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New Tax Benefits for Pass-Through Entities – What’s There to Know?

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By FJV Tax Staff

There is a great new tax benefit available courtesy of tax reform that our pass-through clients don’t seem to know much about.  That great new benefit is IRC Code §199A (“Section 199A”) which provides owners of pass-through businesses, most notably partnerships and S corporations, with an important new tax benefit from a qualified trade or business.

This deduction is for up to 20% of the qualified business income of a U.S. business that is either a sole proprietorship, partnership, S corporation, trust, or estate.  For taxpayers with taxable income that exceeds $315,000 for a married couple filing jointly or $157,500 for all other taxpayers, the deduction is subject to limitations such as the type of business, the taxpayer’s taxable income, the total amount of W-2 wages paid by the business or the unadjusted basis of qualified property held by the business.

The motivation for the new deduction is rather simple.  It allows pass-through businesses maintain tax benefits commensurate with the significant corporate tax cut also provided by tax reform.  Income earned by a C corporation has always been subject to double taxation.  The first level of tax is at the entity level and the second is at the shareholder level when the corporation distributes its income as a dividend.  Tax reform reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%.  Tax reform did retain the top rate on dividend income of 20% but the significant decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.

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In contrast to a C corporation, income earned by sole proprietorships, S corporations, or partnerships is subject to only a single level of tax at the shareholder level.  Owners of these businesses report their share of the business’s income directly on their tax return – Form 1040 – and pay the corresponding tax at ordinary individual rates.  Tax reform reduced the top rate on ordinary income of individuals from 39.6% to 37% and Section 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%.

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What is most important here is that owners of sole proprietorships, S corporations, and partnerships retained a significant federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law.

While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear.  As a result, Sec. 199A has created ample controversy since its enactment with many tax advisers anticipating that until further guidance is issued the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS.  Adding concern is Congress lowered the threshold where any taxpayer claiming the deduction can be subject to a substantial-understatement penalty.  What that means is that they’ve introduced an ambiguous new rule and lowered the margin of error for penalties.

One of the areas giving our clients problems is figuring out exactly what types of business activities are excluded from the 20% deduction.  Service businesses are the real problem.  Section 199A defined specified service business – for which no deduction is allowed once a taxpayer’s taxable income exceed $415,000 for taxpayers filing jointly or $207,500 for all other taxpayers – as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”.  That definition cast a pretty wide shadow.

Proposed regulations have come to the rescue at least a little bit.  The proposed regulations clarified several questions related to specified service businesses.  First, there is a de minimis exception that allows a business that sells products and provides a service to escape classification as a specified service business if gross receipts are less than $25 million for the year and less than 10% of total gross receipts are from the performance of services in one of the specified services business listed above.  Next, the proposed regulations provide guidance on the meaning of various trades or businesses described in Section 199A as specified service business.  These rules are meant to help define who qualifies for the benefits in businesses where the lines are blurry between qualifying and non-qualifying activities.

Some of the most complicated areas are services related to health, consulting, and real estate businesses.  Here are examples of the application of Section 199A from each of these businesses:

Health and Health Care

A qualifying health care business means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.  It excludes the provision of service not directly related to a medical field even though services logically may relate to the health of the service recipient.  An example of these non-qualifying activities would be the operation of a health club or health spa that provides exercise or conditioning to customers or payment processing services for health care providers.

Consulting

Section 199A excludes consulting services defined as the provision of professional advice and guidance to clients to assist in achieving goals and solving problems.  However, these services do not disqualify larger businesses that only involve small levels of consulting.  Disqualified consulting does not include salespeople who provide training or education courses as an auxiliary service to the sale of product.  For example, a construction contractor who provides consultation as part of a home remodeling project is not considered a consultant.

Real Estate

Brokerage services are specifically excluded from Section 199A benefits.  This includes services provided by stock brokers, investment managers, and other similar professionals but does not include services provided by real estate agents and brokers or insurance agents or brokers.  The proposed regulations clarify that the performance of investing and managing real property services are not included in this definition which allows real estate professionals in the trade or business or managing real property to qualify for the deduction.

As one can see, Section 199A provides a tremendous benefit to owners of sole proprietorships, S corporations, and partnerships.  As this post makes clear, granting a 20% deduction to pass-through business owners is far easier in concept than it is in execution.  Many questions still remain.

