international tax

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.

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.

Beware of GILTI Basis Adjustments

December 13, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTAx, CPA

Much has certainly been written about the recently proposed regulations on IRC §951A known more famously as the Global Intangible Low-Taxed Income (“GILTI”) regime. What has not been widely publicized are the basis adjustment rules for consolidated groups. This may not be the most easily understood topic but it may be one of the most important topics to groups that are active or expect to be active in the merger & acquisition arena. The GILTI basis adjustment rules are a new area of complexity and risk.

Overview

The GILTI basis adjustment rules are rather simple to understand but are very complex in practice. They require basis adjustments for consolidated group members and Controlled Foreign Corporations (“CFC”) that contribute tested losses to the group. They are intended to prevent the “double dipping” of tax benefits where a member’s GILTI tested loss is used to reduce a current year consolidated group GILTI income inclusion and then again when the contributing member’s outside tax basis remains high when that group member is sold. The rule’s required downward basis adjustment which corresponds with the member’s GILTI tested loss ensures the benefit is only taken once.

That all seems simple enough in theory but practice is another matter. Maintaining regular individual member and CFC federal tax basis calculations is sufficiently difficult and cumbersome that most consolidated groups fail to do it at all. The price for this is that there is usually a very time crunched calculation performed to model or calculate gain or loss when a group member becomes involved in a proposed transaction. When you take into account that many states have not decided whether to join GILTI or not, you are left with calculating three separate basis calculations for each group member – US federal tax, state tax, and US GAAP/IFRS – all potentially reflecting differences due to GILTI basis adjustments.

The Basis Adjustment Rules

Let’s take a look at the basis adjustment rules in detail. As noted above, the basis adjustments relate to the use of tested losses by the group. The Proposed Regulations provide a complex set of rules intended to prevent US consolidated groups from receiving dual benefits for a single tested loss that results if a domestic corporation benefiting from the tested losses of a tested loss CFC could also benefit from those same losses upon a direct or indirect taxable disposition of the tested loss CFC.

The rules apply to any domestic corporation – not including any Regulated Investment Company (“RIC”) or Real Estate Investment Trust (“REIT”) – that is a US shareholder of a CFC that has what the Regulations call a “net used tested loss amount”. The US group must reduce the adjusted outside tax basis of the member’s stock immediately before any disposition by the member’s “net used tested loss amount” with respect to the CFC that is attributable to such member’s stock. Please be further aware that if this basis reduction exceeds the adjusted outside tax basis in the stock immediately prior to the disposition then this excess is treated as gain from the sale of the stock and recognized in the year of the disposition.

The term “net used tested loss amount” is the excess of:

the aggregate of the member’s “used tested loss amount” with respect to the CFC for each US group inclusion year, over;
the aggregate of the member’s “offset tested income amount” with respect to the CFC for each US group inclusion year.

The amount of the used tested loss amount and the offset tested income amount vary depending on whether the member has net CFC tested income for the US group inclusion year.

For a very basic example, let’s take a US group member with two CFCs. In year one, CFC1 has a $100 tested loss that offsets $100 of tested income from CFC2. In year two, CFC1 has $20 of tested income that is offset by a $20 tested loss from CFC2. The rules tell us that the $100 used tested loss attributable to the CFC1 stock from year one is reduced by the $20 of CFC1’s tested income from year two that was used to offset CFC2’s tested loss. The result is a net used tested loss amount of $80 to CFC1 at the end of year two. If we changed the facts a bit and assumed that CFC1 and CFC2 were held by separate US consolidated tax group members you can see the true complexity emerge regarding outside tax basis determinations at both the CFC and consolidated group member levels.

The Proposed Regulations provide guidance for tracking and calculating the net used tested loss amount of separate CFCs when those CFCs are held through a chain of CFCs. In certain cases, a disposition of an upper-tier CFC may require downward basis adjustments with respect to multiple CFCs that are held directly or indirectly by the upper-tier CFC. Further, the Proposed Regulations provide guidance with respect to tracking and calculating the net used tested loss amount with respect to a US shareholder attributable to stock of a CFC when the CFC’s stock is transferred in a nonrecognition transaction or when the relevant CFC is a party to an IRC §381 transaction.

Conclusion

There is no need to detail any and all adjustments here because the regime is simply too complex to easily summarize. The point is that the outside basis calculation for CFCs and consolidated group members before GILTI has just become much more difficult and complex. Consolidated tax group contemplating current or future transaction activity are well advised to maintain these basis adjustments annually lest they be forced to perform these very difficult – yet meaningful – calculations in the crunch time of a transaction.

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

October 22, 2018 by Frank Vari, JD. MTax, CPA

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.

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

September 17, 2018 by Frank Vari, JD. MTax, CPA

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.

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.

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

July 14, 2018 by Frank Vari, JD. MTax, CPA

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.