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How Does the US Tax UK Pension Lump-Sum Payments to US Citizens?

July 23, 2019 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Our international tax practice gets a large number of questions from United Kingdom (UK) citizens that are also United States (US) citizens and residents regarding their UK pensions. There are a number of complex issues around both UK private and public pensions that need to be addressed and each question requires separate research and analysis. Further complicating matters are issues for dual citizens that are trying to navigate not only both US and UK tax laws but also the US/UK Income Tax Treaty. These are certainly difficult waters to navigate even for experienced tax professionals.

One very common and complex question is the US tax treatment on a 25% lump-sum distribution from a UK pension. As many know, the UK government will not tax the 25% lump-sum payment as a matter of UK law. The tricky question is how does the US treat it?

There is a lot of information out there on the internet and much of it is either wrong or misleading. Many “advisers” claim that the 25% lump-sum payment is tax free both in the US and the UK. These folks claim that in the UK it is tax exempt by statute/law and that it is also tax free in the US by virtue of the US/UK Tax Treaty. They advise that the Treaty will allow you to escape US tax on this payment. Treaty questions are usually rather complex and difficult to understand especially if you’re not used to the language they use meaning things like “savings clause”, etc. I’ll try to explain below both what we’ve seen and what the rule is on this issue.

One thing that seems to be clear is that all of a US citizen’s income from any source is subject to US tax under IRC §61. Further, a dual citizen of the US and UK is entitled to rely on the aforementioned tax Treaty between the two countries by virtue of Article 23(2)(A).

The basic position we’ve seen out there is as such:

There is a “reciprocal pension exemption” in Article 17(1)(b) that requires the US to respect the UK exemption on the 25% lump-sum payment when paid to a US citizen and resident. This is False.
There is something in many tax treaties, including this one, that is called a “savings clause”. Basically, what this says is that if income received by a resident of country #1 is not taxed by county #2, country #1 can tax it. It almost serves as a soak-up clause to make sure all income is taxed by someone. This is true and is contained in many income tax treaties.
An exemption from a savings clause would mean that income received by a treaty country resident – like a dual citizen of the UK and the US residing in the US – is not taxed on that exempted income in either the UK or US. True if it applies.
The position to avoid tax here relies on the Article 1(4) savings clause – citing Article 1(5)(A) – to say that Article 17(1)(B) is not covered by the savings clause meaning, if read in conjunction with the earlier point, that the 25% lump-sum payment is not taxed by the US under Article 17(1)(b) and is exempt from the Treaty’s savings clause. This is false as the savings clause does apply as enumerated below.
Stated alternatively, these advisers are saying that the Treaty binds the US to recognize the UK exemption on the 25% payment and the savings clause does not operate to “soak it up” or otherwise tax it. Thus, you escape both US and UK tax on the 25% lump-sum distribution.

There are some big problems with this. The first is that, if you read the Treaty, this is not what it says. The second is that the IRS has publicly stated that this is not what the Treaty says. Please read the latter as the IRS explains its position on this very specific issue.

Please allow me to explain what the Treaty says on this issue:

Article 17(1)(B) provides us with a reciprocal pension exemption but not at all in the way described above. Treaty Article 17(1)(B) says no such thing. Also, Article 17(1)(B) does not address lump-sum payments which are clearly addressed in Article 17(2).
Article 17(2), covering lump-sum pension payments like this one, tells us that a lump-sum payment that is tax-free in one state shall also be tax-free when received by a resident of the other state. That’s a great answer if you stop there.
The Treaty’s savings clause specifically cites Article 1(5)(A). A reading of that article shows that it exempts Articles 17(3) – dealing with periodic payments of a social security scheme – and 17(5) – dealing with divorce and support payments – from the savings clause. Article 17(2) – dealing with lump-sum payments – is not mentioned or exempted in any way from the Treaty’s savings clause.
As such, the savings clause will require that the lump-sum payment be picked up in the taxpayer’s US tax as neither US tax law nor the US/UK Tax Treaty offers any exemption.

The IRS has specifically said what is clearly in the Treaty:

Article 1(5) of the Treaty provides a number of exceptions to the saving clause, but there is no exception for Article 17(2). Therefore, the saving clause overrides Article 17(2) and allows the United States to tax a lump-sum payment received by a U.S. resident from a U.K. pension plan.

That is sufficiently clear regarding the US tax authority’s position on the issue.

In summary, a UK 25% lump-sum pension distribution is fully taxable to a US citizen and resident and the US tax authorities have specifically stated that the Treaty language agrees. Any other position on this issue contradicts the IRS’s position and, quite frankly, has no basis either in US tax law or the Treaty itself. One taking an alternative position on this issue should be aware that it will likely require a substantive audit defense. Further, any practitioner taking this position should be mindful of IRS Circular 230’s requirements for tax return positions.

