The 2017 Tax Bill (commonly referred to as the Tax Cuts and Jobs Act or TCJA) expands the scope of (and further complicates the application of) the CFC/Subpart F rules. As mentioned in my earlier blogs on the 2017 Tax Bill, the potential impact on non-US investors needs to be assessed. The impact does not stop there however. Far from it. Many US Person taxpayers face the prospect of sudden inclusion in a regime that previously did not implicate their holdings and consequent surges in taxable phantom income over the coming years. Moreover, their non-US investment partners may start asking them questions about their unrelated holdings for their own CFC/Subpart F purposes. In short, these are the sorts of changes that catch law-abiding taxpayers unawares until the IRS deficiency notice arrives bristling with interest and penalties.
First though, some light background music: The CFC/Subpart F rules, in simplified essence, oblige US Shareholders of Controlled Foreign Corporations (CFCs) to include in current taxable income relevant items of income earned by such CFC (so-called Subpart F income), even if not yet distributed to the US Shareholder via a dividend. The theory underlying this special treatment is that US Person taxpayers should not be permitted to defer the recognition of income by holding it through an off-shore corporation if such US Person taxpayers could compel the corporation to pay them a dividend, which would be taxable under the standard income taxation provisions of the Internal Revenue Code. Basically, you cannot defer taxation on income earned through a foreign corporation so long as it’s within your power to cause it be taxed. The core concept is relatively straightforward, but the rules rely on several specifically defined terms, the scopes of which determine inclusion or exclusion from the regime and any of which might present tricky analyses in certain taxpayer situations. Further, these definitions just acquired a few more wrinkles. This blog addresses four major modifications to key definitions, while leaving aside a host of more minor modifications.
Modification to a "US Shareholder"
Prior to the 2017 Tax Bill, the term, “US Shareholder” for Subpart F purposes generally covered any US Person owning 10% or more of a non-US corporation by vote of all classes of outstanding shares. The limitation to voting shares was logical as the aim of these rules was to capture US Persons with the authority to compel the non-US corporations to cough up a dividend. As such, the amount of holdings by value was, in theory, inconsequential. In addition to segregating those with real control from those with purely passive investment stakes, however, it tended to incentivise tax planning. No surprises there. Affected taxpayers sought to restructure their holdings of possible CFCs in order to reduce formal voting control below10%, while retaining actual control and full entitlement to economic benefits. For that reason, presumably, the 2017 Tax Bill adds US Persons owning 10% or more of a non-US corporation by value of all classes of outstanding shares to the definition of US Shareholder. As such, more lucky folks will qualify as US Shareholders of CFCs.
Modification to a "Controlled Foreign Corporation"
The term CFC generally covers any non-US corporations owned greater than 50% by vote or value – directly or indirectly – by US Shareholders. In calculating the percentages of ownership for this purpose, certain attribution rules per §318 apply. The CFC definition long required the application of the so-called upwards attribution rules. As a result shares owned indirectly by a US Person through an entity (of any type, including, corporations, partnerships, trusts or estates) would be treated as constructively owned by that US Person for purposes of this calculation. The 2017 Tax Bill adds downwards attribution to the possible additional sources of constructively owned shareholdings in a CFC.
What is this downwards attribution and how does it work? Well, if upwards attribution means that the holdings of an entity are attributable to its owners (e.g. shareholders, partners, beneficiaries, as the case may be), downwards attribution is the flipside of that: The holdings of one of an entity’s owners may be attributed to the entity itself. For example, in a sister company scenario, the presence of a US subsidiary alongside a non-US subsidiary, both wholly-owned by a non-US holding company, would now result in the downwards attribution of the holding company’s shares in the non-US subsidiary to the US subsidiary. As a result, the non-US subsidiary would qualify as a CFC and any US Shareholders (including US corporations) of the non-US holding company would start incurring potentially includible income if they previously hadn’t. Overall, many more non-US corporations will qualify as CFCs unless the IRS narrows the application of this rule (or suspends it, as it did per Revenue Notice 2018-13 for the Transition Tax rule described below).
As an aside to non-US investors: Due to these downwards attribution ownership rules, the holdings of US Person co-investors may affect your own investments because some of your US holdings may need to start paying more tax than previously as they now qualify as CFCs.
Modifications to includible income (two major modifications here)
Last but not least (actually, last and most of all), the 2017 Tax Bill expands the types of income earned by CFCs that must be treated as currently includible in the incomes of their US Shareholders. While not technically Subpart F income, the rules newly treat the following amounts as currently includible for US Shareholders of CFCs: Deferred foreign income corporation (DFIC) earnings and profits (E&P) and Global Intangible Low Tax Income (GILTI).
The Transition Tax
DFIC taxation per §965 (a/k/a the Transition Tax) is the levy on any post-1986 accumulated E&P of Specified Foreign Corporations that was not yet distributed or otherwise subject to US federal taxation (for further elaboration on this topic, please refer to my prior blog, The Trump Tax Bill: What it means in Switzerland (Part III)). Not all Specified Foreign Corporations are CFCs; it is a broader definition. However, all CFCs are Specified Foreign Corporations, meaning that all CFCs with positive and as-yet untaxed post-1986 accumulated E&P must pay the Transition Tax, which may be paid in installments over eight years. US Shareholders of CFCs with calendar year tax periods owe the Transition Tax starting for tax year 2017, which is thus evidently due by 17 April 2018. Presumably, therefore, in advance of this date, affected US Shareholders must calculate the total amount owed and commit to the installment plan. Somehow. To further complicate the matter, so far, the IRS has issued no forms or guidance on the process. A postponement to this particular deadline may seem inevitable, but even a laxer timetable will necessitate prompt action.
Whereas the Transition Tax is one-time levy on historical income irrespective of its derivation, GILTI under §951A, on the other hand, is an on-going tax on contemporaneous income flows derived from intangible assets. Its underlying objective is to disincentivize the stashing of IP and other intangible assets in low-taxed overseas subsidiaries. It aims to achieve this objective by compelling US Shareholders to include a portion of this income earned by CFCs in their current taxable income prior to the payment of any dividends. An in-depth explanation of the formula used to isolate the specific class of income targeted is beyond the scope of this blog. In essence, however, it taxes a certain amount of the net income earned by a CFC that is not otherwise taxable (e.g. as ECI, Subpart F income, etc.), but reduced by 10% of the adjusted costs bases of depreciable (but not amortizable) assets held by the CFC (an amount itself reduced by interest expenses). The low tax jurisdiction component is implicated by FTCs allowable for 80% of the taxes paid on the income by the CFC (subject to §904 bucket limitations). In short, if a CFC in a low tax jurisdiction is earning mainly non-passive income and holding mainly intangible assets, its US Shareholders are supposed to be handing a portion of that income over to the US fisc each year.