his/her pro-rata share of PFIC income each year. Thus, the QEF election eliminates any deferral of tax, which is what the PFIC rules were designed to combat. Essentially, once the QEF election is made, the PFIC becomes a kind of conduit with income passing through to the US shareholder. The character of the income in the hands of the PFIC will carry over to the shareholder (e.g., long term capital gains or ordinary income). These QEF inclusions in the taxpayer’s income are based on “after-tax” income and long-term gains, and therefore will already be net of the CT paid by the corporation.
There is no indirect FTC for an individual shareholder of a PFIC, even if a QEF election has been made. The aforementioned Section 962 election is not available for a PFIC. Thus, the individual shareholder is out of luck when it comes to using the CT as any kind of FTC or deduction from his personal taxable income. (However, for corporate shareholders owning 10 percent or more of a UAE corporation that qualifies as a PFIC for US tax purposes, generally, a deemed foreign tax credit is available on earnings passed through from the UAE PFIC).
Special FTC rules will apply when a shareholder owns several PFICs or cannot use all of the FTCs with regard to foreign tax paid on “excess distributions” in a given year. Take this scenario – taxpayer pays personal tax to a foreign country on the dividend “excess distribution” he received from a PFIC, and qualifies for FTC on his US tax return with regard to that foreign tax. (Note, this will not apply to the UAE PFIC, as no such personal tax currently exists on income not earned in a trade or business). The taxpayer also has a PFIC in another country that pays an “excess distribution”, but the distribution is not taxed in that country. The taxpayer will be unhappy to learn that FTC for an “excess distribution” received from one PFIC cannot be credited to offset the US income tax liability for an excess distribution received from another PFIC. In addition, no FTC carryback or carryforward is permitted for “unused” foreign tax credits attributable to excess distributions and PFIC distributions that are not an “excess distribution” are treated the same for foreign tax credit purposes just as any other dividend.
Many US tax details will need to be worked out by those doing business in the UAE once the CT becomes effective. If you need assistance in planning to optimize use of the UAE CT on your tax return, we are here to help.
Posted: March 10, 2022
All the US tax information you need, every week –
Named by Forbes, Top 100 Must-Follow Tax Twitter Accounts @VLJeker
Named by Bloomberg, Tax Professionals to Follow on LinkedIn
Subscribe to Virginia – US Tax Talk to receive my weekly US tax blog posts in your inbox. My blog specializes in foreign and US international tax issues.
You can access my papers on the Social Science Research Network (SSRN) at https://ssrn.com/author=2779920