This is surely a complex subject as any Treaty based analysis usually is and any slight change in facts could derive a completely different answer. Each taxpayer situation is slightly different and that is why an experienced international tax practitioners should always weigh in on these questions. We do a considerable amount of work in this area and we hope that this note clears up a situation with considerable confusion around it.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

International Tax Planning Tools for US Individuals with Foreign Investments

February 4, 2019 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

There is no question that Public Law 115-97, commonly referred to as the Tax Cuts and Jobs Act (“Act”), changed the rules governing all US individuals and corporations with foreign businesses and investments. The Act was advertised to reduce taxes and compliance costs for both individuals and corporations and for most parties it has accomplished that goal. However, some of these new rules have had a decidedly negative impact on individual or non-corporate US shareholders of controlled foreign corporations (“CFC”) compared with corporate shareholders. Many non-corporate CFC shareholders actually face an expensive tax increase as well as increased compliance costs.

It is not clear whether the negative impact of these new rules was intended or simply the result of constructing very complicated tax legislation in a somewhat short time period. Whatever the cause, where care was taken in domestic legislation to place individual and corporate shareholders on a somewhat equal footing, e.g., new IRC §199A tax benefits offered along with reduced corporate tax rates, the same efforts were not made in the context of international shareholdings.

US individuals with foreign investments must immediately explore their international tax planning options to avoid these negative US income tax effects. We are actively engaged with a number of US based individuals on their individual international tax planning and we hope this article sheds some light on these important issues and related planning opportunities for you or your clients.

CFC Ownership

A CFC is generally defined as any foreign corporation where US persons own 50% or more (directly, indirectly, or constructively) of the foreign corporation’s stock (measured by vote or value) taking into account only those US persons who own at least 10% of the aforementioned stock. These shareholders are each referred to as a United States Shareholder (“USS”).

US individual ownership of CFC shares was always disadvantaged compared to corporate shareholders primarily due to the inability of individuals to use IRC §902 to credit indirect foreign taxes paid by the CFC. US individual shareholders can only use IRC §901 foreign tax credits which are basically limited to withholding taxes associated with the CFC dividend. Where the CFC’s local income taxes are high, the US individual shareholder’s effective tax rate on their CFC income is effectively equivalent to their US individual rate plus the CFC’s effective rate. It’s not uncommon for us to see an individual effective rate exceed 70% in these cases.

The benefit that US individual CFC shareholders did receive was deferral. In other words, unless an anti-deferral regime such as Subpart F was in play, the US individual did not have to recognize the CFC income until it was actually dispersed to them via dividend or otherwise. Further, if the CFC’s local income tax was a low amount, the increase in their overall effective tax rate for taxes not creditable under IRC §901 may have been worth it if deferral had true economic value to them.

Tax Reform Changes

The aforementioned CFC tax regime has significantly changed under the Act. Here are the major changes affecting individuals:

No Transition Tax Relief

IRC §965 requires the inclusion in income for all CFC shareholders of the CFC’s previously untaxed earnings and profits (“E&P”). The Act offered corporate CFC shareholders a reduced transition tax rate to cushion the blow of this unanticipated income inclusion but no such rate forbearance was offered to individual CFC shareholders. They took their inclusion at their regular individual tax rates.

No Participation Exemption

IRC §245A provides a full participation exemption, also referred to as dividends received deduction (“DRD”), for certain dividends received by a US C corporation from a CFC. However, US individuals who own CFC shares are not eligible for this participation exemption. CFC dividends received by individuals remain taxable either as qualified or non-qualified dividends at higher individual rates.

No GILTI Tax Reduction

The Act added IRC §951A which requires a USS to include in their US taxable income their pro-rata share of the CFC’s Global Intangible Low-Taxed Income (“GILTI”) which is treated, basically, as Subpart F income.

The GILTI calculation is complex by any measure. Quite basically, GILTI is the excess of a USS’s pro-rata share of a CFC’s income reduced by an allowable return equal to 10% of the CFC’s adjusted tax basis in certain depreciable tangible property. US corporate CFC shareholders are given a 50% deduction via newly enacted IRC §250 against any GILTI inclusion and can, subject to certain limits, credit IRC §902 taxes paid by the CFC to offset the US tax resulting from the GILTI inclusion.

Individual shareholders of CFCs are not eligible for either of these benefits afforded to corporate shareholders. Instead, they are subject to US tax at their individual income tax rates up to 37% on their GILTI inclusions without any foreign tax credit offsets. It is certainly a bitter pill for US individual CFC shareholders who engaged in sophisticated and expensive international tax planning to avoid Subpart F income only to be hit with similarly taxed GILTI inclusions.