Until time evolves and provides everyone with the guidance needed, taxpayers must still move forward and claim the benefits they’re entitled to.  To understand and claim the benefits that you’re entitled to please contact us at fjvtax.com and let us guide you to your benefits.

Transfer Pricing for Small & Mid-Size Business – What is Important Now and Why

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Frank J. Vari, JD, MTax, CPA

One of the most common questions we at FJV receive from our small business clients is what is transfer pricing and why must we address it now?  Many clients – and some practitioners – seek an answer but are overwhelmed by the complex and conflicting information generally available.

If your company plans to expand business operations into the U.S. or expand their U.S. operations into another country at least a basic understanding of transfer pricing is required.  Once there is a basic understanding, one can better comply with the legally mandated transfer pricing rules and then create a strategic pricing plan.

To best explain, let’s discuss transfer pricing basics, pricing methods, and documentation requirements.

Transfer Pricing Basics

A “transfer price” is the price at which related companies located in different countries buy and sell goods and services to each other.  This is very important to each country’s taxing authority as each country wants to tax a share of these worldwide profits.  “Transfer pricing” is generally defined as the legal mechanism that allocates the profit from that related party sale between the competing tax jurisdictions without creating double taxation.  This mechanism, as outlined in a variety of laws around the world, allocates global supply chain profits based upon the functions and risks of the related parties.  The party which performs the most important and costly functions, e.g., design and manufacturing, and takes the greatest risk, e.g., capital investment and customer credit risks, is entitled to the greater profit.

For example, let’s assume a U.S. entity manufactures medical equipment and sells it to a related party located in Germany.  The German entity then resells the equipment to its customers within Germany.  The financial elements here are as follows:

  • The medical equipment is manufactured in the U.S. at a cost of $10,000.
  • The parent sells this equipment to its German relative for $17,000 realizing a taxable profit in the U.S. of $7,000.
  • The German entity then resells this same equipment to an unrelated German customer for $20,000 thus realizing a taxable German profit of $3,000.
  • The total taxable profit for the entire global supply chain is $10,000.

How can the U.S. entity justify receiving 70% of the taxable profits, while the German entity only 30%?  In our example, the U.S. entity has performed the costly research, design, and manufacturing functions for the medical equipment.  The German subsidiary is only involved in the local German marketing and distribution of the product which requires little capital or investment.  Thus, the U.S. entity has performed the greater functions and taken the greater risk which legally entitles them to the greater profit.

This profit split may be challenged by either the U.S. or German tax authorities using their own local transfer pricing laws.  However, almost every country, including the U.S. and Germany, requires that each related taxpayer perform and document a transfer pricing analysis of their taxable profit allocation with related parties.  No exceptions.

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Transfer Pricing Methods

The IRS first enacted rules back in 1928 to address intercompany profit allocations that have evolved into present-day IRC Code §482.  These rules actually empower the IRS to reallocate income or deductions between related parties to prevent tax evasion.  If the taxpayer doesn’t perform a properly documented allocation or get it right the IRS will do it for them.  Not a good place to be for sure.

IRC Code §482 requires taxpayers to create and document a transfer pricing policy that chooses the best method to justify the transfer price of goods and services.  The IRS allows various methods for various types of transactions.  Transfers of heavy equipment, software, and consulting services are all sufficiently different that different pricing methods are required.

One of the most common pricing methods – and the one most preferred by the IRS and other taxing authorities – is the Comparable Uncontrolled Price (“CUP”) methodology.  In our example, let’s assume our U.S. entity also sells the same type of medical equipment to unrelated Chinese and Australian customers for more than it sells to the German related party.  The IRS may – and probably will – argue that the U.S. entity is not charging Germany enough and a greater U.S. taxable profit should be reported.  Alternatively, if the U.S. entity sells the medical equipment to all three customers, both related an unrelated, for the same price it could justify the intercompany transfer price between the related U.S. and German entities as an “arm’s-length” price.

IRC Code §482 provides other methods besides the CUP to be used for transfer pricing of goods and services.  These methods include the Cost Plus method, the Resale Price method, the Comparable Profits method, and the Profit Split method.  Taxpayers can even use an unspecified method if they can support it.  Taxpayers must be careful to analyze each of those methods separately and select the “best method” for that particular transaction in order to comply with IRC Code §482.

