Due to the shift in U.S. taxation of business income resulting from the recent U.S. tax reform efforts, the factors considered when determining the most tax-efficient structure for U.S.-based cross-border operations have changed dramatically. The tax reform bill has created a new playing field that compels business owners to take a fresh look at their cross-border arrangements, in order to determine whether they are in the most tax-efficient structure.
Some of the key new tax provisions that this new playing field is comprised of include the following:
- Implementation of a permanent, flat corporate tax rate of 21%
- Full expensing of machinery and equipment acquisitions
- 20% deduction for owners that generate qualified domestic business income through a pass through entity (i.e., sole proprietorship, LLC, partnership or S Corporation.
- Implementation of a quasi-territorial tax system which effectively exempts corporate tax on earnings distributed from foreign subsidiaries other than U.S. income inclusions related to (i) subpart F and (ii) global intangible low-taxed income (GILTI). NOTE: This tax exemption does not apply to U.S. individual shareholders of foreign companies
- Repeal of foreign tax credits for foreign taxes paid with respect to exempt dividends
- Toll charge when converting a directly held foreign branch to a foreign corporate subsidiary
- A controlled foreign corporation must now include in gross income its share of the CFC’s global intangible low-taxed income (“GILTI”), similar to inclusions of subpart F income. The calculation of GILTI involves a complicated formula and is beyond the scope of this article, however, GILTI generally refers to residual income of a CFC in excess of a fixed 10 percent return on tangible assets. GILTI income is subject to U.S. tax at an effective rate of 10.5 percent after applying a 50 percent deduction. The tax may be offset by up to 80 percent of foreign tax credits. U.S. individuals that own a CFC directly or via a U.S. pass through entity will be subject to full U.S. tax rates on GILTI amounts
- Foreign-Derived Intangible Income (FDII) represents income of U.S. corporations derived from marketing products and services outside the U.S. Again, the calculation of FDII involves a complicated formula and is beyond the scope of this article, however, the effective tax rate on FDII is 13.125 percent. It should be noted that U.S. individuals and non-corporate entities with foreign derived intangible income will be subject to full U.S. tax rates on such income
As a result of the interplay of the new provisions, there is now little tax difference at the U.S. entity level between using a U.S. corporation and a pass through entity to hold foreign operating subsidiaries that earn tangible income. Neither type of entity will be subject to U.S. tax on dividends from foreign subsidiaries (other than subpart F and GILTI inclusions).
At the U.S. individual taxpayer level, however, the tax differences may be significant. For example, owners of U.S. pass through entities are now subject to a top marginal rate of 40.8 percent, including the 3.8 Medicare surtax, on foreign-source pass through income earned directly or indirectly via dividends from nontax- treaty foreign subsidiaries. Individual corporate shareholders, meanwhile, pay a top rate of 23.8 percent on dividends from a U.S. company that generates foreign-source income directly or indirectly. In other words, using a U.S. corporate entity to hold foreign operating subsidiaries can result in a tax savings in some circumstances.
The benefit of using a U.S. corporation may even be greater if the business generates foreign source intangible income (i.e., income that is not derived through exploitation of depreciable business assets). Such intangible income benefits from reduced rates (10.5% via the GILTI regime and 13.125 via the FDII regime). In contrast, U.S. individuals generating GILTI through a CFC (directly or via a U.S. pass through entity) are subject to ordinary tax rates as high as 37 percent, not including the 3.8 Medicare surtax. Similarly, U.S. individuals are subject to the highest ordinary tax rates on any income derived via sales from a U.S. pass through entity.
Ultimately, U.S. business owners that receive income from foreign subsidiaries via a U.S. pass through structure may find that using a U.S. corporation could reduce their overall tax burden. In some cases, a Section 962 election, which allows individuals to be taxed as a corporation for tax purposes, may provide some relief by permitting the individual to be taxed at corporate rates on foreign income, as well as allowing an individual to claim foreign tax credits Since U.S.-based businesses doing business abroad come in a range of sizes and have different combinations of domestic- and foreign source income, we recommended having a discussion with our international tax specialists in order to perform detailed analyses and modeling to determine whether a corporate or pass through structure (or a combination of both) is the most tax-efficient form.