With the increase of global economic expansion we are starting to see more and more United States individuals moving to other countries throughout the world. Due to this influx of Americans living and working for non-U.S. organizations outside the U.S., changes to the U.S. tax regime will inevitably impact these individuals and the way they are taxed. U.S. tax reform also impacts non-U.S. spouses of U.S. tax residents and/or the non-U.S. organizations they work for. Additionally, there are many individuals who find themselves as U.S. citizens in name only, as they may have been born in the U.S. or they may have parents where one or both are U.S. citizens.
U.S. Personal Income Tax Regime
The U.S. government is unlike most countries in the world in the way that it taxes its citizens and tax residents (green card holders). They are referred to as “U.S. persons.” This concept of worldwide taxation is a fundamental concept within U.S. tax law.
Regardless if a U.S. person lives and works outside of the U.S., they are required to file annual U.S. income tax returns and report their worldwide income on their annual returns. If the income is also subject to tax in the non-U.S. country it is sourced to, the U.S. person would be allowed to exclude the income (under certain circumstances), or claim a credit for the foreign taxes on the U.S. income tax return as a means to mitigate double taxation. One rationale for this system is that if the U.S. person lives and works in a tax country with a lower tax rate than the U.S., then under this global tax regime the U.S. person would have to pay the difference between their local tax obligation and the higher U.S. tax obligation to the U.S. government. They would not benefit from the reduced tax rate in the local jurisdiction.
Another motivation for requiring U.S. persons to file annual returns is to enable the U.S. government to collect information about the holdings of U.S. persons outside the U.S. The U.S. government likes to know and understand where U.S. persons have invested their money to ensure compliance with this worldwide basis of taxation. The U.S. government has implemented a series of U.S. International Informational Returns/Forms which under certain circumstances would require many U.S. persons (U.S. citizens, green card holders, and U.S. tax residents) to file the following informational returns.
Failure to file these informational returns would likely result in significant civil penalties and possible criminal penalties if the failure to file these forms is determined to be willful in nature. Even non-willful significant penalties could be assessed if there is a general disregard by the U.S. person to comply with the filing requirements associated with these informational returns/forms.
Leading up to tax reform there was a lot of talk about the U.S. moving to more of a territorial system in the way that the U.S. taxes their citizens and other U.S. persons. However, in looking at the details of the tax reform bill signed into law by President Trump, it is clear that the U.S. did not make this move to a territorial system with respect to individuals and will continue to tax U.S. persons as it has in the past with the exception of a few changes which we will discuss.
Tax Reform Changes to the U.S. Personal Income Tax Regime
The Tax Cuts and Jobs Act was signed into law by President Trump on December 22, 2017. One of the underlying objectives of U.S. tax reform was to make it simpler for individuals to file their U.S. tax returns, and in quite a few cases the changes accomplish that.
Revamping of U.S. Taxation of Foreign Corporations Controlled by U.S. Persons
Before the latest U.S. tax reform was enacted, the U.S. government generally taxed U.S. persons based on a worldwide tax system. Under the worldwide tax system, U.S. corporations have been subject to tax on their worldwide income at marginal tax rates with a top rate of 35 percent however, they were allowed to defer the taxation of income earned by any foreign corporate subsidiaries until the income was sent back to the U.S. in the form of dividends. With the implementation of the new tax reform bill, the U.S. is moving to a modified territorial system.
The U.S. move to a modified territorial tax regime begins January 1, 2018. Under the modified territorial system, U.S. corporations who own a foreign corporation(s) that receive dividend income from their foreign corporate subsidiaries would be eligible for a 100 percent dividend received deduction against that dividend inclusion. Thus, foreign dividends received by a U.S. corporate shareholder of a foreign corporation would not be subject to U.S. taxation on those repatriated amounts.
It is important to note that this dividend received deduction generally does not apply to U.S. persons (citizens and tax residents) who are individuals or pass-through entities. Thus, dividends from foreign corporations which are received by U.S. individual shareholders will still be included in their taxable income on their U.S. tax return and they will not receive a dividend received deduction.
Repatriation Tax or Toll Charge
As a transition to a territorial tax system, the U.S. government is implementing a one-time deemed distribution of any foreign corporation’s post-1986 accumulated earnings and profits which have not been taxed in the U.S. This deemed distribution is treated as a special type of income (deferred subpart F passive income). This categorization of income is generally considered to be outside of the income typically considered in the multi-lateral income tax treaties that the U.S. has with various countries. In the recent tax reform legislation, the provision that includes this mandatory deemed repatriation, and resulting tax, is known as the “repatriation tax” or “toll charge” and applies U.S. income tax to a foreign corporation’s accumulated earnings and profits where applicable.
This repatriation tax is applicable when the foreign corporation is considered to be a controlled foreign corporation (defined as a non-U.S. corporation with more than 50 percent ownership by U.S. persons) or in the case where a U.S. domestic corporation owns at least 10 percent of a foreign corporation. It is important to note that this income inclusion is applicable for all types of U.S. shareholders, including individuals, corporations, partnership, LLCs, or even trusts. Due to the unique characterization of this deemed repatriation income under U.S. tax law, there are limited options to avoid the effects of this legislation on U.S. shareholders that meet the stipulations in the law and are subject to this “repatriation tax” or “toll charge” due to the fact that multilateral tax treaties do not address this type of income. Additionally, most U.S. tax treaties include a savings clause that allows the U.S. to assess tax on its residents and nationals as though the treaty were not in effect so for U.S. residents (green card holders) and nationals (citizens) there are few remedies to mitigate the effect of this tax.
This income inclusion and resulting tax applies to tax years of deferred foreign income corporations which began before January 1, 2018. Thus, for a foreign corporation with a calendar year end of December 31, 2017, this repatriation tax would apply to that tax year.
As part of this transition to the territorial system, U.S. shareholders are allowed a deduction to offset the deemed repatriation income inclusion. This calculation is very complicated but works to bring the effective tax rate on the income inclusion to an amount between 15.5 percent and 8 percent. Individuals are also eligible for this deduction; however, the effective tax rate may be different, as the resulting income is taxed at a shareholder’s U.S. marginal tax rate and U.S. individuals are generally taxed at higher marginal tax rates relative to corporate entities.
Any shareholder for which this repatriation tax or toll charge applies may make an election to pay the tax liability which results from the income inclusion in installments annually. The installment payments are structured as follows:
If an election is made, the first installment must be paid on the due date of the U.S. tax return without regard to filing extensions.
Certain acceleration events may trigger immediate payment of any future unpaid installments. These acceleration events include a failure to timely pay an installment; liquidation or sale (including by reason of bankruptcy) of substantially all of the U.S. shareholder’s assets; or stoppage of the U.S. shareholder’s business.
Before tax reform was finalized, there was some anticipation by U.S. persons living overseas that the U.S. government may move to a territorial tax regime for both personal and corporate taxes. However, as outlined in this article regarding the U.S. tax reform, U.S. persons living overseas are impacted by tax reform at a personal tax level, but individuals continue to be taxed on a worldwide basis. The change from a worldwide tax basis to a territorial tax basis is confined solely to U.S. corporations with foreign subsidiaries. The tax provisions that tax foreign corporate earnings related to U.S. individuals and flow through entities continue in effect.
The repatriation tax is a very complicated calculation due to the circular nature of the deduction referenced above. In the event that this new U.S. tax provision applies to U.S. persons outside the U.S., assistance will need to be secured to appropriately calculate and report any repatriation tax or toll charge that would apply.
Tax reform’s impact is far reaching.
This article was first translated into Dutch and published in Over de Gren a business publication in the Netherlands.