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Documentation Requirements & Penalties

One very important and often overlooked rule is that taxpayers are required to prepare and maintain contemporaneous documentation that explains in a very detailed and technical manner their transfer pricing methodologies.  “Contemporaneous” means this documentation must be compiled at the same time their U.S. tax return is filed.  If the IRS requests this documentation, the taxpayer must produce it within 30 days of an IRS request.  If the taxpayer fails to do so, two very bad things can happen.  First, as noted above, the IRS will go ahead and allocate the related party profits as they see fit.  Second, the taxpayer will be subject to the documentation penalty provisions of IRC Code §6662.

If the IRS makes a transfer pricing adjustment resulting in an underpayment of tax and the documentation requirement was not met, IRC Code §6662 permits IRS to impose a 20% or 40% percent non-deductible penalty.  The 20% penalty applies if the transfer price adjustment exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts.  If the transfer price adjustment exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts the IRS may impose a 40% penalty on the adjustment.

Besides proper transfer pricing documentation, U.S. taxpayers must comply with other important requirements including:

  • U.S. taxpayers who have related party transactions with their subsidiaries located outside of the U.S. must report these transactions on Form 5471.
  • U.S. taxpayers who have related party transactions with their foreign owners and their related parties must report these transactions on Form 5472.
  • If the related party sale involves a customs or duty filing, the price on the filing must be the same as that reported in the transfer pricing documentation and the Form 5471 or 5572. The failure to “harmonize” these filings can lead to additional penalties.

These are very harsh penalties that are often incurred by U.S. taxpayers who do not perform written transfer pricing studies to properly allocate or report related party profits.  The problem is there is really no way around them for small taxpayers.  Small taxpayers around the world have long called for exemptions from transfer pricing reporting but there is no significant relief to date.

Conclusion

Transfer pricing is a complicated issue that must be addressed proactively.  If properly addressed in a timely manner, transfer pricing can be addressed at a reasonable cost.  If not, the penalties kick in and the cost of these penalties coupled with the legal and professional fees of a transfer pricing conflict with any tax authority can be very high.

Our advice to any client with related party transactions that cross a foreign border is to proactively address their transfer pricing issues in a timely manner.  Whether they sell tangible property, services, or sell or license intangible property, our advice is the same.  At the end of the day, it saves our clients time and money and brings them fully into compliance with the law.

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.

 

Why is Personal Goodwill Good for Closely Held Corporation Shareholders?

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Frank J. Vari, JD, MTax, CPA

Personal Goodwill is a popular planning tool for sellers of closely held C Corporations.  This timely article explains this often misunderstood and improperly applied tax planning technique.

In our practice, we see a number of closely held C corporations with shareholders either actively looking to sell and/or examining the possibilities of selling their business.[1]  Many of these shareholders are actively engaged in these businesses and many have been so engaged for long periods of time.  These businesses include, but are not limited to, legal and CPA practices, insurance agencies, medical practices, and other similar entities where the shareholder’s relationships are integral to the business and customer relationships.

What we also see are a potential buyer’s general avoidance of closely held C corporation share purchases largely for tax reasons.[2]  The buyer’s primary tax reason is often goodwill.[3]  As an asset buyer, they will enjoy the tax amortizable goodwill generally resulting from an asset purchase.

For the seller, a C corporation share sale allows them to enjoy lower preferential capital gain tax rates.  On the other hand, an asset sale results in double taxation.  The asset sale proceeds are first taxed at the C corporation level and again at the individual shareholder level when the sale proceeds are distributed.  However, in practice, a C corporation share buyer can be difficult to find which forces sellers to look for ways to lower their tax bill.

For the C corporation shareholder facing a corporate asset sale and the selling shareholder has a strong relationship with his or her customers forming the basis of the business itself, attributing goodwill to the shareholder instead of the business may result in substantial tax savings to the seller.  In essence, the buyer is making two separate purchases.  First, the assets of the business are purchased from the C corporation and, second, the personal goodwill from the shareholder.

The concept that personal goodwill is a separate transferable asset in a corporate asset sale is not new or terribly unique.[4]  In general, to establish personal goodwill, one must support the premise that the goodwill’s value is attributable to the continued presence and/or abilities of a certain person and that this person is the legal owner of this goodwill and, as such, is the only person who can sell or transfer it.  The taxpayer must successfully demonstrate that the value of their personal relationships was far more valuable than the business entity itself without them.  If you envision a long time CPA practice with one primary member who built and sustained the practice you can see where this is quite often the case.

