Tax Reform Could Be Expensive For U.S. Investors with Offshore BusinessesDecember 2017
On December 15, 2017, the conferees completed their reconciliation of the House and Senate versions of tax bill H.R.1, "An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018," formerly known as the Tax Cut and Jobs Act (the “Act”). Though on balance the Act cuts taxes, its specific consequences will vary from person to person. However, for persons owning 10% or more of certain foreign corporations, it will most certainly be costly.
Under current law, U.S. shareholders of a foreign corporation generally are not taxable on their shares of the corporation’s undistributed earnings except to the extent of earnings that constitute “subpart F income” (i.e., passive investment income and income from certain related-party transactions). Well-advised taxpayers have structured the operation of their foreign corporations to minimize subpart F income, allowing their corporations’ earnings to accrue income offshore free from U.S. tax.
How the Act Changes Accrued Offshore Business Earnings
The Act provides that U.S. persons who own 10% or more of the voting stock of “any specified foreign corporation” are generally required to include their share of the corporation’s accumulated post-1986 deferred foreign income this year, 2017. This encompasses all types of income and is not limited to what typically constitutes subpart F income. A “specified foreign corporation” is any controlled foreign corporation (e.g., a corporation owned mostly by U.S. persons) and any foreign corporation with respect to which one or more domestic corporations is a 10% or greater shareholder. This means that the “well-advised taxpayers” referenced in the preceding paragraph that have amassed significant wealth through foreign corporations may be taxed on this wealth during 2017 even in the absence of repatriation.
While the Act provides a payment plan for these taxes, and reduced rates of income tax at the federal level on such income, these ameliorative efforts may be little consolation to shareholders resident in high-tax states as there is no indication that high-tax states will likewise permit their residents to pay their increased state income tax under a payment plan or at reduced tax rates. Moreover, shareholders of offshore corporations that have deployed their accrued income into active business ventures may not have the liquidity needed to pay this tax, even if this tax is payable pursuant to a payment plan and at reduced tax rates.
If you find yourself subject to these rules, one affirmative step you might take is to pay additional estimated income taxes this year to the state in which you reside. The Act limits income tax deductions for state and local income taxes, and does not permit individuals to claim a deduction on their 2017 federal tax return for the prepayment of state income taxes for the 2018 tax year. However, an estimated payment of additional state income taxes for the 2017 tax year should not be limited because such payment would relate to additional income earned during the 2017 tax year, not the 2018 tax year.
For persons who do not have the liquidity to begin paying tax this year on their deferred foreign income, there might be other steps that could be implemented to change their exposure to the rules described in this alert. The challenge is that any such steps would have to be implemented before January 1, 2018, so any person subject to this unexpected burden should act quickly, in consultation with their tax advisors, to address this looming issue.
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