The following example illustrates the disparate impact of the GILTI regime on an individual CFC shareholder who is also a USS. Assume a CFC operates an active services business in a jurisdiction that imposes a 30% income tax rate. The CFC has no tangible depreciable assets and generates $100 of net taxable income annually that is not otherwise classified as Subpart F income. The following graphic compares the tax consequences to a US corporate shareholder to those of an US individual shareholder:

	C Corporation USS of a CFC	Individual USS of a CFC
GILTI inclusion (IRC §951A)	$100	$100
50% Deduction (IRC §250)	$50	N/A
US Taxable Income	$50	$100
Foreign Income Tax (30%)	$30	$30
US Pre-Credit Tax	$10.5 (21% x $50)	$25.9 (37% x $70)
US Foreign Tax Credit	$24 IRC §960(d) 80% FTC limit	$0 No IRC §902 Credits
US Tax Liability	$0	$25.9
GILTI Effective Tax Rate	30% No GILTI FTC Carryforward	55.9%

Corporate CFC shareholders who utilize foreign tax credits to offset their GILTI tax expense are not only limited by the 80% IRC §960(d) limitation but also the inability to carryforward or carryback GILTI basket foreign tax credits. However, the IRC §78 gross-up still applies to 100% of the foreign tax expense. Even with these limitations, corporate shareholders get a much better deal than individual shareholders under the GILTI rules as a whole.

No FDII Benefits

The Act introduced, via IRC §250(a), the Foreign Derived Intangible Income (“FDII”) regime which provides C corporations with export sales important new tax benefits. These export benefits provide a reduced US tax rate on income attributable to intangible assets owned within the US in a similar manner to how the GILTI rules create income inclusions for the same activities conducted offshore. For a detailed description of the FDII rules, please see this recent article we authored on this topic.

The FDII rules were theoretically intended to provide tax benefits to offset the impact of GILTI inclusions. The result is a new benefit to US C corporations for using US based intangible property that they’ve owned all along. Even better, they don’t have to patent, copyright, or even identify the intangible property as the benefit is derived from a deemed return on assets calculation. It’s all good but it does not apply to individuals, S Corps, or partnerships. As a result, individuals take a harder hit from the GILTI rules with no corresponding relief from the FDII regime.

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Planning Options

For a US individual with existing or planned CFC ownership, there are various options available to mitigate some of these new provisions but each involves different steps with different side effects. We continue to see new options arise depending on the facts and circumstances of each particular taxpayer but here are some of the most common planning options we’ve been using thus far:

Contribute CFC Shares to a C Corporation

The logic here is easy enough to understand. Once the CFC shares are held by the C corporation, the corporation can utilize IRC §902 credits for taxes paid by the CFC, use offsets to the GILTI provisions provided under IRC §250 and elsewhere, and utilize the FDII regime. However, double taxation still occurs to the individual shareholder and there can be considerable complexity and costs in restructuring the CFC’s ownership chain.

Making an Annual IRC §962 Election

An IRC §962 election is a rarely utilized election employed to ensure that an individual taxpayer is not subject to a higher rate of tax on the earnings of a foreign corporation than if he or she had owned it through a US C corporation. This is an annual election with respect to all CFCs for which the individual is a USS including those owned through a pass-through entity.

The primary benefits of this election are that it provides a 21% corporate tax rate on any GILTI or Subpart F inclusion as well as allowing the use of IRC §902 credits. The individual taxpayer also does not have to endure the administrative burden of actually creating a C corporation holding structure for the CFC(s). However, in addition to having to make an annual election, the election does not allow the taxpayer to take the GILTI IRC §250 deduction or utilize the FDII export incentive regime.

Check-The-Box / Disregarded Entity Election

The taxpayer may also solve many of the problems created by the Act by using the now commonly exercised tool of a CFC check-the-box or disregarded entity election. This changes the CFC into a disregarded entity or foreign branch for US tax purposes while leaving it unchanged for local country purposes.

This has long been an instrument for individuals invested either directly or indirectly, via S corporations or partnerships, in a CFC. The primary benefits have been to allow individuals to benefit foreign tax losses in the US and to convert IRC §902 taxes into creditable IRC §901 taxes thus significantly reducing their individual tax burden on foreign earnings. Now, however, a disregarded entity election also allows the US individual shareholder to escape both GILTI and Subpart F inclusions

Prior to the Act, the main downside of a disregarded entity election by an individual was that it eliminated foreign deferral via the CFC. The conversion of a CFC to a disregarded entity could also be very expensive due to rules around CFC conversion. Most of the expense and complexity are due to a disregarded entity election being treated the same as a CFC liquidation.

