The TCJA: Double taxation for US citizens living abroad

Editor: Mark Heroux, J.D.

At the end of 2017, the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, drastically changed the international tax landscape. One of the more substantial provisions was the addition of Sec. 965, in which U.S. shareholders of controlled foreign corporations (CFCs) are required to pay a transition tax on a CFC’s untaxed foreign earnings as if those foreign earnings had been repatriated to the United States. For most U.S. shareholders, the Sec. 965 liability is determined and paid in whole or ratably over eight years at an 8% or 15.5% rate equivalent on their pro rata share of the CFC’s deferred earnings.

Sec. 965 accelerated the tax payment on deferred foreign earnings, which would have otherwise been taxed upon the issuance of an actual dividend or as a result of a possible gain on a sale or liquidation. U.S. domestic corporations can use direct and indirect foreign tax credits from the current year, or carried forward from the last 10 years, to reduce their Sec. 965 tax liability. Individuals, who are not afforded the benefit of using indirect foreign tax credits, are unable to reduce their Sec. 965 liability with foreign taxes generated at the foreign company level.

Despite the accelerated payment and lack of indirect tax credits, for some U.S. individual shareholders resident only in the United States, Sec. 965 proved beneficial as the transition tax owed is at a reduced tax rate. Without this reduced tax rate, U.S. individual shareholders would either be subject to a capital gains tax of up to 20% or an ordinary income tax of up to 37% on those foreign earnings.

A potential issue arises, however, when those U.S. individual shareholders are also considered tax residents in foreign jurisdictions.

Example: A, a U.S. citizen, is a German tax resident for German income tax purposes and directly owns 100% of a German corporation (German CFC). A’s historical basis in German CFC is $1 million. For purposes of the Sec. 965 calculation in 2017, German CFC has $10 million of untaxed foreign earnings and profits. If German CFC has no cash or cash equivalents, A pays $800,000 ($10 million × 8%) of Sec. 965 tax liability for the 2017 tax year. Assume there are no changes in U.S. or German tax law before 2031. In 2030, A as a German tax resident sells German CFC for $11 million.

For U.S. federal income tax purposes, A will receive a U.S. tax basis step-up equal to the Sec. 965 inclusion in 2017, resulting in a total U.S. tax basis of $11 million. Assuming German CFC has no positive earnings and profits between 2017 and 2030 and no transactions occur between A and German CFC within this time period, A recognizes no gain in the United States on the sale of the German CFC in 2030. If A was resident only in the United States, the calculation would end here, as the gain on the sale of personal property is sourced based on the individual’s residency and should not be subject to German tax under the United States-Germany Income Tax Treaty. In the example, however, A is considered a German tax resident and therefore is subject to tax in Germany on the gain from the sale of German CFC.

For German income tax purposes, A will not receive a German tax basis step-up for the Sec. 965 tax paid on German CFC’s foreign earnings because the German tax authorities will not recognize the unrealized taxable U.S. transaction and, as a result, will not allow a foreign tax credit on A’s German income tax return for the $800,000 of Sec. 965 transaction taxes paid. Furthermore, under Article 23(5) of the treaty, the German tax authorities will only allow a foreign tax credit for U.S. taxes paid by U.S. nonresident aliens in connection with U.S. taxable income. In 2030, when A’s German CFC is sold, her $10 million capital gain should be subject to a German income tax rate of approximately 28.5%.

The German income taxes paid in connection with the sale of German CFC can be used on the 2030 U.S. federal income tax return. However, because the sale of German CFC results in no capital gain for U.S. federal income tax purposes, A will not have any foreign-source income available to use the German income taxes paid as a foreign tax credit. As a result, A effectively paid tax twice on the same foreign earnings — once in the United States due to Sec. 965 and a second time on the actual sale in Germany — without an ability to offset either taxable event with foreign tax credits.

Potential planning options available to US citizens resident abroad

For a U.S. individual shareholder of a CFC with a fiscal year ending in 2018 and a 2018 Sec. 965 tax liability, there is still an opportunity for foreign tax credit planning. For U.S. federal tax purposes, foreign tax credits can be carried back one year; therefore, any foreign taxes generated in 2019 on an actual dividend or sale/liquidation of a foreign CFC can be carried back to 2018 to reduce the Sec. 965 tax liability. For most calendar-year taxpayers with facts similar to the example, this type of planning is no longer practical due to Sec. 965 generating a tax liability in 2017 and the one-year limitation on carryback of foreign taxes.

Another option available to a taxpayer is to invoke competent authority, as provided in the treaty, in the year of German CFC’s sale in order to resolve the dispute (i.e., double taxation) by mutual agreement between the United States and Germany. The competent authority procedure is available to taxpayers with cross-border disputes under the treaty. While the authors cannot ascertain how a competent authority would rule on the example, there is potential it could provide relief in recognizing that a double taxation event has occurred. It is important to note that a competent authority is not required to review every request it receives, and going this route can also be expensive for most taxpayers.

For U.S. taxpayers unable to utilize a carryback of foreign tax credits and who would not view competent authority as a plausible option, there still remains a planning opportunity to avoid double taxation.

Under U.S. tax law, individuals have the option to make a Sec. 962 election to be subject to tax at corporate rates for any given tax year. Sec. 962 was enacted to ensure an individual taxpayer is not subject to a higher rate on earnings of directly owned foreign corporations than if the taxpayer owned the foreign corporation through a U.S. corporation. Additionally, an individual who makes a Sec. 962 election is allowed to credit indirect foreign taxes as if the individual were a domestic corporation. Sec. 962 is elected on an annual basis and is made by filing a statement with the individual’s U.S. federal Form 1040, U.S. Individual Income Tax Return, in the year of the election.

For a U.S. individual with direct ownership in a CFC located in a foreign jurisdiction with a tax rate higher than the U.S. rate, a Sec. 962 election could prove beneficial, as the U.S. individual is allowed to credit indirect foreign taxes against his or her foreign-source income. A Sec. 962 election made in the year of the Sec. 965 inclusion will allow the U.S. individual to use foreign taxes to potentially reduce the Sec. 965 liability to zero.

While it is clear a Sec. 962 election can be made with a timely filed original return, Sec. 962 and the current Sec. 962 Treasury regulations do not specifically address the ability to amend a U.S. federal Form 1040 to make a valid election. Before the TCJA, the former Sec. 962 Treasury regulations included language in which a Sec. 962 election could be made for certain tax years falling before the publication of the Treasury regulations “with his return or any amended return.” The current Sec. 962 Treasury regulations, however, merely contain the language of a valid election occurring “with his return.” While this change may give rise to concerns regarding the ability to make an election with an amended return, the IRS stated previously that a Sec. 962 election on an amended return would be valid under some circumstances, but it did not elaborate on the circumstances that would qualify.

Assuming U.S. taxpayers can make a valid Sec. 962 election with an amended return, the deadline to amend an individual return by filing a U.S. federal Form 1040X, Amended U.S. Individual Income Tax Return, is three years from the date the original tax return was filed, or within two years of the date of payment of the tax, whichever is later. In making the retroactive Sec. 962 election in the same year the Sec. 965 transition tax was calculated, a U.S. individual shareholder may owe less U.S. tax because of the ability to offset the additional income with indirect foreign tax credits. However, a U.S. individual shareholder will not receive a tax basis step-up in the entity for the amount of foreign income offset with an indirect foreign tax credit. Any subsequent dividends paid by the CFC or any capital gain on the sale or liquidation of the CFC will be taxed to the U.S. individual shareholders at regular tax rates.

In the example, A would amend her 2017 U.S. federal income tax return to make a valid Sec. 962 election. Assuming German CFC has previously paid German taxes at a rate of 25% on its earnings and profits, A could use a foreign tax credit in 2017, potentially reducing her Sec. 965 liability to zero. In 2030, when A sells German CFC, she will pay German tax on the capital gain at approximately 28.5%. A will also be subject to tax on the German CFC gain at U.S. capital gains tax rates but will be able to offset the direct foreign tax credits against the U.S. capital gains tax.

Further considerations should be taken into account when making a Sec. 962 election (e.g., the ability to receive capital gains treatment, global intangible low-taxed income, unearned income Medicare contributions, the rate of tax paid in the foreign country, and the length of time the individuals anticipate holding their investment, etc.). These issues will need to be considered and integrated into a working model, but an amended Sec. 962 election to offset the Sec. 965 transition tax could prove beneficial in reducing the impact of double taxation for U.S. individual shareholders resident in foreign jurisdictions.

EditorNotes

Mark Heroux, J.D., is a principal with the Specialty Tax Services Group at Baker Tilly Virchow Krause LLP.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.