Series 204: US Based Companies with Foreign (i.e. Outbound) Operations – Part 1: Anti-Deferral and US Tax Base Shifting Provisions

In addition to the issues and method of taxation covered in Series 203: US International Tax Systems for Businesses, US businesses with foreign operations (i.e. “outbound” operations) have a number of unique issues they need to be aware of. This article primarily covers those issues applicable to corporations and individuals/businesses owning corporations, and includes a discussion on—

  • Controlled Foreign Corporations—Anti Deferral Safeguards
  • Passive Foreign Investment Companies
  • Base Erosion Anti-Abuse Tax

Controlled Foreign Corporations—Anti Deferral Safeguards

As discussed in Series 203: US International Tax System for Businesses, the threshold issue to determine if a person or business is subject to US taxation is their residency. If a person is a resident of the US or an entity formed under US law, it is subject to tax on its worldwide income. If, however, the person is not a resident to the US or an entity formed under a foreign country’s laws, the income earned is subject to tax in limited situations. 

Since corporations are viewed as separate and distinct taxpayers from that of their owners, many individuals and businesses will form foreign corporations to defer the imposition of US tax on their foreign earnings. If you remember our discussion from Series 203, generally the only time a foreign corporation’s income is subject to tax in the US is when it derives investment income from the US or derives income from a trade or business in the US. This limited system of taxation provides a large planning opportunity to shift income-producing activities to low tax jurisdictions for US taxpayers and avoid the imposition of US tax. Generally, the only time that the foreign corporation’s income would be subjected to tax is if and when there was a repatriation of earnings (generally in the form of a dividend) back to its ultimate US owner.

This is a method of deferral that many US taxpayers took advantage of for years. The US government realizing this implemented a number of “safeguards” to limit the amount of deferral or exemption of a foreign corporation’s income from US taxation when owned and operated by US taxpayers. Without the imposition of these safeguard measures, a US taxpayer could theoretically defer tax on their foreign earnings for an indefinite amount of time.

These anti-deferral safeguards are informally known as “Subpart F” and derive their name from the portion of the Internal Revenue Code they are named after. The Subpart F regime accelerates the US taxation of certain earnings of foreign corporations that are controlled by US shareholders, regardless of whether such earnings are distributed to the US shareholders. This regime only applies to those foreign corporations that are deemed to be “controlled foreign corporations” (CFCs). 

Thus, the threshold to this anti-deferral regime applying is the existence of a CFC. If no CFC exists, there is no need to examine Subpart F. So, what then is a CFC? A CFC is a foreign corporation of which more than 50% of the stock is owned by “United States shareholders’ on any day during the corporation’s taxable year. A “United States shareholder” is a US person who owns 10% or more of the total voting power or value of all classes of the foreign corporation’s stock. A US person can be a US citizen or resident, or a domestic corporation, partnership estate, or trust. Thus, to have a CFC, more than 50% of its stock must be owned by US persons or entities, and anyone of those US persons must own at least 10% of the CFC’s stock during the year. 

What should be noted is that a US shareholder’s interest can be held directly or indirectly through certain attribution rules. These are very complex rules, but do allow for planning if a foreign corporation is on the edge of being considered a CFC. If you have questions as to whether a foreign corporation you own is considered to be a CFC, please contact our team to help you make a determination.

If it is determined that you as a US shareholder own a CFC, then you must analyze and account for any potential Subpart F income inclusions during the tax year. There are various types of income that could be the subject of a Subpart F income inclusion—

  • Global Intangible Low-Taxed Income (GILTI)
  • Foreign Personal Holding Company Income (FPHCI)
  • Foreign Base Company Sales Income
  • Foreign Base Company Services Income
  • Indirect Repatriation of CFC Earnings 
  • Sale of CFC Stock

Global Intangible Low-Taxed Income (GILTI)

Global Intangible Low-Taxed Income, better and informally known as GILTI. While technically Subpart F income, the GILTI regime functions as a residual category of Subpart F income. This is one of the most impact provisions passed as part of the recent Tax Cuts and Jobs Act (TCJA) of 2017. As we explained above, prior to the passage of the TCJA, generally the only time a foreign corporation’s earnings and profits were subjected to US taxation is when such earnings were repatriated back to the US or the foreign corporation earned a specific category of Subpart F income. This regime still allowed for foreign corporations to earn income offshore without being subject to US tax. 