US individuals may not use IRC §332 to effectuate a tax-free CFC liquidation. Instead, they must rely on IRC §331 where a liquidating distribution is considered to be full payment in exchange for the shareholder’s stock rather than a deemed dividend distribution. These shareholders generally recognize gain or loss in an amount equal to the difference between the fair market value (“FMV”) of the assets received, whether they are cash, other property, or both, and the adjusted basis of the stock surrendered. If the stock is a capital asset in the shareholder’s hands, the transaction qualifies for capital gain or loss treatment. The detailed tax effects of an IRC §331 CFC liquidation are outside the scope of this document but they are important and must be addressed thoroughly as part of any related analysis.

For a corporate USS, IRC §332 will generally apply to provide tax-free treatment but IRC §367(b) steps in and requires that the liquidating corporate USS include, as a deemed dividend, the CFC’s “all earnings and profits” amount (“All E&P Amount”) with respect to the CFC. The All E&P Amount generally is the corporate USS’s pro rata share of the CFC’s E&P accumulated during the USS’s holding period.

What’s important to note here is that the corporate USS’s All E&P Amount is reduced by E&P attributable to previously taxed income (“PTI”). The CFC’s E&P subject to the IRC §965 transition tax distribution, which is likely now in the past, becomes PTI. A corporate USS’s PTI amount resulting from the transition tax will likely equal the shareholder’s All E&P Amount and therefore reduce the required All E&P Amount inclusion to $0. If the All E&P Amount is $0, the disregarded entity election will not trigger any incremental US income tax to the electing corporate shareholder.

Here, we may actually have an instance where the IRC §965 transition tax, likely already incurred by the corporate shareholder, will serve to greatly reduce the cost of a disregarded entity election by making the deemed liquidation much less expensive. It’s an unusual situation for sure but one that allows a low-tax way for corporate USS’s to escape GILTI and Subpart F inclusions.

Here again we have another distinct advantage provided to corporate CFC shareholders but not individuals.

Here is a basic example of how CFC earnings are taxed to corporate, individual, and individual assuming the CFC is now treated as a disregarded entity:

	C Corporation USS of a CFC	Individual USS of a CFC	Individual Shareholder of a Disregarded Entity
Foreign Entity Income	$100 Dividend	$100 Dividend	$100 Pass-Through Earnings
Foreign Income Tax (assumed 30%)	$30	$30	$30
US Pre-Credit Tax	$21 (21% x $100)	$25.9 (37% x $70)	$37 (37% x $100)
US Foreign Tax Credit	$30	$0 No IRC §902 Credits	$30
US Tax Liability	$0	$25.9	$7
Effective Tax Rate	30% Possible FTC Carryforward	55.9%	37%
Tax on $70 Corporate Dividend to Individual Shareholder	$16.7 (23.8% x $70)	$0	$0
Post- Distribution Effective Tax Rate	46.7%	55.9%	37%

Conclusion

The US tax reform rules are certainly not advantaged to individuals as originally enacted. There is certainly the possibility that the Act will be amended to balance the negative effect on individual CFC shareholders but there is no guarantee. In the interim, there are some planning tools that the taxpayer can utilize to offset the negative impact of these new rules. This is not and is not intended to be an exhaustive list of each planning opportunity that we see or that we will see. What each shareholder should do depends upon a detailed analysis of the taxpayer’s unique facts coupled with sophisticated modeling to confirm the planning benefits. Anything short of that is likely to fail in some regard.

We’ve authored other articles on GILTI that you may find helpful by clicking here.

Please let us know how we can help you plan for your international investments. Learn more about our international tax practice or our firm by contacting us at FJVTAX.com.

The Foreign Earned Income Exclusion Dilemma

January 14, 2019 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Our practice deals with many expatriate US citizens of varying income levels working abroad as well as supporting CPAs and attorneys with their expatriate clients. We find that many clients are directed by their advisers to take advantage of the US Foreign Earned Income Exclusion (“FEIE”) rather than the US Foreign Tax Credit (“FTC”). The problem that we see is that those taking, or many giving, this advice do not understand how these different rules apply or even how they may interact to benefit the taxpayer.

Our advice to any expatriate taxpayer is that there is no one size fits all answer to which method works best. A US citizen working and/or living abroad must pay US tax on their worldwide income so the question of what works best is very important. Each methodology has some rather basic pros and cons that can help the taxpayer or their adviser pick what works best for that taxpayer. Let’s take a basic overview of these rules to outline the issues and recommended approach. This is not meant to be a technical dissertation of these rules but rather a practical approach.

The Foreign Earned Income Exclusion

The most popular method to address US expatriate taxation is the FEIE. It’s relatively easy to apply and understand and most US tax preparation software can do the heavy lifting. Those are all positives for the tax preparer or adviser but not always for the taxpayer.

The FEIE only applies to foreign earned income which is generally defined as salary and wages and related income. The FIEI for 2018 is $104,100. This means that this amount of foreign earned income may be excluded from US taxable income provided it otherwise qualifies. It may not be excluded from local country taxation but the US will allow it to escape US taxation.

