The desire to expand markets and the lure of low foreign labor costs have thrust many small and midsized businesses into the global marketplace. Many now find themselves forming foreign subsidiary corporations, meaning they are navigating the same international tax issues once reserved for large publicly held companies. One of the most fundamental decisions to make early on is how the foreign entity will be treated for U.S. income tax purposes.
The check-the-box regulations simplify entity classification by allowing a taxpayer to choose to be treated as a corporation or transparent entity for U.S. tax purposes. The regulations permit "eligible entities" to choose among various business classifications. Both domestic and foreign entities may be eligible entities if they meet the requirements of the regulations. Specifically, a business entity that is not classified as a per se corporation in Regs. Sec. 301.7701-2(b) is considered an eligible entity under Regs. Sec. 301.7701-3(a).
Eligible entities failing to make an election will be classified under the default rules, which attempt to classify entities as they would most likely classify themselves if an election had been made. Under these rules, foreign eligible entities will be classified depending on whether the owners have unlimited liability. Under Regs. Sec. 301.7701-3(b)(2)(i)(B), a foreign eligible entity whose owner(s) all have limited liability will be considered a corporation. A single-owner foreign eligible entity with unlimited liability will be considered a disregarded entity under Regs. Sec. 301.7701-3(b)(2)(i)(C). A multimember foreign eligible entity that has at least one member with unlimited liability will be considered a foreign partnership under Regs. Sec. 301.7701-3(b)(2)(i)(A).
Due to legal liability concerns, many U.S. taxpayers will form limited liability eligible entities that have the default classification of a foreign corporation. A foreign eligible entity whose default classification is a corporation can elect to be treated for U.S. tax purposes as either a foreign disregarded entity (if it has one owner) or a foreign partnership (if it has more than one owner). If an entity makes a change in classification, it cannot make a subsequent change for five years. However, Regs. Sec. 301.7701-3(c)(1)(iv) provides that an election by a newly formed eligible entity is not considered a change, meaning that these entities could potentially change their classification within the first five years.
The ability to check or not check the box and choose the U.S. tax treatment of a foreign eligible entity provides U.S. taxpayers the powerful option of electing how to treat their foreign subsidiaries. Whether they check the box will affect both the timing and ultimate U.S. taxation of the foreign income.
Deferral and Timing of Income
In the domestic context, corporate subsidiary income is not imputed immediately to the parent corporation. Rather, the parent corporation is taxed when the subsidiary pays a dividend (except in the case of a consolidated group). The same rules apply to income earned in a foreign subsidiary treated as a foreign corporation; its income is normally deferred from U.S. taxation until it is repatriated (absent any Sec. 951(a) Subpart F income inclusions).
Choosing a tax structure that allows foreign-source income to be deferred from U.S. taxation can be advantageous because of the resulting time-value-of-money benefit. Accepting a foreign eligible entity's default classification has the effect of obtaining an interest-free loan in the amount of the U.S. tax that otherwise would have been paid on those foreign profits.
Deferring recognition of foreign income also allows taxpayers to control the timing of the repatriation and related income recognition. A taxpayer can achieve permanent tax savings if the income is repatriated in a year in which U.S. tax rates are lower than the year in which the foreign subsidiary earned the income. Certain taxpayers also may be able to time the income to maximize their foreign tax credit.
While U.S. taxpayers often choose to reinvest foreign profits in their overseas operation, some may want to bring back money to the United States on a more regular basis. This may be because there is not a current need to reinvest in foreign operations or because there is a greater need for the cash in the United States. Taxpayers who plan to repatriate profits in the near term will forfeit some of the deferral benefits, possibly making the choice to treat the foreign eligible entity as a corporation a less attractive option, especially considering the potential foreign tax credit limitations faced by certain taxpayers (this point is discussed later).
U.S. taxpayers are taxed on worldwide income, meaning owners of transparent foreign entities (disregarded entities and partnerships) are not able to control the amount or timing of U.S. tax on their foreign income. They pay U.S. tax when they earn the income, regardless of whether they repatriate the cash. Future repatriations will be considered a nonevent for U.S. tax purposes but may be considered a dividend from the perspective of the foreign jurisdiction. The requirement to immediately include any foreign income earned in their annual tax filings takes away some of the planning techniques available to U.S. taxpayers because they have no control over the recognition of income in the United States.
Rate Differential
Distributions from a foreign entity treated as a corporation likely are treated as dividends, which may be eligible for the preferential tax rate on qualified dividends. Individual owners (including those whose ownership is through flowthrough entities such as S corporations and partnerships) are eligible for this preferential rate.