GILTI made a large impact on this regime. To put it simply, GILTI requires CFCs to run their earnings and profits through a complex test, on an annual basis, to determine if the income of a CFC can remain “exempt” from US taxation until a repatriation event. The passage of this provision has led to many large foreign corporations change their structure to avoid the ownership of CFC to avoid GILTI on an annual basis.

How does GILTI work?

Simply put, GILTI is the net of the following two items—

(1) the CFC’s “tested income”

(2) the CFC’s “deemed ordinary return”. If “tested income” is greater than the CFC’s “deemed ordinary return”, the CFC’s shareholders must include in gross income their pro-rata share of the CFC’s GILTI amount as of the end of the CFC’s year.

A CFC’s “tested income” is the CFC’s taxable income less income and expenses in the following five categories—(1) the CFC’s other Subpart F income; (2) US source effectively connected income (as defined in Series 203: US International Tax Systems for Businesses); (3) related party dividends; (4) Subpart F income exempt due to the high-tax kick-out rule; and (5) other oil and gas extraction income. If after this calculation there is no “tested income”, the CFC’s shareholders do not have the income to recognize by reason of this provision. Additionally, if there is a “tested loss”, the US shareholder can use this loss to offset “tested income” it is attributed to other CFCs.

“Deemed ordinary return” is generally 10% of the CFC adjusted basis intangible, depreciable property used to produce tested income, averaged on a quarterly basis. This amount is also reduced by the net interest attributable to the “tested income”. Essentially, net interest is interest expenses already considered in calculating “tested income” that is derived from financing on the CFC’s tangible, depreciable property.

While we won’t cover all the complex nuances of this provision, there is one distinct consideration to keep in mind when considering the ownership of a CFC that will be subject to GILTI—that is whether the CFC should be owned through a corporation or an individual. Corporate shareholders with GILTI inclusion are eligible for a reduced rate of US tax not to exceed 10.5% on their GILTI inclusion. This is because corporate shareholders are afforded a special deduction under IRC Section 250, between known as Foreign Derived Intangible Income (FDII). Lots of acronyms to remember, right? This deduction reduces a corporation’s GILTI inclusion by 50%. In addition to this benefit, corporate shareholders are also entitled to a foreign tax credit for foreign taxes paid on their tested income. 

An individual is not out of possibilities to take advantage of the favorable provisions provided to corporations—there is a special provision under IRC Section 962 that allows individuals to be treated as a corporation for US tax purposes. If elected, an individual shareholder will be afforded the deduction under FDII and the ability to take a foreign tax credit on foreign taxes associated with a CFC’s tested income.

Foreign Personal Holding Company Income (FPHCI)

The next type of Subpart F income we will cover is Foreign Personal Holding Company Income (FPHCI). This category of income generally includes that of a passive nature, such as dividends, interest, rents, and royalties. The purpose of this provision is to tax passive income that is easily moved offshore to foreign jurisdictions for the purposes of avoiding the US tax base. 

The purpose behind this provision also leads to the many exceptions provided to FPHCI. Essentially, if a CFC earns income such as dividends, interest, rents, and royalties in the course of its active trade or business, then it is not FPHCI as the activities are much harder to move to another jurisdiction in the hopes of avoiding the US tax base. Specifically, there is an exception for rents and royalties derived in the active conduct of the CFC’s trade or business from unrelated parties. Furthermore, dividends and interest from a related corporation are generally excluded from FPHCI if the related corporation is incorporated in the same country as the CFC.

One last provision to note is how FPHCI applies to the sale of partnership interests. If a CFC sells it’s capital or profits interest in a  foreign partnership and owns less than 25% of said partnership, all such gain is treated as FPHCI. If, however, the CFC’s ownership interest is 25% or greater, then the CFC calculates its gain is if it owns its proportionate share of the partnership’s assets and sold them directly.

Foreign Base Company Sales Income 

The next category of Subpart F income we will cover is Foreign Base Company Sales Income. The purpose of this provision was to prevent US companies from setting up subsidiary distribution centers in low tax jurisdictions through which they made sales. In very simple terms, to have an income inclusion under this provision, a US parent or related party must sell or purchase to or from a CFC personal property, manufactured outside of the CFC’s country of incorporation, for use out of the base company’s jurisdiction. 