The FEIE does not apply to foreign source passive income like, for example, any interest, dividend, or investment income earned outside the US. It also does not shelter foreign self-employment income from US self-employment taxes. Thus, you can have income from self-employment earned outside the US that is excluded from US income tax that is still subject to US self-employment taxes. Determining whether the self-employment tax applies is a separate analysis that depends upon whether the US has what is known as a Totalization Agreement with the country where the self-employment income is earned.

One final point to note regarding the foreign earned income exclusion is that once a taxpayer decides to take the exclusion, and then does not take it in a subsequent year, they are barred from taking it for the following 5 years. The only way to reverse is IRS permission via a US tax ruling which can be complicated and costly to obtain.

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The Foreign Tax Credit

The US FTC is a tax credit that reduces or offsets a US taxpayer’s US income tax liability based on the foreign income taxes that have been paid during the relevant tax period. It sounds simple enough but it can be complex in practice and, sometimes more importantly, most US tax software packages cannot handle the FTC or are unable to properly take into account the many variables impacting a properly prepared FTC calculation. This leads many US tax preparers and advisers to avoid it even when it would provide a better result.

The purpose of the US FTC is to avoid double taxation on US taxpayers. In general, if the taxpayer lives and pays taxes in a country where the income taxes are higher than the US the expected result of utilizing the FTC will usually be that the taxpayer owes zero income tax to the IRS. If the foreign taxes paid are lower than the US tax rate, then there will likely be incremental US taxes due to meet the US tax expense.

If a US taxpayer has unused FTCs from prior years, they are automatically carried forward and can be utilized in future years where the taxpayer may not have paid sufficient foreign income tax credit to offset their US income tax owing. This is a valuable tool for US expatriates moving between high tax and low tax jurisdictions.

It must be noted that foreign social security taxes cannot be used for the US FTC since only income taxes are creditable. This is a common error that is made and it must be noted that if the IRS audits the related personal tax return, they will disallow from the FTC any foreign social security taxes or any other taxes for that matter that are not income taxes including sales taxes, VAT, etc.

Taking Both the FEIE and the FTC?

Most practitioners understand that a US taxpayer can either take the FEIE or the FTC on the same income but not both. This rule is simple enough but it leads to much confusion.

For example, does this mean if the US taxpayer earns over $104,100 in foreign earned income in 2018 that they have to pick one regime over the other? The answer is no. The US taxpayer can actually use the FEIE for the foreign earned income up to the annual limitation and then use the FTC mechanism for the remainder. This blended approach is often the approach for high income taxpayers.

The rules tell us these two regimes can be used in the same tax year but the same foreign income taxes excluded by the FEIE cannot be credited under the FTC. In other words, if a certain amount of foreign earned income was excluded, and there is additional income to be taxed exceeding the FEIE, then the foreign taxes paid on the income that was already excluded cannot be used to offset US income taxes on the remaining income.

Why is this so complicated and misunderstood? As noted above, the US FTC can be very complex. Also, most US tax software packages are not able to handle this blended approach to foreign income taxation and the FTC calculation must be performed offline and typed into the return.

The Bottom Line

The proper taxation of a US taxpayer’s foreign earned income can be very complex especially when that income exceeds the FEIE. However, as this article points out, there are still ways to reduce or entirely avoid US income taxes for these taxpayers. The problem is that many practitioners are not familiar with these methods and most US tax preparation software packages do not help with a blended approach of the FEIE and FTC. As such, practitioners and taxpayers must remain aware that this approach exists and it could save them a considerable amount of current and future US taxes.

Can a Partnership With Some Service Activities Claim Section 199A Benefits?

November 16, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

We recently went on the Massachusetts Society of CPAs (“MSCPA”) tax practitioner website, aka the “HUB”, to answer a question regarding the ability of a partnership that has some service type activities to claim Section 199A benefits. We do get a number of questions on this so we felt it would be great to share on our blog.

The basic question presented was whether a partnership that manufactures and sells goods but has some consulting or service type activities may claim Section 199A benefits?

This is a very good Section 199A question that, as noted above, we’re seeing quite a bit in our business practice. It highlights the fact that Section 199A is actually a very complicated piece of legislation lacking solid administrative guidance and detailed understanding among many professionals. Many clients have assumed they qualify for Section 199A benefits when they actually do not.

When Section 199A was enacted and reviewed by the tax community there were more questions than answers to many specific fact situations. In particular, the statute itself left unclear to us the treatment of trades or businesses with both a Qualified Trade or Business (“QTB”) component which is benefit eligible and a Specified Service Trade or Business (“SSTB”) component which is not benefit eligible.

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Section 199A only applies to pass-through businesses. C Corporations received their tax break separately by reduced tax rates. The Proposed Regulations issued in August created the term “relevant pass-through entity” (“RPE”). An RPE is generally a partnership, other than a Publicly Traded Partnership, or an S corporation that is owned, directly or indirectly, by at least one individual, estate or trust. In most states, including Massachusetts, partnerships are mostly multi-member LLCs.

Section 199A defines a QTB rather simply as any trade or business except a SSTB or services performed as an employee. A SSTB includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. For practitioners familiar with former Section 199 and the former Extraterritorial Income Exclusion (“EIE”) rules, one could foresee how services besides architecture and engineering were going to be excluded from benefits – and they were but in a complicated fashion.

The Proposed Regulations provide us with our only guidance on our issue of a partnership, i.e., an RPE, with both QBI and SSTB activities. Prop. Reg. 1.199A-5(c)(1) provides a de minimis rule based on trade or business gross receipts and the percentage of gross receipts attributable to a SSTB under which a trade or business will not be considered a SSTB merely because it performs a small amount of services in a SSTB. The Preamble to the Proposed Regulations explains that this rule was created because the Treasury Department and the IRS believe that requiring all taxpayers to evaluate and quantify any amount of specified service activity would create administrative complexity and undue burdens for both taxpayers and the IRS. It is simply an administrative safe harbor.

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Under this rule, a trade or business, determined before application of the aggregation rules, which I’m not addressing here, would not be a SSTB if in a specific tax year it has: (1) gross receipts of $25 million or less, and (2) less than 10% of the gross receipts are attributable to the performance of services in a SSTB. Take note that this includes the performance of activities incidental to the actual performance of services. For a trade or business with gross receipts greater than $25 million, the trade or business qualifies for the de minimis rule if less than 5% of the gross receipts are attributable to the performance of services in a SSTB.

The bottom line is that if the SSTB activities rise above these safe harbor amounts within a single RPE, the entire trade or business is tainted and is considered to be a SSTB. The law does not allow you to otherwise create allocations within a single RPE. It is either a QBI or a SSTB depending upon the results of the test outlined above.

We are assisting many of our clients with both QBI and SSTB activities with restructuring options to qualify for Section 199A benefits. However, any restructuring alternatives are fact dependent. There is no one option that applies to all businesses but restructuring options do exist that allow many taxpayers to claim these important new benefits.

Has Subpart F Been Greatly Expanded?

July 23, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

For many years, international tax planners took great care to design global tax structures to avoid Subpart F. Now, in what is perhaps an unintended error, Subpart F appears to have been greatly expanded for many multinationals and particularly private equity investors. This potential expansion of Subpart F is a result of new share ownership attribution rules under the Tax Cuts and Jobs Act (TCJA) where U.S. taxpayers that were not considered U.S. Shareholders of certain foreign corporations for purposes of Subpart F may now be liable for those foreign corporation’s Subpart F income beginning in 2017.

The issue that is causing such concern is the repeal by the TCJA of IRC §958(b)(4). Prior to repeal, this Code section prohibited “downward” attribution of stock ownership from a foreign person to a U.S. person. This prevented what would otherwise be Subpart F income being attributed to a U.S. Shareholder via a foreign parent.

How exactly did IRC §958(b)(4) operate prior to repeal? Here is a quick example. In a typical Subpart F avoidance structure, foreign parent (FP) owns 80% of a foreign corporation (FORCO) and 100% of a U.S. corporation (USCO). USCO owns the remaining 20% of FORCO. Prior to repeal, USCO would not be considered a U.S. Shareholder of FORCO for purposes of Subpart F. As such, USCO never considered or included any of FORCO’s income that would have qualified as Subpart F income had FORCO been owned directly by USCO. Quite simply, the IRC §958(b)(4) rules prevented FORCO from ever being a Controlled Foreign Corporation (“CFC”) for U.S. tax purposes.

What has changed? After repeal of IRC §958(b)(4), USCO is, for purposes of determining U.S. Shareholder and CFC status, treated as owning all of FORCO’s stock. USCO now owns 20% directly and 80% constructively (via FP) under newly enacted IRC §318(a)(3) making it a U.S. Shareholder of FORCO and also making FORCO a CFC. As such, USCO is now liable for U.S. tax on 20% of FORCO’s Subpart F income. That’s a really bad answer from both an income inclusion and information reporting standpoint.

This example is not the only situation where this may cause a significant expansion of Subpart F. There are many others out there. In practice, every foreign structure involving a U.S. owner needs to be tested. That’s a tall order, but when the scope of how the repeal of IRC §958(b)(4) operates is considered it’s not something that can be reasonably ignored.

As if Subpart F expansion is not enough to worry about, this also impacts whether a taxpayer is a 10% or more U.S. Shareholder for purposes of calculating the Global Intangible Low Taxed Income (GILTI) inclusion.

