Tax Reform Series #4: Transition Tax on Offshore Earnings

The Tax Cuts and Jobs Act has proven to be more complex than it appears, and the international tax provisions are no exception. This week’s alert describes the transition tax that converts our tax system from worldwide taxation to a form of territorial taxation.

Background

Previously, corporations and individuals were taxed on their worldwide income. U.S. tax on foreign earnings could be deferred in many cases, although if the U.S. owners were individuals (whether direct owners of foreign corporations or through S corporations or partnerships), the cost of that deferral often outweighed the benefits.

If you think about the new rules for a moment, it becomes clear that for the sake of equity, the earnings on which U.S. income tax has been deferred should be taxed as part of the transition. That’s the subject of this alert.

The Transition Tax

The Act requires “U.S. owners” of “specified foreign corporations” to pay tax on their appropriate share of all foreign earnings accumulated after 1986 and before 2018. The tax for C corporations is at reduced rates of 15.5% and 8% (as compared to 17.5% and 9.1% for individuals); foreign tax credits may reduce the transition tax.

Below is a high-level view of how it works.

• First, “U.S. owners” are shareholders who own at least 10% of the foreign corporation’s shares.  These U.S. owners can be corporations or individuals, direct owners or indirect through chains of ownership.
• Second, “specified foreign corporations” are C corporations under U.S. tax law (regardless of their status under foreign law) that have at least one domestic corporation as a U.S. owner. It is not necessary that the foreign corporation have a majority of U.S. owners.

More of the Mechanics

To determine how much U.S. tax is due for a U.S. owner, one starts by determining accumulated earnings. While GAAP-based retained earnings are a rough equivalent, there are special tax accounting rules that apply. If the foreign corporation was acquired or mergers or other restructurings occurred, this creates more complexities.

In addition to determining the taxable earnings, C corporation owners must also calculate (and provide support for) foreign income taxes paid on those earnings. This task, especially finding the right documentation, is often the most difficult part of the project.

Having settled these two amounts, one needs to figure out how much of the earnings is taxed at each of the two tax rates. Accumulated earnings represented by cash and cash equivalents on the foreign corporation’s balance sheet are taxed at 15.5%. Any remaining earnings are taxed at 8% (or 17.5% and 9.1%, respectively for individuals). As mentioned, a portion of foreign taxes may offset the resulting U.S. tax but only for C corporation shareholders. Individual owners do not receive a foreign tax credit except for withholding taxes on actual distributions.

A Few Complexities
In addition to applying U.S. tax accounting rules and documenting past foreign tax payments (as many as 30 years’ worth), there is the definition of cash and equivalents for the 15.5% / 17.5% rates. If the U.S. owner has net operating losses, that owner can offset the one-time income with that loss; however, the benefit is only 15.5% or 8%, so the owner might be better off preserving the losses to use at a 21% future tax rate rather than at the lower transition tax rates. (Net operating loss benefits for individuals may be as high as 37%.)

To help ease the pain, Congress also allows U.S. owners to pay the transition tax in installments over eight years. For S corporation shareholders, there is a deferral mechanism that appears to allow nearly indefinite deferral of the transition tax.

The new “territorial” tax regime applies only to C corporations. Individual shareholders will continue to be taxed on their worldwide income.

What Do I Do?For the transition tax to apply, the threshold is 10% direct or indirect ownership in a foreign corporation. If you know or suspect you have an investment that meets this ownership test, we highly recommend you speak with your BMF tax advisor promptly. Assembling the information to determine your transition tax liability may be difficult and time consuming, and if you are a minority owner in a faraway company, you may have little or no influence over them.

We stand ready to assist you with this aspect of the Act, just as we are with all other changes. Contact us to discuss this and other provisions of the new Act.