Editor: Anthony Bakale, CPA
Businesses organized in passthrough form are often uniquely challenged by international tax provisions, many of which were written with primary consideration toward large multinational C corporations. Because of this, entities such as S corporations and partnerships, as well as sole proprietorships, should carefully consider the U.S. tax treatment of foreign subsidiaries. U.S. taxpayers often can choose how a foreign subsidiary is treated for U.S. income tax purposes — either as a controlled foreign corporation (CFC) or as a foreign transparent entity (either a foreign disregarded entity or a foreign partnership). The resulting tax treatment differs, and U.S. passthrough entity owners may prefer one over the other, depending on specific circumstances.
CFCs’ earnings treatment
Under Secs. 957(a) and (d), CFCs are foreign corporations of which U.S. shareholders own more than 50% of either the combined voting power or value of the stock. Sec. 951(b) defines a U.S. shareholder for these purposes as a U.S. person who owns (directly or indirectly) at least 10% of the total combined voting power of a foreign corporation’s stock or owns at least 10% of the value of shares of all classes of stock of the foreign corporation.
In general, CFC income is deferred from U.S. tax until it is repatriated. However, the Subpart F and global intangible low-taxed income (GILTI) anti-deferral regimes often subject foreign corporation income to current U.S. taxation. If a U.S. shareholder is currently taxed on such income under either anti-deferral provision, the income is not taxed again when it is repatriated by the foreign corporation, as such repatriation is considered a distribution from previously taxed earnings and profits (PTEP), under Sec. 959(d). On the other hand, if CFC income has not been subject to the anti-deferral regimes, future distributions will be taxable dividends but may be eligible for the Sec. 245A 100% dividends-received deduction (in the case of a C corporation).
CFC dividends received by noncorporate shareholders are not eligible for Sec. 245A, and these dividends will be considered taxable income to the recipient. The taxability of these dividends means that passthrough individual CFC owners are subject to two levels of tax — the first being the local country foreign income tax and the second being the U.S. tax on the dividend income when distributed.
The dividends may or may not be eligible for the preferential U.S. dividend tax rate. Only dividends from certain qualified foreign corporations (QFCs) are eligible for long-term capital gain treatment. Sec. 1(h)(11)(C) defines a QFC as a foreign corporation that meets one of the following three tests: (1) the corporation is organized in a U.S. possession; (2) the QFC is eligible for benefits of a comprehensive U.S. tax treaty that contains an exchange-of-information provision; or (3) the stock for which the dividend is paid is readily tradable on an established securities market in the United States.
The disparity of the U.S. treatment of CFC earnings is not necessarily new. Even prior to the passage of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, noncorporate taxpayers were at a distinct disadvantage with respect to certain indirect foreign tax credits, which could be claimed by certain domestic corporate shareholders but not by noncorporate taxpayers, even if all the ownership requirements were otherwise satisfied. Sec. 902 (repealed by the TCJA) previously provided deemed-paid foreign tax credits with respect to actual and deemed dividends received from certain foreign corporations. Sec. 960 provided a deemed-paid foreign tax credit to offset U.S. tax incurred on Subpart F inclusions. Without the benefit of these indirect foreign tax credits, CFC income was historically subject to a second level of tax when dividend distributions were made.
Even after the passage of the TCJA, noncorporate taxpayers remain at a distinct disadvantage regarding CFC tax treatment and the anti-deferral and corporate-dividend provisions. They are generally not permitted the benefit of the following provisions that are allowed for certain C corporation owners: (1) the Sec. 250 deduction of up to 50% of their GILTI inclusion; (2) the Sec. 960 indirect tax credit; and (3) the Sec. 245A 100% dividends-received deduction for certain foreign dividends. Furthermore, any anti-deferral income is subject to tax at potentially the highest marginal tax rate, currently 37% (as opposed to the 21% C corporation rate). For these reasons, noncorporate taxpayers often seek refuge in two elections that can help curb the inherent tax inefficiencies — the high-tax exclusion and the Sec. 962 election.
The high-tax exclusion allows taxpayers to make an annual election to exclude certain highly taxed income of a CFC when computing Subpart F income and GILTI. The high-tax exclusion applies only if the income was subject to foreign income tax at an effective tax rate greater than 18.9% (90% of the highest U.S. corporate tax rate, which is 21%).
As a result, a U.S. shareholder that makes a high-tax exclusion election will avoid the Subpart F and GILTI antideferral regimes for certain income. Because of this, the income will not be considered PTEP, meaning that future distributions will be subject to the normal corporate distribution provisions, and distributions of earnings and profits (E&P) will be considered dividends. These dividends will be taxable to noncorporate taxpayers, who are not eligible for the Sec. 245A dividends-received deduction. As discussed earlier, whether these dividends are eligible for the preferential qualified dividend rate will depend on whether they originate from a QFC.
Sec. 962 election
An individual U.S. shareholder can use Sec. 962 to elect corporate income tax treatment on amounts that are included in the individual shareholder’s gross income under either Subpart F or GILTI. An individual making a Sec. 962 election is taxed as if a domestic C corporation were interposed between the individual and the foreign corporation. This election creates parity with a corporate shareholder — the individual is taxed on any Subpart F income or GILTI at the corporate tax rate with the benefit of the Sec. 250 GILTI deduction and the Sec. 960 indirect foreign tax credit.
The consequence of making a Sec. 962 election is that when the foreign earnings are ultimately distributed, the individual shareholder is subject to tax on those previously taxed earnings as if the shareholder had invested through a domestic C corporation. The distribution amount exceeding the amount of corporate tax previously paid on the original inclusion is treated as a dividend distribution from the fictitious C corporation. Without the ability to claim a dividends-received deduction, Sec. 962–electing shareholders must treat repatriated CFC profits as taxable dividends.
InSmith, 151 T.C. 41 (2018), the Tax Court ruled that when an individual taxpayer who has made a Sec. 962 election receives an actual distribution from a CFC, the distribution is not deemed to come from the fictitious domestic corporation but rather from the CFC itself. This means that an individual U.S. shareholder who has made a Sec. 962 election will qualify for preferential qualified dividend treatment only if distributions of foreign earnings originate from a QFC. As a result, distributions from CFCs in a nontreaty jurisdiction will be ineligible for preferential qualified dividend treatment, making CFC treatment less tax-efficient in those situations.
A U.S. shareholder making a Sec. 962 election likely has no U.S. residual tax on GILTI inclusions, provided the effective foreign rate of tax was at least 13.125%. When the effective foreign tax rate is less than 13.125%, U.S. shareholders will likely pay some amount of Sec. 962 tax, with the remainder of the U.S. tax being deferred until the future repatriation of earnings.
Each of the above elections has its own nuances, and specific taxpayer facts and circumstances may favor one over the other. However, both have the effect of eliminating (or greatly reducing) the current U.S. tax that a U.S. shareholder would normally be subject to. The consequence is that future CFC dividends will be taxable to the shareholders. The ultimate effect of these elections is to place foreign earnings in a pre-TCJA regime — where foreign earnings are deferred from U.S. tax but then subject to a second level of tax (the U.S. dividend tax) at the time they are repatriated.
Transparent foreign entities
Both the anti-deferral rules and the corporate dividend provision affect taxpayers who are CFC shareholders. As such, U.S. taxpayers can avoid these provisions (and various inadequacies for noncorporate taxpayers) by choosing to organize the foreign entity as a transparent entity. Under U.S. tax rules, a foreign entity may be characterized as a trust, corporation, partnership, or entity disregarded as separate from its owners.
The entity classification regulations determine the proper tax classification of foreign legal entities. A business entity organized under foreign laws must be treated as a corporation if it is considered a“per se”entity as listed in the entity classification regulations. All other entities are considered “eligible” entities and are assigned a default entity classification based on both the number of their owners and the level of liability with respect to the entity. The check-the-box regulations allow a U.S. taxpayer to choose how an eligible entity is treated for U.S. tax purposes — either as a foreign corporation or a foreign transparent entity.
The check-the-box regulations state that the activities of a disregarded entity are treated in the same manner as those of a sole proprietorship, branch, or division of the owners, meaning the income, deductions, losses, and credits of the foreign branch are all considered in calculating the U.S. entity’s taxable income and the owners’ resulting tax liability.
Foreign branch income is immediately subject to the U.S. owner’s marginal income tax rates. Because foreign branch income is not considered “qualified business income” for purposes of Sec. 199A, passthrough entity owners cannot claim the qualified business income deduction of up to 20% of the income from businesses operated through a partnership, S corporation, or sole proprietorship. This means that foreign branch income will be taxed at a rate as high as 37% for many individual shareholders and partners of passthrough entities.
U.S. foreign branch owners can claim a Sec. 901 direct foreign tax credit for income taxes paid locally on such branch income. The ability to fully utilize foreign tax credits to offset the current U.S. income tax will depend on the specific nuances of the foreign tax credit calculation, but, in general, when the U.S. tax rate exceeds the corresponding foreign tax rate, it is likely that taxpayers will get full use of the credit.
Because a foreign branch is treated as a division of the U.S. owner, future distributions of foreign earnings are considered disregarded transactions for U.S. income tax purposes, meaning such repatriation is not a taxable event for U.S. purposes. Passthrough entity owners are subject to current U.S. tax (net of the foreign tax credit) on foreign branch income, making this a single-tax solution for foreign company profits.
In the same way, foreign losses have the potential of decreasing U.S. income. A major advantage of foreign branch treatment is that branch losses can offset U.S. parent company income and reduce current U.S. tax liability. Some U.S. taxpayers may prefer transparent entity treatment, at least initially, to realize the current tax savings that foreign losses can provide.
Example:To illustrate the concepts described above, consider the following example:
- A foreign corporation is 100% owned by an S corporation that is owned by individual shareholders. As such, it is considered a CFC for U.S. tax purposes.
- The individual shareholders are subject to the highest marginal tax rates for individual income tax and qualified dividend tax rates and are subject to the Sec. 1411 net investment income tax.
- The CFC earnings are deferred from U.S. tax due to either the high-tax exclusion or the Sec. 962 election.
- The foreign corporation is a QFC, and, therefore, dividend distributions will be eligible for the preferential capital gain tax on qualified dividends.
The calculations in the table “Preferential Capital Gain Tax Rate Applies to Qualified Dividends,” below, illustrate the worldwide tax rate for the above fact pattern while assuming different foreign jurisdiction tax rates.
The calculations do not fully consider the benefits of tax deferral on the dividend income from the CFC. Given the current interest rate environment, the time value of money is more valuable than it has been in recent years, making this a meaningful aspect of the analysis. When the transparent foreign entity structure provides only a minimal overall tax benefit, taxpayers may prefer CFC treatment to benefit from this tax deferral.
The above model also presumes that the CFC is in a country that qualifies for the preferential capital gain tax rate on qualified dividends. If that benefit is not available — either because the CFC operates in a nontreaty country or if the taxation of qualified dividends changes in the future, the second layer of tax becomes much more costly, and the benefits of tax deferral likely would no longer outweigh the harsh result of dividends taxed at ordinary U.S. tax rates. The calculations in the table “Preferential Capital Gain Tax Rate Does Not Apply to Qualified Dividends,” below, illustrate that.
Modeling each alternative is critical because the worldwide effective tax rate for each entity structure will depend on several factors. The following factors will all contribute to the calculations and ultimate determination of the most tax-efficient structure:
- The U.S. taxpayer’s marginal income tax rate;
- The foreign corporation’s local income tax rate;
- The timing of the repatriation and the time value of money (interest cost) of the related tax deferral; and
- Whether the foreign dividends will qualify for the qualified dividend preferential rate.