To break down this provision technically, there are four requirements that must be met—

  1. Purchase or sales must be made to, form, or on behalf of, a person related to the CFC; 
  2. The transaction must involve personal property;
  3. The personal property must be manufactured or produced outside of the CFC’s country of incorporation; and
  4. The purchase or sale must be for use or destination outside the CFC’s country of incorporation.

A simple planning technique to avoid the imposition of Subpart F income inclusions due to this provision is to avoid setting up a distributing company in one country to sell products from a related party in one country or customers located in a third country.

There is a further exception to the production of Foreign Base Company Sales Income—that is if the CFC itself performs substantial enough manufacturing or production activities with respect to the personal property sold. The standards of providing substantial enough manufacturing or production activities by the CFC are either complete production or manufacture or “substantial transformation of the property.” As a rule of thumb, if the property sold by the CFC is completely different than the property purchased by the CFC, there is a “substantial transformation”.

There are more nuanced exceptions to Foreign Base Company Sales Income related to the property sold comprised of purchased component parts that are beyond the scope of this article, but should be kept in mind.

Foreign Base Company Services Income

Foreign Base Company Services Income is very similar to that of Foreign Base Company Sales Income, however it pertains to the provision of services. Simply put, this category of Subpart F income arises when services are performed for or on behalf of a related person and performed outside of the laws of the country in which the CFC is incorporated. The purpose of this provision was to prevent manufacturers, producers, and other US companies alike form shifting certain income to a low tax jurisdiction which were performed on behalf of a related party.

Once again, the more technical definition of this category of Subpart F income includes (but is not limited) to the items listed below—

  1. Services paid for or reimbursed by a person related to the CFC;
  2. Services which a related person is obligated to perform;
  3. Services which were a condition of a related-party sale of property; and
  4. Services to which a related person gave “substantial assistance”, which is equated to providing at least 50% of the cost of the performed services.

Indirect Repatriation of CFC Earnings

If a CFC earns income that does not fall within the grasp of GILTI or the other categories of Subpart F discussed above, it will hold untaxed earnings and profits that will not be subjected to US taxation until there is a repatriation event of some kind. Even then, there is a special provision passed by the TCJA that exempts some repatriations of a CFC’s foreign untaxed earnings and profits (see discussion on Dividends Received Deduction later). Traditionally, US shareholders would take advantage of this by borrowing from the CFC, pledging its stock, or investing the untaxed earnings and profits into the US. Thus, this provision was enacted to prevent US shareholders form investing the untaxed earnings and profits of a CFC into the US without being subject to US tax. 

Specifically, this anti-deferral provision applies if a CFC invests untaxed earnings and profits into “United States property”. This definition includes four broad categories of assets—(1) tangible property located within the US; (2) stock of a domestic corporation; (3) obligations of domestic persons; and (4) rights in certain intangible assets for use in the US. The Subpart F income inclusion is calculated as the lesser of (1) the excess of the shareholder’s pro-rata share of the CFC’s average quarterly adjusted bases of US property over the earnings and profits attributable to the amount previously included in income thereunder or (2) the shareholder’s pro-rata share of the sum of the CFC’s applicable earnings reduced by current year distributions and earnings and profits attributable to amounts previously included thereunder.

Sale of CFC Stock

As previously mentioned, if a CFC can escape its income being subject to US taxation via GILTI or Subpart F, it will accumulate untaxed earnings and profits. These untaxed earnings and profits can sit overseas until there is some sort of repatriation event that would trigger US taxation. This even now is becoming limited as there is a specified Dividends Received Deduction that qualifying shareholders can tax advantage of for dividends related to foreign earnings and profits. In addition to this, a US shareholder could sell their stock in the CFC and convert such untaxed earnings and profits from what would ordinarily be ordinary income into capital gains.