The biggest problem is that we simply don’t know if this expansion has really taken place. We certainly do know that IRC §958(b)(4) is gone and we also know the statutory language of IRC §318(a)(3). Thus, the statutes tell us downward attribution is now the rule.

However, the legislative history behind the TCJA states that the repeal of IRC §958(b)(4) was not intended to cause a foreign corporation to be a CFC with respect to any U.S. Shareholder as a result of downward attribution under section 318(a)(3) to any U.S. person that is not a “related person” (as defined by IRC §958(d)(3)) to such U.S. Shareholder. This means that Congress intended this to apply solely to related parties, particularly those involved in inversion transactions, and not to unrelated parties. That’s both logical and simple enough to understand but it is not part of any statute, regulation, or even authoritative guidance for that matter.

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Why hasn’t this been resolved by now? One could reasonably theorize that Treasury feels it lacks authority to limit the scope of these rules via regulation and that a legislative correction, i.e., congressional action, is required to implement the result described in the legislative history. Congress, on the other hand, will find it difficult to enact a comprehensive technical corrections bill in short order considering the scope of the TCJA. In the absence of regulations, technical corrections, or some authoritative guidance, it is extremely difficult to reconcile the statutory language with the intent articulated in the legislative history.

One piece of guidance by the IRS has been regarding Form 5471. You can see where that would be a nightmare under these rules. IRS Notice 2018-13 provides an exception to filing Form 5471 for certain U.S. Shareholders considered to own stock via downward attribution from a foreign person. The Notice also states that they intend to modify the instructions to the Form 5471 as necessary which has not yet occurred.

The uncertainly outlined above has left taxpayers searching for the right approach here. To say there is no good approach is an understatement. For now, here are some of the choices:

Wait for a technical correction, regulation, or other clarifying authority to make clear the intent of these new rules.
File 2017 returns taking a technical position in favor of the legislative intent – on the basis that no other guidance currently exists – and keep your fingers crossed that the position outlined in such legislative authority is ultimately adopted.
Liquidate, or check-the-box, on your U.S. C Corporation that’s contributing to the CFC attribution to have it treated as a disregarded entity.
Liquidate, or check-the-box, on the foreign subsidiary creating the Subpart F income to have it treated as a disregarded entity.

Not a lot of great choices there. However, one could have reasonably anticipated that there would be problems like this as a result of the speed at which the TCJA was enacted. In the meantime, taxpayers must make a choice and prepare for the possibility that these rules may stand as such.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

Maximizing IC-DISC Benefits After Tax Reform

July 9, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Those that have followed the journey of the Interest Charge Domestic International Sales Corporation (IC-DISC) through the winding legislative process behind the Tax Cuts and Jobs Act of 2017 (TCJA) know by now that it has survived intact. Those that have followed these export tax benefits from the 1970’s DISC, whose enactment was somewhat contemporaneous with the unrelated peak of disco music, to FSC to EIE and now back to IC-DISC know that it has really been quite a legislative and judicial journey for these important export tax benefits. Now that we can be sure that IC-DISC benefits have survived, where exactly do we stand post-tax reform and what can we do to maximize IC-DISC benefits?

IC-DISC one of the last remaining export incentives provided to U.S. based taxpayers. It’s been an important part of tax planning for closely held companies since the Jobs and Growth Tax Relief Reconciliation Act of 2003 cemented into law reduced capital gains tax rates making IC-DISC a profitable tax strategy. As an added bonus, it is not currently on the World Trade Organization’s radar unlike some other current U.S tax incentives, i.e., the Foreign Derived Intangible Income (FDII) regime, so IC-DISC beneficiaries can rest assured that they are playing nice with our trade partners which is comforting. Also, don’t forget that IC-DISC is probably the last remaining tax planning technique where the IRS is willing to look past substance over form, at least a little bit – more on that later, which is not something seen too often.

Everyone probably knows the bad news by now that the reduction in U.S. individual tax rates has also reduced the IC-DISC benefits. To corporate shareholders, it still provides a hefty 13.2% tax rate benefit to individuals which is only a slight reduction from the pre-TCJA rate of 15.8%. The difference is the 2.6% top individual tax rate drop from 39.6% to 37%. If the business is a pass-through, and assuming newly enacted §199A is available to the taxpayer, it still provides a 6% rate benefit. Thus, even post TCJA, IC-DISC remains an important planning tool for businesses of all types.