The primary issue with using personal goodwill as part of a business asset sale is that it relies almost exclusively on facts and circumstances.  This means that all relevant facts must be understood and addressed under the prism of tax case law and that the transaction must be supported by adequate supporting documentation in order to withstand audit.  Make no mistake, these transactions are quite frequently audited and the IRS is often successful when favorable facts, misapplied law, and adequate documentation are lacking.

As far as facts and circumstances, the IRS places the burden of proof on the taxpayer to demonstrate the valid separation of corporate goodwill from individual goodwill.  How, in general is this done?  In the seminal case of Martin Ice Cream v. Commissioner[5], the selling shareholder of an ice cream distributor successfully claimed that he had built his distribution business on the foundations of his personal relationships with supermarket owners and, further, that his relationships were still considerably valuable to the business at the time of sale.  One very key fact in Martin was that the selling shareholder had never transferred his personal goodwill to the corporation via an employment agreement or covenant not to compete.  That was, and is, a very significant fact (more about that later).  As a result, this personal goodwill was valued separately and was deemed to be sold separately for tax purposes.  Later cases continue to apply this same logic.

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As noted in Martin and related authority, the existence of an employment agreement or covenant not to compete agreement, or the lack therof, can significantly impact a personal goodwill analysis.[6]  These agreements can be fatal to a personal goodwill position especially where these contracts either restrict the seller’s activities outside of those benefiting the business and/or transferring their goodwill to the business itself.

In one landmark case[7], a dentist sold his C corporation practice that he had built and maintained for years.  He took the position that his personal goodwill was integral to the business and was his to sell separately to the buyer.  Points well taken, but the dentist had executed a covenant not to compete with his corporation where he was restricted from practicing with fifty miles of his corporate practice’s location.  In this case, the IRS was victorious by arguing that, by virtue of this agreement, his goodwill with his existing patients was almost nil as they would likely not travel over fifty miles to retain him as their dentist.  Even though the dentist, as sole shareholder, could have renounced this agreement prior to the sale he failed to do so.  The bottom line here is to understand all of the facts and especially any written agreements that could impact the value of personal goodwill and that a little upfront planning goes a long way.

What must a practitioner do to ensure the tax benefits of a personal goodwill sale are realized and will withstand IRS audit scrutiny?  Here are some hallmarks of a successful personal goodwill analysis:

  • Begin any personal goodwill analysis in advance of any sale discussion. This is easier said than done but trying to perform a thoughtful analysis during the timeline of negotiations is difficult and inherently dangerous particularly when the detailed analysis of historical data is required.
  • Thoroughly understand the history and the substance of the personal relationships involved in the business. Facts and circumstances are often unclear and documentation can be ambiguous.  It is absolutely essential that time and effort be taken to understand all of the facts and that they are appropriately documented.  You never want facts to come out during audit that you did not address and/or fully consider their impact.
  • Understand the authority around personal goodwill. This is especially true of authority that addresses your specific facts and circumstances that you are relying upon to support your personal goodwill position.  As with facts, you never want the IRS for any taxing authority to outline negative authority that you’ve not previously evaluated.
  • Discover and understand any existing legal agreements, written, oral, or otherwise that impact the position that the shareholder’s personal goodwill belongs exclusively to them and that this goodwill is a considerably valuable asset at the time of the sale. Is it possible that you need a lawyer’s opinion that the goodwill does not belong to the corporation and is exclusively the shareholder’s transferable legal property?    If you do, please proceed in that direction.
  • Have the buyer separately contract with the selling shareholder for the purchase of their personal goodwill. This contract should be as separate and distinct as possible from the corporate asset purchase and should recognize the personal goodwill as separate and distinct from any corporate goodwill.
  • Obtain a separate independent valuation of the seller’s personal goodwill. This valuation should be performed in accordance with Generally Accepted Valuation Principles and should properly measure both the value and ownership of the goodwill.
  • One should also consider performing an overall valuation of the entire business asset values including and excluding the selling shareholder’s personal goodwill. You may want to do this to ensure that the asset values support the economic value of the transaction.  For those that have performed IRC 1060 asset value allocations, one knows that although those allocations are binding on the taxpayers, they are not binding on the IRS per the longstanding Danielson[8]  This valuation can provide valuable substance to the transaction.
  • Analyze securing a covenant not to compete agreement with the buyer contemporaneous with the sale. Properly constructed, this helps support the position that the seller had a valuable asset that the business requires to maintain its value.
  • Raise the personal goodwill issue with the potential buyer early in the process. The buyer will likely need time to consider it with their advisors and its simply bad practice not to raise it if it will be the seller’s course of action.

Personal goodwill is a popular planning tool and is very effective at lowering a selling shareholder’s tax bill when the facts are right and the transaction is properly structured and supported.  Understanding these rules and practices will make sure your clients can enjoy this valuable tool with minimal risk.

[1] This may also apply to S corporation with earnings and profits or an S corporation subject to the built-in gains tax.

[2] There are also driving legal concerns particularly avoiding legacy legal issues around the selling corporation.  This is especially often true of smaller closely held corporations.

[3] Other tax reasons include a “stepped up” basis in depreciable assets and avoiding any undisclosed tax liabilities within the selling corporation.

[4] see Thompson v. Thompson , 576 So.2d 267 (Fla. 1991); Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998); Norwalk, TC Memo 1998-279.

[5] id.

[6] see Kennedy, T.C. Memo. 2010-206.

[7] Howard v. US, 106 AFTR2d 2010-5533 (DC WA, 2010).

[8] Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967); see also Peco Foods, Inc., T.C. Memo. 2012-18.

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.

Foreign Derived Intangible Income Deduction – Tax Reform’s Overlooked New Benefit for U.S. Corporate Exporters

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Frank J. Vari, JD, MTax, CPA

This article has been previously published in the Tax Adviser magazine published by the American Society of Certified Public Accountants (AICPA) in the August, 2018 edition.

The newly enacted U.S. tax act has ushered in a number of new rules and, to strategic tax planners, new opportunities.  This new opportunity is a preferential tax rate for U.S. C corporations that sell goods and/or provide services to foreign customers.  Qualifying income is subject to a rate of approximately 13% which is even lower than the new 21% corporate rate.  This new opportunity is IRC §250(a) containing the Foreign Derived Intangible Income (FDII) deduction.

FDII is intended to operate in tandem with newly enacted IRC §951A describing Global Intangible Low-Tax Income (GILTI).  GILTI is a new category of income for U.S. taxpayers owning a Controlled Foreign Corporations (CFC).  GILTI, similar to the existing Subpart F provisions, is a deemed income inclusion.  The interaction of these rules, a benefit for the use of intangible property in the U.S. via FDII and a deemed income inclusion for using intellectual property outside the U.S. via GILTI, has been referred to as a “carrot and a stick” approach to taxing intellectual property on a global basis.  However, if the taxpayer does not own a CFC, meaning it has no GILTI exposure, it secures all the carrots without worrying about any stick.

The bottom line is a new benefit to U.S. C corporations for using U.S. 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.  Because FDII is intertwined with GILTI, many believe it is simply an international tax provision and fail to see the benefits to U.S. exporters with no foreign operations.

The Benefit

The FDII benefit itself is not difficult to understand.  FDII produces an effective tax rate, based on the newly enacted 21% corporate tax rate, as follows:

13.125% for tax years beginning after December 31, 2017 and before January 1, 2026

16.406% for tax years beginning after December 31, 2025

Even with reduced corporate tax rates, it is still a benefit well worth pursuing.

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The Calculation

The FDII calculation is rather complex but it can be summarized in steps.  First, the U.S. corporation’s gross income is determined and then reduced by certain items of income including any foreign branch income.  This amount is further reduced by deductions allocable to such income bringing about deduction eligible income.

Second, any foreign portion of such income is established.  This includes any income derived from a sale of property or certain services to a foreign person for foreign use.  Please note that here a “sale” is defined very broadly and includes any lease, license (including royalties), exchange, or other disposition.  Foreign use is any use, consumption, or disposition which is not within the United States.

Third, the foreign sales and services income from step two above is reduced by expenses properly allocated to such income.  The result is foreign derived income.

Fourth, the corporation’s deemed intangible income is determined.  This is the excess of the corporation’s foreign derived income less 10% of its qualified business asset investment (QBAI).  QBAI is the average of the corporation’s adjusted basis in its tangible property used to produce the deduction eligible income.  For this purpose, adjusted basis is determined using straight line depreciation and an annual average using quarterly measures.