Naturally, the US government enacted a provision to avoid this result. Upon certain dispositions of CFC stock, a portion of the gain representing previously deferred earnings is recharacterized as a dividend. Thus, a portion of the income recharacterized as a dividend can be treated as ordinary income. Specifically, this recharacterization applies if the taxpayer-owned 10% or more of the CFC’s stock at any time during the five year period preceding the sale, such that the portion of the gain attributable to the deferred earnings and profits will be treated as a dividend. Any gain recognized in excess of this amount retains its character, which generally consists of capital gains/losses. Please note that losses on the sale of CFC stock are not subjected to this recharacterization provision.

Passive Foreign Investment Companies (PFICs)

As you may imagine, may US persons plan their operations around avoiding the hindering CFC rules to avoid paying US tax on income they earn overseas. Beyond the CFC provisions, there is another set of anti-deferral for certain foreign investment companies, better known as Passive Foreign investment Companies (PFICs). The PFIC regime, similar to the Subpart F regime for CFCs, has an anti-deferral regime that prevents US taxpayers from shifting passive income overseas to non-US, low-tax jurisdictions with respect to qualifying passive corporations they own a certain percentage of. Much like the rules set out for CFCs, if a foreign corporation does not qualify as a PFIC, then the punitive anti-deferral regime of PFICs will not apply.

What is a PFIC?

A PFIC is a foreign corporation that either meets a passive income test or a passive asset test, regardless of its domestic ownership or lack thereof. The passive income test is met if the foreign corporation’s income consists of 75% or more of passive income. This generally includes the same type of passive income as defined for purposes of Subpart F’s FPHCI anti-deferral regime. Additionally, a foreign corporation meets the passive asset test if the average percentage of the fair market value or adjusted basis of its passive income-producing assets represents at least 50% of the value or adjusted basis of all the entity’s assets. This test is determined on a quarterly gross basis. 

If a foreign corporation meets the definition of a PFIC, its income is subjected to a default anti0deferral test, with two alternatively elective tests it may follow. First is the default “excess distribution test”, followed by the elective “QEF” or “Mark-to-Market” regimes. 

The “excess distribution test” imposes a special shareholder tax and interest charge on deferred income. This test comes into play upon the shareholder’s sale of PFIC stock and/or the receipt of certain PFIC distributions related to previously untaxed earnings and profits of the foreign corporation. Essentially, a triggering distribution must consist of a distribution from the PFIC that is 125% of the average of the prior three-years distributions. If that is the case, a tax and interest charge is imposed against such “excess distribution”.

The next possible method for calculating US taxes on certain deferred income of a PFIC is under the elective “QEF” regime. This election allows domestic shareholders to elect to have their share of PFIC earnings taxed currently so long as the shareholders elect to treat the PFIC as a “qualifying electing fund” (i.e. QEF). Generally, this creates current year income and net capital gain inclusions for the US shareholder. However, in order to make this election, the US shareholder must receive a qualifying tax statement from the PFIC showing the amount of income/loss they would be attributed if they did make such QEF election. In practicality, most foreign investment companies do not prepare and provide this statement, preventing US shareholders from electing this treatment.

Finally, the last elective method of calculating US tax on income earned by a PFIC is that of the “Mark-to-Market” regime. If elected, the US shareholder recognizes gain or loss on the appreciation or depreciation of the PFIC’s stock on an annual basis. To note, a US shareholder can only recognize a loss on the depreciation of a PFIC’s value to the extent they have recognized gain in the past on the appreciation of such PFIC stock. Additionally, it is worth noting that this election is only available for PFIC’s whose stock is marketable on a public exchange and the shareholder makes such an election to use the “mark-to-market” regime.

The PFIC anti-deferral regime is complex and nuanced and should not be traversed alone. If you have questions on how the PFIC regime works, please contact our team to assist you.

Base Erosion Anti-Abuse Tax

The last topic discussed in this article is the impact and workings of the recently passed Base Erosion Anti-Abuse Tax, better known as the “BEAT”. The BEAT, as its name implies, is a tax imposed against certain qualifying corporations that shift their US taxable income to related parties in foreign, low-tax jurisdictions through the means of deductible payments. The good news is that corporations with large operations are only subjected to this tax. Additionally, as you’ll see below, the BEAT works similarly to that of the Alternative Minimum Tax (“AMT”), whereby it recalculates the corporation’s taxable income by adding back said foreign related party deductible payments, subjects it to a 5%, 10%, or 12.5% (depending on the tax year) tax rate and compares it to the corporation’s regular tax amount. If the BEAT tax is in excess of the corporation’s regular US tax liability, then the corporation must pay the difference to the US. This is a complex provision that requires the parsing out of many technical definitions.