What many taxpayers are missing is that there are planning tools out there that can make IC-DISC an even better tax planning vehicle without increasing shareholder risk. Some are more complex than others but here are some that we’re using with our IC-DISC clients:

Ensuring IC-DISC Compliance

If an IC-DISC is not properly qualified there are no benefits and there are likely penalties. This is pretty simple to understand but it is very often a problem. IC-DISC is an attractive planning tool but it is often adopted by taxpayers who don’t want to deal with the complexities of IC-DISC qualification or by an inexperienced practitioner who fails to properly implement or advise their client on the importance of these rules. I have been part of many acquisitions of middle market companies where the seller’s IC-DISC was determined to be defective during due diligence as a result of taxpayer error. Similarly, the IRS understands this very well and disqualifies many IC-DISC benefits on this basis. It is never good when an IC-DISC fails this way but in practice many do. Please don’t be the advisor that has to tell your client their IC-DISC has been disqualified.

Utilize IRC §482 Transfer Pricing

IC-DISC is one of the few areas where the IRS cannot force a taxpayer to use IRC §482 arm’s length principles to determine the profit allocation between related parties. However, IRC §482 is best used here proactively by the taxpayer. Most IC-DISC taxpayers that I work with use the 4% of export gross receipts methodology. For many taxpayers that’s a mistake. Most often, their IC-DISC advisor doesn’t fully understand how IRC §482 works and is unable to even model what the answer would be so the taxpayer doesn’t get to see what the options truly are. By addressing the IRC §482 options, or consulting with an IRC §482 expert, an IC-DISC may see greatly enhanced profits. It is certainly fact dependent, but I’ve seen it deliver enough benefits that is part of every IC-DISC analysis we perform.

Grouping Transactions vs. Transaction by Transaction (TxT)

For those of us that practiced in the FSC days, TxT was one of the most popular tax planning tools out there and was used by FSCs with literally millions of individual transactions. We all know that FSC is long gone but the TxT method is alive and well but is a little of a lost art since the very large companies had to stop doing it. Most of the IC-DISCs out there utilize grouping(s) of transactions. Grouping is a proper methodology and it can be the best and is certainly the easiest to apply. However, like transfer pricing above, TxT often produces significantly better benefits. It requires that each individual transaction be treated separately which is beyond the capabilities of many IC-DISC practitioners. At a minimum, grouping vs. TxT must be modeled to ensure that the taxpayer is obtaining, or maintaining, maximum benefits.

Appropriate Expense Allocations

In order to properly determine the profitability of foreign sales, the taxpayer must utilize the principles of IRC Treas. Reg. §1.861-8 and its relations. These rules can certainly be complex and they are not often applied properly. For example, many U.S. based exporters spend large amounts on things like interest and selling expenses which are, in practice, mostly directed toward U.S. activities. By improperly overallocating these expenses to foreign sales they are artificially dampening IC-DISC profits. The IRC §861 expense allocation rules are not optional and it is imperative that the practitioner fully understand them.

IC-DISC for the Foreign Owned U.S. Company

There are many closely held U.S. companies with foreign shareholders that export. Please keep in mind here that sales to Canada and Mexico are also exports. Many of these corporations do not utilize IC-DISC but many should. Especially those that reside in treaty countries with low dividend tax withholding rates. This can be difficult because to properly model the results you need to understand the shareholder’s resident country tax laws as well as the shareholder’s tax posture. That said, I’ve seen this benefit work for foreign shareholders often enough that I always consider it when I see these facts.

Utilizing a Roth IRA

This has been a somewhat popular planning tool utilizing a Roth IRA to avoid annual contribution limits. The Roth IRA value grows while the IC-DISC profits are not taxed. Simple enough but it is not a risk free strategy. The IRS feels that this is a violation of substance over form and argued that, albeit unsuccessfully, in Summa Holdings, Inc., No. 16-1712 (6th Cir. 2/16/17). My view is that the IRS argued this case wrong but that’s another article. If you live in the 6^th Circuit, good for you. The primary risks here are that the IRS does not like this and Summa Holdings predated the enactment of IRS §7701(o) which codified the economic substance doctrine. Until the IRS makes another run at this you certainly have substantial authority for this position where it makes sense.

IC-DISC as Non-Qualified Executive Retirement Tool

You don’t see this one too often but it makes sense. I advised with a practitioner whose client was retiring along with a sibling from a leadership position in a successful family business. IC-DISC itself made sense as a planning tool but it also played a neat part in the transition of the business by placing the IC-DISC ownership in the hands of the retiring executives. Keep in mind that the IC-DISC does not have to be held by the same shareholders as the related supplier. This planning, in essence, permits the related supplier a full tax deduction and the retired executives enjoy reduced qualified dividend tax rates.

Summary

The bottom line here is that IC-DISC remains alive and well for the foreseeable future courtesy of the TCJA. Thus, it is time to start considering using IC-DISC again and, more importantly, maximizing IC-DISC benefits with proven and reliable strategies. We help our IC-DISC clients on these and other tax planning issues. Let us help you or your clients.

To learn more about FJV’s IC-DISC or transfer pricing practices and our considerable experience with this important topic and how it impacts your business and tax positions, please contact FJV Tax or visit us at fjvtax.com.