For example, assume a domestic C corporation produces widgets for a foreign customer that are used outside of the U.S.  The corporation earned $100,000 in deduction eligible income and $20,000 of foreign derived income.  QBAI is $120,000 (calculated separately) which results in deemed intangible income of $88,000 ($100,000 foreign derived income less 10% of QBAI, i.e., $12,000).  FDII is $17,600 or the deemed intangible income of $88,000 multiplied by the ratio of foreign derived income to deduction eligible income (20% or $20,000/$100,000).   The FDII deduction is $6,600 (FDII of $17,600 at a corporate tax rate of 37.5%).

The Corporation is then allowed to deduct 37.5% of FDII against its taxable income.  The upshot is taxable FDII of $1,000 and a tax liability of $210 which is an effective tax rate of 13.125% on the FDII of $1,600 and a $126 tax savings.

 

Deduction Eligible Income $100,000
Foreign Derived Income $20,000
QBAI $120,000
Foreign Derived Income $20,000
Less: QBAI Exemption (10% of $120,000) $12,000
Deemed Intangible Income $88,000
FDII ($88,000 x ($20,000/$100,000)) $17,600
Taxable FDII (FDII less 37.5%) $11,000
Corporate Tax (21% Rate) $2,310
FDII Effective Tax Rate ($210/$1,600) 13.125%
FDII Savings $1,386

 

Please do note that the benefit is subject to a taxable income limitation which means the FDII deduction cannot reduce taxable income below zero.  Likewise, there is no benefit if deemed intangible income is zero or less.

The taxpayer may take a foreign tax credit against any taxes levied upon the foreign derived income if it otherwise qualifies.  The credit will only apply to the taxable FDII within the general limitation basket matching the FDII but all of the associated foreign tax credits should remain available for credit.

Taxpayers wishing to utilize FDII benefits should be aware of rules regarding the involvement of related parties.  FDII applies to sales or services rendered to related foreign persons provided that the property is either resold or used in the sale of other property to an unrelated foreign person.  Thus, the sale of goods, the provision of services, and the license of intangible property to related foreign persons may yield FDII-eligible income.  In the case of services, the related party may not provide substantially similar services to persons in the U.S. or FDII benefits can be limited or eliminated entirely.  Service industry corporations should explore these rules in more detail.

The benefits only apply to property sold or services rendered for foreign use.  On its face, this appears quite simple.  However, the taxpayer must be very careful to support this as special rules apply here.  For example, property sold to an unrelated foreign person is not treated as sold for foreign use if it is further manufactured or modified within the United States even if the property is only used outside the U.S.  Likewise, services provided to an unrelated person located within the United States are not treated as “foreign use” even if the other person uses such services in providing services outside the United States.  Both of these results can be favorably changed with planning but one must make sure their entire supply chain qualifies.

Beneficiaries

The clear beneficiary of these new provisions are U.S. based corporate exporters of goods and services with no CFC ownership.  These corporations have long suffered higher tax rates than their multinational competitors who have had the ability to move intellectual property outside of the U.S. to lower tax jurisdictions.  FDII is a big step toward eliminating their competitor’s tax advantage.  Furthermore, because FDII does not involve intangible asset identification, it avoids cumbersome and expensive valuation and segregation studies as well as complex legal and tax intellectual property undertakings.

The bigger winners will certainly include technology corporations including software developers, pharmaceutical manufacturers, and similar industries.  These corporations generate foreign sales including FDII eligible licensing and royalty income with minimal tangible assets.  These types of industries generally also produce higher margins which will further increase the FDII benefits.

Issues to Consider

FDII only pertains to C corporations for now.  This includes U.S. subsidiaries of foreign-based multinationals that are taxed as C corporations.  However, FDII excludes S corporations, REITs, partnerships, LLCs, and individuals.

As of the date of this article, FDII lacks any technical guidance via regulations or otherwise.  The IRS has not issued a Notice or other guidance on FDII as they have on other parts of tax reform.  A technical corrections bill affecting FDII will be issued but it’s difficult to speculate on when, what it will contain, and in what form it will become law.  However, one may reasonably speculate that FDII could be expanded to include pass-throughs and individuals to alleviate some of the corporate centric aspects of the entire act that have drawn scrutiny.

It is possible that FDII will be contested by our foreign trade partners as an impermissible tax benefit.  Practitioners who recall the journey of DISC to FSC to ETI will be able to see the clear parallels here.  The good news is that if this does occur, it will likely take years to resolve any international tribunal litigation and, in the event FDII is deemed to be illegal, the IRS is unlikely to claw back benefits that have already been claimed by U.S. taxpayers.

Conclusion

FDII is certainly a gift to U.S. C corporations that export goods and services but do not own a CFC.  This is particularly true for technology companies with higher margins and limited tangible assets.  As with any new comprehensive tax law, uncertainties abound and guidance is limited but there is no doubt that FDII is a benefit worth pursuing.

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.

 

Has Subpart F Been Greatly Expanded?

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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.

New U.S. Global Intangible Income Rules – New Opportunities and New Risks

by

Frank J. Vari, JD, MTax, CPA

There is certainly a great deal of buzz around the new Global Low Tax Intangible Income (GLTI) and Foreign Derived Intangible income (FDII) rules enacted as part of the Tax Cuts and Jobs Act (TCJA) in late 2017.  At this same time, there is a lack of understanding amongst many practitioners and taxpayers as to what this means for them.  What follows here is a general explanation of how these new rules work.

GLTI

The TCJA has introduced newly enacted IRC Code §951A as well as the catchy new acronym pronounced as “guilty” by those who want to be hip and cool in tax circles.  GLTI requires U.S. CFC shareholders to include in income its GLTI income in a very similar manner to our old friend Subpart F.  The entire GILTI amount is included in a U.S. shareholder’s income in a manner similar to Subpart F.  Corporate shareholders are allowed a deduction equal to 50% of GILTI for 2018 through 2025, which is reduced to 37.5% in 2026.  As a result of the 50% deduction, the effective tax rate will be 10.5% until 2026 and increasing to 13.125% when the deduction is reduced in 2026.

The GLTI deduction is limited when the GILTI inclusion and FDII (described below) exceed the corporation’s taxable income determined without regard to the GILTI and FDII deductions.  Because the GILTI deduction is limited by taxable income, net operating losses are used first against the gross GILTI amount before any GILTI deduction is allowed.  Further, there is no carryforward for the lost portion of the GILTI deduction due to the taxable income limitation.

It is very important to understand who GLTI applies to.  In general, when a U.S. person is (i) a 10% U.S. shareholder of a CFC, under the Subpart F constructive ownership rules, on any day during the CFC’s tax year during which the foreign corporation is a CFC; and (ii) the U.S. person owns a direct or indirect interest in the CFC on the last day of the foreign corporation’s tax year on which it is a CFC without regard to whether the U.S. person is a 10% shareholder on that date, then the U.S. person will be required to include in its own income its pro-rata share of the GILTI amount allocated to the CFC for the CFC’s tax year that ends with or within its own tax year.  The U.S. shareholder will increase their basis in the CFC stock for the GILTI inclusion, which generally would be treated as “previously taxed income” for Subpart F purposes.  This may be a little hard to follow but it is absolutely critical to understand who GLTI applies to.

Individual and noncorporate shareholders are generally subject to full U.S. tax on GILTI inclusions.  However, qualifying U.S. shareholders may make an IRC Code §962 election with respect to GILTI inclusions where the electing shareholder is subject to tax on the GILTI inclusion based on corporate rates and may claim foreign tax credits on the GLTI inclusion as if the noncorporate shareholder were a corporation.  This is intended, in theory, to place corporate and noncorporate shareholders with a similar tax burden.

GILTI is calculated at the U.S. shareholder level as the excess of the CFCs’ net income over a deemed return on tangible assets.  The GILTI inclusion is calculated as the excess of a U.S. shareholder’s “net CFC tested income” over its “net deemed tangible income return,” which is 10% of the CFC’s “qualified business asset investment” (QBAI) reduced by certain interest expense.

“Net CFC tested income” is the excess of the U.S. shareholder’s aggregate pro rata share of the tested income of each CFC for which the shareholder is a U.S. shareholder for such taxable year over the aggregate pro rata share of the tested loss of each such CFC.  For this purpose, “tested income” of a CFC generally is described as the CFC’s gross income other than (i) effectively connected income; (ii) Subpart F income; (iii) amounts excluded from subpart F income under the IRC §954(b)(4) high-tax exception; (iv) dividends received from a related person (as defined in Code section 954(d)); and (v) foreign oil and gas extraction income, over deductions allocable to such gross income under rules similar to IRC Code §954(b)(5) or to which such deductions would be allocable if there were such gross income.  “Tested loss” is defined to mean the excess of deductions allocable to such gross income over the gross income itself.