What US taxpayers are subject to the BEAT?

This includes (1) C corporations, (2) that have average annual gross receipts of at least $500 million over the past three years, and (3) a base erosion percentage of 3% or higher for the tax year. The first test is self-explanatory. For the second test, in the case of a foreign person, the gross receipts test only takes into account gross receipts that are taken into account in calculating “Effectively Connected Income” as defined in Series 203: US International Tax Systems for Business. 

However, for the third and final test of BEAT applicability, what does a “base erosion percentage” consist of? This is the percentage of (1) certain “base erosion tax benefits” of the taxpayer for the year to (2) the aggregate amount of deductions allowed to the taxpayer for the year, taking into account the “base erosion tax benefits”. Furthermore, a “base erosion tax benefit” includes any deduction allowed with respect to a “base erosion payment”, and for “base erosion payments” made to purchase property subject to depreciation, any depreciation deduction allowed with respect to the property acquired with such payment. Finally, a “base erosion payment” in any amount paid or accrued by a taxpayer to a foreign, related person of the taxpayer that is allowed as a deduction. For purposes of this final definition, a “related party” includes (1) a 25% owner of the taxpayer, (2) any person who is related to the taxpayer or to any 25% owner, and (3) any other person related to the taxpayer. 

Now that we’ve gone through the formulaic rules of the BEAT, you should understand how it operates from a high-level. If your business is a qualifying, large corporation whose has deductible payments made to foreign related parties in a given year exceeding 3% of their total deductions, then you will have to run through the BEAT test.

 Once you’ve determined that your corporation is subject to the BEAT, its income and deductions for the year must be run through the BEAT test. Simply put, the BEAT is equal to the excess of a 5%, 10%, or 12.5% (depending on the tax year) tax of the taxpayers “modified taxable income” over the taxpayer’s normal US tax liability, reduced by certain tax credits. A taxpayer’s “modified taxable income” consists of a taxpayer’s taxable income for the year without regard to (i) any “base erosion tax benefit” from a “base erosion payment”, or (ii) the “base erosion percentage” of any net operating loss deduction allowed for the tax year. 

Now that we have gone through the formulaic rules for the BEAT, lets flesh this concept out with an example. Assume Corporation X, a US corporation with more than $500 million in average gross receipts in the prior three years, owns 25% of a foreign corporate subsidiary named Corporation FC. In the current year, Corporation X has $300 million in deductions. Of these deductions, Corporation X makes $100 million of deductible interest, rent and royalty payments to Corporation FC with respect to its operations abroad. In consideration of Corporation X’s total gross receipts and total deductions, Corporation X preliminarily has taxable income of $200 million. When subjecting this to the 21% US corporate rate, Corporation X’s normal tax liability is $42 million. 

The first part of this analysis is to determine that Corporation X is subject to the BEAT. First, Corporation X is a corporation and meets this first test. Second, Corporation X has more than $500 million in average gross receipts as provided by the facts. Third, Corporation X has a “base erosion percentage” of greater than 3%. This is determined by taking Corporation X’s total “base erosion payment” of $100 million to Corporation FC and dividing it by Corporation X’s total deduction for the year of $300 million. This creates a “base erosion percentage” of 33.33%–much higher than the 3% required to meet this final eligibility test. 

Now that Corporation X is subject to the BEAT, we must calculate it’s BEAT liability (if any). First, we must determine Corporation X’s modified taxable income. This is calculated by taking Corporation X’s taxable income of $200 million and adding back the $100 million of deductible “base erosion payments” made to Corporation FC. This leaves us with a modified taxable income of $300 million for Corporation X. Next, we must subject the $300 million to the 10% BEAT rate for 2019 and 2020. This leaves Corporation X with a minimum BEAT liability of $30 million.

Finally, to determine if Corporation X has a tax liability resulting from the BEAT provision, we must compare its normal US tax liability to its BEAT minimum tax liability. Corporation X’s normal US tax liability is equal to $42 million. