COVID has brought the world closer together and companies are exploring global expansions now more than ever. Understanding how foreign subsidiaries, acquisitions, and investments impact your company’s tax burden is an important part of making these decisions. We’re working with several clients to establish or acquire overseas subsidiaries, and here’s what we’re discussing around foreign tax planning and compliance.
US TAX OPTIONS FOR OVERSEAS OPERATIONS
Whether for increased revenue potential, cost savings, or access to new talent, many businesses are interested in expanding overseas, but understanding and navigating the tax implications can be overwhelming.
When it comes to the tax structure of foreign operations, there are a few different structures available. The foreign subsidiary can be taxed separately from the U.S. company, typically as a Controlled Foreign Corporation (CFC). This is a separate legal entity set up in the foreign country. Historically this arrangement allowed foreign income to be deferred for US tax purposes until the money was brought back to the US. It should be noted, however, that subsequent to tax law changes made in 2017, it presently is more difficult to qualify for U.S. tax deferral, and a substantial amount of CFC income now may be taxed currently to the U.S. owners (see GILTI discussion below). The tax form to have on your radar for this type of arrangement is Form 5471.
Alternatively, operations can run through a foreign branch/disregarded entity and taxed together with the U.S. company as one combined group. This scenario involves the US company registering in the foreign country without creating a new legal entity. The relevant tax form for this scenario is Form 8858. Pass-through treatment also may be accomplished in the case of a jointly owned foreign legal entity that is classified as a partnership under US tax rules. In the case of a Controlled Foreign Partnership (CFP), the relevant tax form is Form 8865. Please note the IRS routinely imposes substantial penalties for failure to file these and other international tax forms.
GILTI TAX FOR CONTROLLED FOREIGN CORPORATIONS
The Tax Cuts and Jobs Act (TCJA) of 2017 dramatically changed the foreign tax landscape. The introduction of the global intangible low-taxed income (GILTI) tax aimed to tax current profits earned offshore at a minimum of 10.5%. For income earned through a CFC, GILTI is taxed at the corporate tax rate, but receives a 50% Section 250 deduction, bringing the effective tax rate down to 10.5%. However, if the US owner of a CFC is not a C-Corporation, the GILTI is generally taxed at ordinary income tax rates, and no 50% deduction is generally permitted. The foreign tax credit is available but is limited to 80% of the foreign taxes related to GILTI. The excess foreign tax credits cannot be carried back or forward. GILTI can be avoided completely under the high tax exception if the foreign tax rate is over 90% of the US corporate rate (18.9% currently). This high tax exception can be applied on an amended return in case you missed it.
When calculating GILTI, it’s important to remember the first 10% return on tangible assets is not subject to GILTI. This calculation is done using the qualified business asset investment (QBAI) base. There is also a Section 78 gross up that comes into play when calculating your Section 250 GILTI deduction. This is for the foreign taxes that were deemed to have been paid by the US corporation. When calculating your Section 250 deduction, Form 8993 will come into play.
FOREIGN BRANCHES AND THE FOREIGN-DERIVED INTANGIBLE INCOME DEDUCTION
Foreign branch income is taxed directly on the US return. This can be beneficial when foreign losses offset US net income. However, this leads to higher taxes when profits are being earned through the foreign branch. The relatively low GILTI tax rate of 10.5% should be compared to the 21% US corporate tax rate paid on foreign branch income when analyzing the best structure for your organization.
Foreign branch income is not eligible for the foreign-derived intangible income (FDII) deduction. This deduction (also under Section 250) is 37.5% of foreign earned income through US operations, bringing the net effective tax rate down to 13.125%. This results in a US corporation being taxed at 13.125% for foreign income earned through its US operations and 21% for income earned through its foreign branch. Companies should revisit if a foreign branch makes sense. US taxpayers with a foreign branch should analyze if profits can be shifted to the US operations to qualify for the FDII deduction. Taxpayers are required to allocate expenses of the US company to the foreign branch when calculating the FDII deduction.
In certain cases, the foreign branch taxes paid can be claimed as a US tax credit to avoid double taxation. When the foreign tax rate exceeds the US corporate rate, the likely result is $0 of additional US tax. Unlike GILTI, there is no 80% foreign tax credit (FTC) limitation on foreign branch income. Also, unused FTCs for foreign branches can be carried back one year or forward ten years. However, there are basket rules which separate the foreign branch income from other types of foreign income for foreign tax credit purposes. Form 1118 is used by C-corporations to compute the foreign tax credits.
SUBPART F INCOME
CFCs should continue to review the subpart F income regime, although it has become less relevant since GILTI came into existence. Subpart F income is typically “movable” income. This includes passive income such as dividends, interest, rents, and royalties. It can also include sales of tangible goods to end users outside the CFC’s country and services provided by persons located outside of the CFC’s country. Subpart F income is outside the scope of this article, but careful attention should be paid to the foreign tax credit rules. Foreign tax credits with respect to Subpart F income are not limited to 80% and are eligible to be carried back one year or forward ten years.
SECTION 962 ELECTIONS
This article focuses on US C-Corporations, but we work with many passthrough entities including S-Corporation and partnerships. The ability to make a Section 962 election can provide tax savings to the individual shareholder or partner. This election allows the taxpayer to be taxed as if they were a C-Corporation. This avoids the top individual tax rate of 37% from kicking in and offers the ability to take the Section 250 deduction.
For a S-Corp shareholder who is passed out $100 of GILTI and $10 of foreign taxes, the following example shows the net effect. Without a Section 962 election, the US taxpayer will pay an additional $33.3 (37%*($100-$10)) of US tax, bringing the global tax to $43.30.
With a 962 election, the individual has US tax of $11 (21%*($100-$50)) and a foreign tax credit of $8 ($10*80%). The global tax in this case is $13. When making a 962 election, the US taxpayer will be subject to tax when the GILTI is eventually distributed. Assuming a 20% qualified dividend rate, the additional US tax will be $17.4 (20%*($100-$13)). This part of the tax is deferred until the money is received and still only brings the global tax to $30.4 compared to $43.3 without the election.
Whether you are considering a future expansion and want to understand the potential tax implications or currently operate overseas and want to ensure you are taking advantage of the best options available to you, we can help. Contact us today.