Article prepared by Tax Partner Fuad Saba and Tax Director Scott Simpson.
On October 31, 2018, the United States Department of the Treasury and the Internal Revenue Service released proposed regulations relating to one type of “deemed distribution” from a controlled foreign corporation (“CFC”). These proposed regulations explain how domestic C-Corporations that are “U.S. Shareholders” of a CFC can reduce their deemed income inclusions from the CFC’s “investment in U.S. property” to the extent that such amounts would not be included in the taxable income of the C-Corporation if paid as an actual dividend eligible for the new 100% foreign dividends received deduction.
Prior to TCJA, the taxation of earnings of CFCs generally was deferred until the earnings were repatriated as actual dividends to the United States. Exceptions to this general rule were codified in the Internal Revenue Code in 1962 to ensure that earnings of a CFC would be taxed in the U.S., including (but not only) when a CFC either made an “investment in U.S. property” or earned “Subpart F” income. An “investment in U.S. property” includes ownership of: tangible property located in the U.S.; stock of a domestic corporation; an obligation of a U.S. person; and rights to use intangible property in the U.S. A “U.S. Shareholder” is a U.S. “person” (including most legal entities) that owns 10% or more, by vote or value, of a CFC, and a CFC is a foreign corporation that is more than 50% owned by one or more U.S. Shareholders. If a CFC makes an “investment in U.S. property”, and to the extent that the CFC possessed non-previously-taxed, current or accumulated “earnings & profits,” deferral of U.S. tax on such earnings would be terminated and U.S. tax would be imposed on the U.S. Shareholder, although foreign tax credits could be available to C-Corporation U.S. Shareholders to reduce or avoid double taxation. When appropriate, C-Corporations had the potential ability to trigger Subpart F inclusions, or “investment in U.S. property” inclusions, recognize foreign tax credits in the “general basket,” and lower or eliminate the residual U.S. tax on such inclusions. CFC Income “affirmatively” taxed this way would become “previously taxed income” and thus available for low-tax or tax-free repatriation to the United States.
Note that individual taxpayers who are U.S. Shareholders of a CFC, whether directly or through a pass-through entity such as a partnership or an S-Corporation, are ineligible for the new foreign dividends received deduction and normally cannot claim foreign tax credits against their CFC income. This means that, without tax planning, such individuals will pay federal income tax on any deemed dividends at a rate up to 37%, plus state income tax, if applicable, regardless of the amount of income tax paid by the CFC on its income. The individual now must fund a significant tax liability, although the CFC might not have distributed any profits to the individual. It should be noted that actual dividends, if received as Qualified Dividend Income (“QDI”), would be subject to a maximum federal income tax rate of 20%, plus state tax, and net investment income tax if applicable. However, QDI is available only from entities in countries with which the United States has an income tax treaty and an exchange-of-information agreement in place.
A potential avenue of relief for individual taxpayers with respect to the deemed distribution from the CFC is an annual election to pay tax on the deemed income as if the taxpayer was a corporation. This election is typically economically preferable only if the foreign earnings were subject to a relatively high foreign income tax rate.
Under the TCJA, and before the new proposed regulations were issued, a CFC’s “earnings & profits” could have been taxed in the U.S. in 2018 or later as “investments in U.S. property”, even though they would have escaped tax in the U.S. if they had been received by a C-Corporation as an actual dividend under the new dividend received deduction. Therefore, the new proposed regulations restore a certain degree of symmetry between the taxation of actual and deemed dividends after tax reform – but only for C-Corporations.
In the post-tax reform world, even after the changes brought about by the new proposed regulations, the earnings of a CFC may still be taxable on a “deemed repatriated” basis under the new GILTI tax (see FGMK’s November 7, 2018 newsletter) or under the Subpart F regime. In each case, C-Corporation U.S. Shareholders may be able to offset the U.S. tax with foreign tax credits. However, the GILTI regime has its own foreign tax credit basket, under which excess GILTI foreign tax credits cannot be carried forward or back, and credits associated with GILTI income cannot be applied against U.S. tax on other forms of foreign source income. Thus, depending on a taxpayer’s tax situation, a Subpart F inclusion could be preferential to a GILTI inclusion in terms of the foreign tax credit outcome but deemed income inclusions from investments in U.S. property are no longer an option for managing foreign tax credits because GILTI takes precedence over such inclusions.
If you have additional inquiries about this article, or any cross-border tax matters, please contact FGMK.
Scott Simpson firstname.lastname@example.org or Fuad Saba email@example.com.