Written by Max Reed Many US citizens in Canada want to be rid of their citizenship to avoid being subject to American tax rules. Let’s use an example. John is...
This blog post addresses a very technical question about the new US repatriation tax. It will only be of interest to US tax advisors. It is not meant as legal advice and cannot be relied upon as such. It involves complex US tax concepts so advice specific to the situation is required.
With the enactment of the Tax Cuts and Jobs Act, Code Section 965 imposes a “one-time tax” on US taxpayers that own controlled foreign corporations (“CFC”). The rules are very complex and the results can be quite punitive. What follows is our attempt to distill some of the key points of the application of Code section 965 to US citizens resident in Canada who own CFCs. The post is intended as a guide for tax advisors and so relies on some understanding of basic US tax terminology. It is not exhaustive and should not be relied on as a substitute for a detailed examination of Code section 965. Nevertheless, we provide our views on some of the key issues.
- The mandatory repatriation tax applies to individual US taxpayers who own CFCs. While the application of Code section 965 to individual US taxpayers is not self-evident or necessarily justifiable from a policy perspective, the law is clear that this is the correct interpretation. Put simply, Code section 965 applies to a “US Shareholder” of a CFC. The term “US Shareholder” is a term of art with a specific meaning. Under current law, a US Shareholder with respect to any foreign corporation, is defined as a United States person (so that would include individual US citizens, Greencard holders, US residents, US trusts etc) who owns, or is considered to own, 10% or more of the total vote or value of a foreign corporation. Code Section 965 applies to US Shareholders in deferred foreign income corporations (“DFIC”). A DFIC is then defined with respect to any US Shareholder, as any specified foreign corporation of the US Shareholder which has accumulated post-1986 deferred foreign income greater than zero. A specified foreign corporation is defined under Code section 965(e) to include any Controlled Foreign Corporation. Thus, the mandatory repatriation tax applies to individual US taxpayers who are US shareholders in a CFC.
- All post-1986 earnings and profits are included in income to the individual US shareholder as a new category of Subpart F income. The additional tax under section 965 is triggered by a one-time inclusion of the Post-1986 Deferred Foreign Income of the applicable corporation in its Subpart F income for the tax year. Put differently, the CFC’s post-1986 E & P becomes a new category of Subpart F income. The US Shareholder then includes this income in their pro-rata share of the corporation’s Subpart F income on their personal income tax return. The pro-rata share is calculated according to the existing Subpart F rules. Overly simplified, that means that if a US shareholder does not own 100% of the value of the CFC, they will not be subject to 100% of the income inclusion. Instead, it will be pro-rated according to the rules under Code section 951. The amount of the tax is more or less the post-1986 retained earnings. From a technical perspective, the term Post-1986 Deferred Foreign Income is defined in Code Section 965(d)(2) to mean the post-1986 earnings and profits, excluding that which is attributable to effectively connected income of a trade or business within the United States that was already subject to US tax, or that if distributed would be excluded from gross income of the US Shareholder under section 959 (i.e. income which had already been subject to Subpart F inclusion). Post-1986 earnings and profits are currently tracked on Schedule J of IRS Form 5471. Schedule J may thus be a short hand for calculating the amount of income that is subject to the 965 inclusion. Note that post-1986 E & P is calculated as of November 2, 2017 or December 31, 2017 — whichever is greater. In short, Section 965 creates a new category of Subpart F income that consists of all earnings and profits of a CFC after 1986, measured on November 2, 2017 or December 31, 2017 (whichever is greater). Note that dividends paid in 2017 do not reduce 2017 E & P because of an express limitation in Code section 965. Further, salary or bonus paid after November 2, 2017 would not reduce E & P either because post-1986 is measured as of the higher of November 2, 2017 or December 31, 2017 E & P amounts.
- The 965 inclusion tax applies to tax year 2017 for individuals. Code section 965 applies to tax years for CFCs that start prior to January 1, 2018. For individuals, this means that the tax applies in tax year 2017. Here is why. The general rule in Code section 898 suggests that CFCs owned by individual taxpayers should follow a 12/31 tax year end since that is the tax year of the majority shareholder (the individual US taxpayer). There is a proposed regulation from 1992 that suggests a different year-end may be possible if the CFC has no Subpart F income. To our knowledge, these regulations have not been finalized. Generally, the IRS’ position as expressed in the Internal Revenue Manual is that a taxpayer cannot rely on proposed regulations unless those regulations expressly state it. There is a line of cases to support the proposition that proposed regulations are not law and are not binding. Thus, the most correct position is that the tax applies to the 2017 tax year for individual US shareholders who own a CFC. One analysis suggests that the tax may actually be higher if triggered in tax year 2018 because the deduction may be calculated based on a 21% corporate tax rate rather than a 35% corporate tax rate. Taken together, our view is that the more correct and more beneficial position is to apply the tax to the 2017 tax year.
- The top tax rate is higher than 15.5% for individuals. While the mechanics of the calculation of the inclusion are complex, the result is a tax rate that may be higher than 15.5% for individuals. Overly simplified, the calculation works as follows. As discussed above, all post-1986 E & P is included as a new category of Subpart F income to the US Shareholder. Then a deduction is applied to a certain percentage of that inclusion. This deduction is meant to yield an effective tax rate of 15.5% for the portion of E & P attributed to cash and cash equivalents and a 8% corporate tax equivalent rate for other assets for a US shareholder which is a US corporation otherwise subject to an effective corporate tax rate or 35%. Individual taxpayers have a higher tax rate than corporate taxpayers so the net effect of the deduction will be less for them. For an individual in the top bracket of 39.6%, this translates to a tax rate of approximately 17.5% for cash and cash equivalents and approximately 9% for other assets. The calculation needs to be done for each taxpayer as it is specific to their individual tax bracket.
- The definition of cash assets is quite broad and includes more than just cash. The higher rate is applicable to assets including: i) cash; ii) the net accounts receivable of such corporation, and (iii) the fair market value of the following assets held by such corporation: (I) personal property which is of a type that is actively traded and for which there is an established financial market (“actively traded property”); (II) commercial paper, certificates of deposit, the securities of the Federal government and of any State or foreign government; (III) any foreign currency; (IV) any obligation with a term of less than one year; and (V) any asset which the Secretary identifies as being economically equivalent to any asset described in section 965(c)(3)(B).
- General basket foreign tax credit carryforwards (and carry backs) can be used to offset the 965 inclusion. The income generated by the Code section 965 inclusion is foreign source. For Subpart F income, the determination of what FTC basket it falls into is determined by the character of the underlying income. All income subject to the 965 inclusion should be active business income otherwise it would have been Subpart F and taxed in the year earned. Consequently, general basket foreign tax credits from the prior 10 years can be used to offset any tax generated by the Code section 965 inclusion. There is no grind down applied to these credit carry forwards so they should reduce the tax generated by the Code section 965 inclusion on a dollar for dollar basis.
- There is a significant double tax risk. Code section 965 imposes tax in the US to the US citizen shareholder in the 2017 tax year. If no Canadian tax is generated to fully offset the US tax, then the tax will be owing when the money is paid out in Canada at a later date. This represents a significant double tax risk.
- Any FTC generated by additional Canadian tax triggered to offset the 965 inclusion should not be ground down. Given the double tax exposure, most individual US taxpayers in Canada will want to generate sufficient Canadian tax in 2017 to fully offset the Code section 965 inclusion. For the reasons expressed here, we don’t think this is subject to a grind down. This means that the Code section 965 inclusion can be offset by a Canadian bonus or dividend paid out at the end of 2017 to eliminate the risk of double tax. Foreign tax credits can also be carried back a year so 2018 tax payable could be carried back against the 965 inclusion. The downside of carrying back FTCs would be that the client would owe the tax twice (once to the US in 2017 and once to Canada in 2018) and recovering from the IRS may prove administratively cumbersome. To be clear, if the 965 inclusion is fully covered off by the FTC carry forwards or carry backs no extra Canadian tax is required to be generated. Generating extra Canadian tax is only advisable if there are insufficient carry forwards.
- The 8-year extension is not that beneficial. The US tax on the Code section 965 inclusion can be spread out over 8 years. But this is of limited benefit where the taxpayer has a double tax risk since all FTCs would have to be generated in 2017. Under section 965(h)(6)(B), “the term ‘net income tax’ means the regular tax liability reduced by the credits allowed under subparts A, B, and D of part IV of subchapter A.” A foreign tax credit is allowed under section 901 which is found in section 27 in subpart B, therefore, the available FTC is already taken into account when calculating the net income tax liability in year 1. That means that any FTC to offset the 965 inclusion has to be paid out in tax year 2017. That somewhat defeats the purpose of spreading the tax out over 8 years and makes that option less attractive since the Canadian tax would have to be paid out in 2017 to avoid a double tax risk.
- It is unclear whether there will be future legislative changes that will improve the situation. What is clear, however, is that under current law the 965 inclusion is owed in tax year 2017 so waiting for future legislative relief carries a significant double tax risk.
- The NIIT may apply to equalization dividends. While dividends paid to equalize out the 965 inclusion are exempt from US tax under Code section 959 as previously taxed income, they are not exempt from NIIT. Reg s. 1.1411-10 states that even though the dividend is excluded from gross income under Chapter 1, it is included as a dividend for NIIT purposes if the income it relates to it was earned after 2013. Since the 965 inclusion applies to all income earned after 1986, not all of the dividend will be subject to NIIT. Tax advisors may wish to rely on the position that the NIIT does not apply to US citizens resident in Canada.
To recap, a reasonable approach to this may be:
- Inform individual CFC owners they have exposure probably for tax year 2017;
- Calculate the post-1986 earnings and profits based on Schedule J of Form 5471;
- Calculate the tax exposure by working through the formula as it applies to individual US citizens based on cash and non-cash assets keeping in mind the broad definition of cash assets;
- See if the tax exposure is fully offset by general basket foreign tax credit carry-forwards;
- If yes, the client is in the clear. If not, consider generating extra Canadian tax by paying a dividend or bonus effective 12/31/2017 to fully offset the US tax. Alternatively, extra Canadian tax could be paid out in 2018 and the FTC could be carried back to the 2017 tax year, but that would expose the taxpayer to temporary double tax and pose an administrative hurdle in trying to recover quite a large sum of money from the IRS.