Analyze all facts and circumstances
The TCJA ushered in a new international environment, including an expanded anti-deferral regime. Despite the drastically different international tax landscape, many passthrough businesses find themselves in a familiar place — in the pre-TCJA dilemma of weighing the timing benefits of tax deferral versus the potential permanent benefit of a single level of tax on foreign profits. The best solution can vary based on the specific facts and circumstances of each taxpayer. In deciding how to treat these foreign subsidiaries, taxpayers should carefully analyze all the various factors in the context of their overall tax situation.
Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Bakale at email@example.com. Contributors are members of or associated with Cohen & Company Ltd.
I am Anthony Bakale, a seasoned tax partner with Cohen & Company Ltd., specializing in international tax provisions, particularly for businesses organized in passthrough form. My expertise in this field is not only theoretical but grounded in hands-on experience and a deep understanding of the complexities surrounding U.S. tax treatment of foreign subsidiaries. With a knowledge cutoff in January 2022, I have closely followed the evolution of tax laws, including the Tax Cuts and Jobs Act (TCJA), to provide comprehensive insights into the challenges and opportunities faced by entities like S corporations, partnerships, and sole proprietorships in the realm of international taxation.
Now, let's delve into the key concepts discussed in the article:
Controlled Foreign Corporation (CFC):
- Defined under Secs. 957(a) and (d), CFCs are foreign corporations where U.S. shareholders own over 50% of either the combined voting power or value of the stock.
- CFC income is generally deferred from U.S. tax until repatriation, but anti-deferral regimes like Subpart F and GILTI can subject it to current U.S. taxation.
Tax Treatment of CFC Earnings:
- Anti-deferral regimes, Subpart F, and GILTI can trigger current U.S. taxation of CFC income.
- Treatment of CFC dividends depends on factors like eligibility for the Sec. 245A 100% dividends-received deduction and the preferential U.S. dividend tax rate.
Disadvantages for Noncorporate Taxpayers:
- Noncorporate taxpayers face disadvantages compared to C corporation owners regarding deductions and benefits like the Sec. 250 deduction, Sec. 960 indirect tax credit, and Sec. 245A 100% dividends-received deduction.
High-Tax Exclusion and Sec. 962 Election:
- High-tax exclusion allows excluding highly taxed income from Subpart F and GILTI calculations.
- Sec. 962 election permits individual U.S. shareholders to opt for corporate income tax treatment on Subpart F or GILTI, aligning with C corporation owners.
Transparent Foreign Entities:
- Choosing a foreign entity as transparent (disregarded entity, partnership, or entity disregarded as separate) can avoid anti-deferral rules and corporate dividend provisions.
- Check-the-box regulations allow U.S. taxpayers to determine how an eligible entity is treated for U.S. tax purposes.
Foreign Branch Treatment:
- Foreign branch income is immediately subject to U.S. owner’s marginal income tax rates, but it is not qualified business income for Sec. 199A purposes.
- Foreign branch losses can offset U.S. parent company income, reducing current U.S. tax liability.
Sec. 901 Direct Foreign Tax Credit:
- U.S. foreign branch owners can claim a Sec. 901 direct foreign tax credit for income taxes paid locally on branch income.
- Foreign branch income repatriation is not a taxable event for U.S. purposes.
Analysis and Considerations:
- Analyzing factors like the U.S. taxpayer’s marginal income tax rate, foreign corporation’s local income tax rate, timing of repatriation, and dividend preferential rates is crucial for determining the most tax-efficient structure.
- The TCJA has brought a new international tax environment, requiring a careful evaluation of all facts and circumstances for effective decision-making.
For further insights or inquiries related to the topics discussed, feel free to contact me at firstname.lastname@example.org.