Written by Max Reed and Charmaine Ko This blog post addresses a very technical question about the new US repatriation tax. It will only be of interest to US tax...
The newly passed US tax law (the Tax Cuts and Jobs Act (“TJCA”)) makes it much more complex for American citizens outside the United States to run a business. Specifically, there are two new complex tax regimes to consider: 1) the one-time mandatory repatriation tax and 2) the annual GILTI rules. The one-two punch of these two tax regimes may drive US citizens to renounce their citizenship. They are discussed below along with a brief discussion of renunciation.
1. The one-time mandatory repatriation tax
A key part of the new US tax law is the transition of the US corporate tax system from a worldwide model to a territorial model. Because of the current worldwide system, large companies like Apple have an incentive to keep profits offshore in foreign subsidiaries and not repatriate them to the US. Apple, for instance, currently has over USD $ 200 billion offshore that is deferred from US corporate taxation. To pay for the transition of the corporate tax system, TCJA imposes a tax on all such profits deferred from US tax since 1986 (the “one-time tax”). From a US federal corporate tax perspective, this makes sense. Apple will benefit significantly from the new corporate tax system, so it is logical to impose a one-time tax on deferred profits to pay for the transition to the new system.
Unfortunately, the “one-time tax” extends to US taxpayers beyond Apple and also includes US citizens who own foreign (i.e. non-American) corporations. Overly simplified, under the TJCA, the “one-time tax” is integrated into the existing controlled foreign corporation (CFC) regime. That means that a US citizen who owns 10% of a controlled foreign corporation is subject to it. While all the technical details of the “one-time tax” are complex (we have discussed them here and here) the simple version is that it taxes all profits of the CFC that have been previously deferred from personal tax since 1986. The one-time tax has two different tax rates – 15.5% for cash and investments and 8% for illiquid investments.
A simple example illustrates the severity of this tax. Dr. Jones is a US citizen in Canada who practices medicine through a Canadian corporation that she wholly owns. Her medical corporation has $ 1 million in investments that come from deferred profits. The “one-time tax” would cost her $155,000 (15.5% of her corporately owned investments that have been deferred from personal tax since 1986).
While renouncing does not negate the impact of the “one-time tax”, it does alleviate the burden of the GILTI regime (discussed next).
2. The GILTI regime
The second new US tax regime that makes life more complex for US expat business owners is the GILTI regime. GILTI is an acronym for “Global Intangible Low-Taxed Income”. As noted above, under the new US corporate tax system, US corporations like Apple are now generally only being taxed on the income of the US company itself, and dividends received from a foreign subsidiary are tax-free. To ensure that companies like Apple do not then try to shift all profits to foreign subsidiaries in a low tax country to then be repatriated tax-free, the GILTI regime was enacted. That’s a laudable goal as applied to Apple and other large multi-nationals, but as is often the case, US taxpayers living abroad are also caught up in these complicated and punitive rules.
While the mechanics of the GILTI regime are absurdly complex, put very simply it works as follows. Profits earned through a controlled foreign corporation (a technical term with a defined meaning) owned by a US taxpayer are judged to be GILTI or not GILTI. Overly simplified, profits are GILTI if they exceed a 10% return on depreciable tangible assets owned by the corporation. Many professional corporations don’t require a lot of tangible property (think equipment). For instance, a doctor who is a Canadian resident US citizen performing services through a Canadian corporation, often will not have much in the way of assets. The corporation’s tangible business assets may be limited to computers and some medical equipment, and the profits of the doctor’s corporation will be GILTI income to the extent they exceed 10% of its investment in these depreciable tangible assets. GILTI income is taxed to the US taxpayer personally even if it is not distributed to the US taxpayer personally. What’s worse is that the ability to use tax paid to Canada to offset the GILTI inclusion is limited.
Stepping back from the details, the outcome is problematic:
- Because the GILTI rules are so complicated, the annual accounting associated with determining whether profits are GILTI or not GILTI will be high.
- For US citizens who perform services through a foreign corporation the ability to defer income from personal tax will be quite limited.
- The limitation on the foreign tax credits creates a significant double tax risk.
To illustrate these consequences, let’s look at the case of Dr. Jones again. She uses a Canadian corporation to conduct her medical practice. She earns profits of CAD $500,000, but only takes a salary from the corporation of $100,000. Prior to the new US tax law, she was able to defer the remaining CAD $400,000 from personal tax until she needed the money. However, because she is a doctor working in a hospital her company’s tangible assets are limited to a laptop worth $3,000. Under the new GILTI rules, all profits earned by the company ($400,000) in excess of a 10% return on her laptop ($300) would be taxed to her personally in the US. The implication is that her ability to defer her medical income from personal tax would be significantly limited. That dramatically increases the amount of tax she pays annually from personal tax on $100,000 to personal tax on basically the full $500,000 she earns. Further, the complexity of the GILTI rules means that her annual US tax accounting bill will increase dramatically.
The end result is that Dr. Jones will be substantially worse off. If Dr. Jones attaches little value to her US citizenship, the one-two punch of the one-time tax and the GILTI rules may encourage her to look at renouncing her US citizenship.
3. Renouncing US citizenship
A full discussion of the pros and cons, as well as tax and immigration implications of renouncing US citizenship, can be found here. The rules on renunciation have largely not changed with US tax reform. The TJCA allows more people to renounce US citizenship without paying taxes. In order to renounce without tax exposure, a US citizen’s net worth has to be less than USD $ 2 million. It is now possible to make gifts of up to USD $11 million (up from USD $5.5 million under prior law) to reduce a US citizen’s net worth below the $2 million threshold. Thus, with proper advice, it should be possible for Dr. Jones to renounce her American citizenship without paying any taxes and without any border risk. If the practical and emotional value of the citizenship is less than the tax headaches caused by the “one-time tax” and the GILTI regime then that may be a wise decision.
In short, the new US tax rules made life far more complex and expensive for US citizens abroad who own foreign corporations. The one-two punch of the mandatory repatriation tax and the GILTI regime might drive US citizens who own businesses outside of the US to renounce US citizenship if they do not place a high value on the citizenship. Renunciation is a viable solution to these problems and with proper advice can be done with no tax or immigration consequences.