International Tax Corner: Edition 7

The International Tax Corner: Edition 7

Why does the US Tax Code Punish Foreign Investment?

Since 1962, the US made it difficult for US taxpayers to defer taxation on passive income, e.g., dividends and interest on investments held through a foreign company owned by a US shareholder (more on this later). On the other hand, if the foreign company conducted an active trade or business (e.g., manufacturing or a hotel resort in sunny climes), tax on such income was deferred until the cash was distributed. In late December 2017 (December 22, 2017, to be exact, i.e., three (3) days before the Christmas holidays), Congress rammed through significant changes abolishing deferral of active business income retroactive to, basically, January 1, 1987 [as the saying goes: “Happy Holidays”].

In essence, the US tax system does not make it easy for US persons to invest globally since it taxes foreign income even before it’s distributed to the US. We’ll discuss the how but not the why. We don’t know if anyone really knows the why. Was it to make up for the so-called other “tax cuts” [The 2017 bill was called the Tax Cuts and Jobs Act] although it yielded, by all estimates, a $1 trillion deficit? No one really knows.

What are we talking about? As relevant to this international tax discussion, US persons become relevant in IRC §951(b), the definition of a US Shareholder. We’ll come back to why being a US shareholder is important. For now, just know the section reads [Emphasis added] – For purposes of this title, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957(c)) . . .

IRC §957(c) provides its own roundabout definition by stating, For purposes of this subpart [Subpart F — Controlled Foreign Corporations (Sections 951 to 965)], the term “United States person” has the meaning assigned to it by section 7701(a)(30), and then has some exceptions not relevant here (to Puerto Rico, Guam, American Samoa, and the Northern Mariana Islands). IRC §7701(a)(30) defines a United States person as a citizen or resident of the US, a domestic partnership or corporation, or any estate (other than a foreign estate, within the meaning of paragraph (31)), and US trusts.

So, let’s assume we’re talking about a US individual just to make things easier. We’re focusing on whether there’s a controlled foreign corporation (“CFC”). IRC §957 defines a CFC as any foreign corporation if more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote, or the total value of the stock of such corporation, is owned by United States shareholders on any day during the taxable year of such foreign corporation. There’s direct and indirect (including constructive) ownership, and we’re not getting into that detail here.

Let’s assume Pat is a US citizen owning 100% of the vote and value of a foreign company (“ForCo”). Well, clearly more than 50% is owned. But what’s a United States shareholder? Let’s finish the IRC §951(b), definition – For purposes of this title, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation.

We know Pat’s a United States person owning 10 percent or more of the total vote or value. So, Pat’s a United States shareholder. Thus, the only United States shareholder owns more than 50 percent of the vote or value. ForCo is a CFC.

We care about this because IRC §951(a) effectively provides that United States shareholders of a CFC must include certain items in income, even if not distributed to the shareholders. We’ll continue with more next time.

 

About Schwartz International

The International Tax Nerds at Schwartz International team with individuals, companies of all sizes and other accounting and law firms to provide practical international tax planning, structuring, implementation, and compliance advice.

We live and breathe international tax daily, and since we’ve lived in various countries, we understand the diverse cultural challenges you face. We work in four key areas: International Tax Advisory; International Tax Compliance; Cryptocurrency; and Law via our sister company, The Schwartz Law Firm.

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