Sec. 1(h)(11)(B) defines "qualified dividend income" as dividends received during the tax year from domestic corporations and qualified foreign corporations. "Qualified foreign corporations" include any foreign corporation that is eligible for the benefits of an income tax treaty with the United States that includes an exchange of information program (Sec. 1(h)(11)(C)(i)).
For years, taxpayers were unsure whether these preferential dividend rates would expire with the "fiscal cliff" at the end of 2012. Certainty came with the American Taxpayer Relief Act of 2012, P.L. 112-240, which increased the top tax rate on qualified dividend income by five percentage points (from 15% to 20%) but maintained the nearly 20-percentage point difference between the qualified dividend tax rate and the highest marginal tax rate for individuals (20% vs. 39.6%). This preferential tax rate is no longer threatened with repeal, creating a friendly tax planning landscape. The preferential dividend rate available to some taxpayers is an important benefit that favors treating certain foreign eligible entities as foreign corporations.
In contrast, treating a foreign eligible entity as a transparent entity means that the U.S. owner is considered to be earning the entity's income directly, and, therefore, the income is subject to U.S. tax at the owner's marginal rate. Currently, the highest marginal rates are 39.6% for individuals and 35% for corporations.
Use of Foreign Losses
Because U.S. persons are subject to tax on worldwide income, they are required to include foreign income earned in their calculation of taxable income. In the same way, foreign losses have the potential of decreasing U.S. income. This situation is fairly common—a profitable U.S. taxpayer may begin foreign operations and expect to incur startup losses as the related business gets up and running efficiently.
A U.S. taxpayer may prefer transparent entity treatment, at least initially, to realize the current tax savings that foreign losses can provide. However, the taxpayer must recapture the losses under the overall foreign loss (OFL) rules of Sec. 904(f). An OFL arises when foreign deductions exceed foreign-source income, making the excess loss available to offset U.S.-source income.
The OFL rules exist to prevent U.S. taxpayers from benefiting twice from the same foreign loss—by offsetting domestic income currently yet not adversely affecting the foreign tax credit in future years. Without a corrective provision, the impact over a multiyear period would be to lower U.S. taxation of U.S.-source net income. If a U.S. taxpayer has an OFL in one year and foreign income in a subsequent year, Sec. 904(f) generally re-sources subsequent foreign income to a U.S. source for purposes of the foreign tax credit limitation (to the extent of the aggregate overall foreign loss, until recaptured). Re-sourcing applies to 50% of foreign income or a greater percentage elected by the taxpayer.
In addition to the re-sourcing rule, if a taxpayer has an OFL, virtually all restructurings of its directly held foreign businesses' assets become taxable transactions that are then subject to the Sec. 904(f)(1) re-sourcing rule (at 100%) to the extent of the lesser of the realized gain and the remaining overall foreign loss (Sec. 904(f)(3)). This provision may preclude taxpayers subject to it from restructuring their foreign business operations, even for bona fide business reasons.
While the ability to offset foreign losses against domestic income may provide an immediate tax benefit, the OFL rules effectively make current use of the foreign loss essentially a timing benefit that must be "paid back" in the form of a potentially reduced foreign tax credit in the future. These re-sourcing rules may take some of the luster off of the perceived benefits of choosing transparent-entity status for a foreign eligible entity.
In addition, some U.S. taxpayers must be mindful of the dual-consolidated-loss (DCL) rules of Sec. 1503(d). These provisions generally prohibit domestic corporations from using DCLs to offset the income of other members of the corporation's affiliated group. A DCL is a net operating loss of a U.S. corporation that is also subject to residence-based taxation in a foreign country because the corporation is considered to be a resident in two jurisdictions (Sec. 1503(d)(2)(A)). Such a corporation is considered a dual-resident corporation. Losses incurred by branches of, or interests held by the corporation, also may be considered DCLs and therefore will not be available for use by the corporation to reduce its income for U.S. tax purposes. This will include transparent entities, such as foreign disregarded entities and foreign partnerships.
Generally, a U.S. taxpayer with a DCL cannot use the loss generated by the dual-resident company to offset income of another member of the U.S. group. However, a dual-resident corporation can be relieved of this restriction by making a domestic-use election—an election to forgo the use of the loss to offset income of another foreign taxpayer (Regs. Sec. 1.1503(d)-6(d)). If a dual-resident corporation makes a domestic-use election, its loss can be used to offset income of another member of the U.S. consolidated group. A taxpayer can only make the election if the taxpayer can certify that under no circumstances will the loss be used to offset income of another foreign entity during the subsequent five-year period. A DCL either can be taken to offset income of another U.S. taxpayer or to offset income of another foreign taxpayer—but not both.
These rules apply to domestic corporations but not to S corporations (Regs. Sec. 1.1503(d)-1(b)(1)) or to U.S. individuals or partnerships. As such, U.S. C corporations should consider these rules when deciding whether to check the box for an eligible foreign entity. These rules should not affect the decision for other taxpayers.
Foreign Tax Credit Regime
The foreign tax credit regime exists to prevent U.S. taxpayers from paying U.S. income tax on income that a foreign jurisdiction has already taxed. Under Sec. 901(b), U.S. citizens and domestic corporations may credit income taxes paid to foreign countries (subject to the limitations of Sec. 904(a)). Generally, a taxpayer may only claim a credit for foreign income tax it paid itself. However, Sec. 902 allows domestic corporations to claim a credit for taxes paid by an underlying foreign corporation, as if the U.S. taxpayer paid these taxes directly. U.S. shareholders claim this deemed-paid credit in the same year the undistributed income is taxed to them. To qualify for these indirect tax credits, the domestic corporation must meet certain requirements, including owning at least 10% of a foreign corporation's voting stock (Sec. 902(a)).
Small and midsize businesses are often organized as S corporations, partnerships (including limited liability companies treated as partnerships for tax purposes), and even as sole proprietorships. While these forms of business offer certain domestic tax benefits (namely, the avoidance of double-taxation inherent in C corporations), the mechanics of Sec. 902 provide an obstacle to maintaining a tax-efficient cross-border structure. The Sec. 902 credit applies only to "domestic corporations" and is not available to individuals, partnerships or their partners/members, or S corporations or their shareholders, even if all of the requirements are otherwise satisfied.
Electing to be treated as a foreign corporation allows the repatriated profits to be treated as dividends, potentially subject to favorable U.S. tax rates. This means that those persons are subject to U.S. tax on the dividends from their foreign subsidiaries but are not able to claim a foreign tax credit for the foreign taxes paid by a controlled foreign corporation, resulting in two layers of tax on that income. By making a check-the-box election, certain taxpayers effectively turn uncreditable Sec. 902 foreign taxes into creditable ones under Sec. 901. C corporations do not need to rely on this mechanism to generate foreign tax credits since Sec. 902 was designed specifically for their benefit.
The ability to claim a credit for foreign taxes paid or accrued allows U.S. taxpayers to avoid potential double-taxation on foreign earnings. Taxpayers not eligible for the Sec. 902 credit have the effect of paying a second level of tax on their foreign earnings (albeit often at a favorable dividend rate). Naturally, the greater amount of foreign taxes paid, the greater the potential tax inefficiency. In the same way, the lower the amount of foreign income taxes paid, the more efficient the tax structure becomes. Foreign corporations organized in low-tax jurisdictions can minimize the effect of Sec. 902's restrictions.
Reductions in corporate income tax rates in recent history have occurred across the globe, considerably reducing worldwide average tax rates. For example, the worldwide average income tax rate was approximately 30% in 2013. By 2015, the average rate had declined by a little more than 7 percentage points to 22.8% (Pomerleau, "Corporate Income Tax Rates around the World, 2015" (Tax Foundation, Oct. 1, 2015)). The largest absolute drop in average top marginal corporate tax rates was in Asia, an area of the world where many U.S. businesses are seeking to form subsidiaries. The average declined from 31% in 2003 to 20.6% in 2015.
The decline of these worldwide income tax rates lessens the potential indirect tax credit issue faced by certain U.S. taxpayers. This potentially makes a check-the-box election on foreign entities less attractive for individual, S corporation, and partnership owners. Lower foreign income taxes also leave more after-tax dollars available to take advantage of U.S. tax deferral.
Conclusion
Taxpayers continue to enjoy the ability to choose the U.S. income tax treatment of a foreign eligible entity. For many foreign limited liability entities, choosing to not accept the foreign eligible entity's default classification provides the opportunity to change the U.S. tax treatment of those foreign earnings. Taxpayers should weigh the benefits and detriments of making a check-the-box election for a foreign eligible entity. For some, the election can garner a current benefit from foreign losses and provide relief from the indirect foreign tax credit limitations. However, to achieve these benefits, taxpayers must forfeit U.S. tax deferral, and some may forgo the preferential rate available for certain foreign-source dividends. Taxpayers should make the decision of whether to check the box on a foreign eligible entity only after careful analysis of the various factors and in the context of the taxpayer's overall tax situation. Only after in-depth evaluation will taxpayers be able to make an informed decision on the most tax-efficient cross-border structure.
EditorNotes
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.