“Net deemed tangible income return” is the excess of 10% of the aggregate of each CFC’s QBAI over the interest expense taken into account in determining the shareholder’s net CFC tested income to the extent the interest income attributable to the expense is not taken into account in determining the shareholder’s net CFC tested income. QBAI is determined as the average of the adjusted bases, determined at the end of each quarter of a tax year, in “specified tangible property” that is used in the production of tested income and that is subject to IRC §167 depreciation.  The conference explanation states that specified tangible property would not include property used in the production of a tested loss, so a CFC that has a tested loss in a taxable year would not have any QBAI for that year.

If GILTI is includible in a U.S. corporate shareholder’s income, the new law provides for a limited deemed paid credit of 80% of the foreign taxes attributable to the CFC’s tested income as defined above.  The foreign taxes attributable to the tested income are determined using a U.S. shareholder level calculation as the product of (i) the domestic corporation’s “inclusion percentage,” multiplied by (ii) the aggregate foreign income taxes paid or accrued by each of the shareholder’s CFCs that are properly attributable to tested income of the CFC that is taken into account by the U.S. shareholder under IRC §951A.

The inclusion percentage is the ratio of the U.S. shareholder’s aggregate GILTI amount divided by the aggregate U.S. shareholder’s share of the tested income of each CFC.  This ratio seeks to compare the amount included in the U.S. shareholder’s income to the amount upon which the foreign taxes are imposed, i.e., the tested income, to determine the percentage of foreign taxes that should be viewed as deemed paid for purposes of the U.S. foreign tax credit.

The IRC Code §78 gross-up is calculated traditionally by including 100% of the related taxes rather than the 80% that are allowable as a credit.  Although the gross-up amount is included in income as a dividend, it is not eligible for the IRC Code §245A 100% dividend received deduction but is eligible for the GILTI deduction.

There is also now a new separate basket for the GLTI deemed paid taxes to prevent them from being credited against U.S. tax imposed on other foreign-source income.  Additionally, any GLTI deemed-paid taxes cannot be carried back or forward to other tax years.

These rules are effective for tax years of foreign corporations beginning after December 31, 2017 and for tax years of U.S. shareholders in which or with which such foreign corporation’s tax years end.

FDII

In connection with the new GLTI tax regime on excess returns earned by a CFC, the TCJA provides a 13.125% effective tax rate on excess returns earned by a U.S. corporation from foreign sales, including licenses, leases, and services, which increases to 16.406% starting in 2026.  For tax years 2018-2025, a U.S. corporation may deduct 37.5% of its “foreign-derived intangible income” (FDII).  Starting in 2026, the deduction percentage is reduced to 21.875%.  The FDII deduction is limited when the GILTI inclusion and FDII exceed the corporation’s taxable income determined without regard to the GILTI and FDII deductions.  The deduction is not available for S corporations or domestic corporations that are RICs or REITs.

Generally, a U.S. corporation’s FDII is the amount of its “deemed intangible income” attributable to sales, or leases or licenses, of property to foreign persons for use outside the United States or the performance of services to persons, or with respect to property, located outside the United States.  A U.S. corporation’s deemed intangible income generally is its gross income that is not attributable to a CFC or foreign branch reduced by (i) related deductions including taxes and (ii) an amount equal to 10% of the aggregate adjusted basis of its tangible depreciable assets other than assets that produce excluded categories of gross income, such as branch assets.

Thus, a domestic corporation is subject to the now standard 21% corporate tax rate to the extent of a fixed 10% return on depreciable assets and a 13.125%, increased to 16.406% as of 2026, tax rate on any excess return that is attributable to exports of goods or services.

There are special rules for foreign related-party transactions.  A sale of property to a foreign related person does not qualify for FDII benefits unless the property is ultimately sold to an unrelated foreign person, or is used by a related person in connection with sales of property or the provision of services to an unrelated foreign person for use outside the United States.  A sale of property is treated as a sale of each of the components thereof.

The provision of services to a foreign related person does not qualify for FDII benefits if the services are substantially similar to services provided by the foreign related person to persons located in the United States.

The FDII provisions are effective for tax years beginning after December 31, 2017.

Summary

The GLTI and FDII rules in connection with the new territorial income rules are a seismic shift in the international tax landscape for those who have learned and practiced international tax under the post-1986 international tax regime.  This article is really only a primer of these evolving rules.  Once official guidance is produced, we will be able to deliver clearer client guidance on these important new rules.

 

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.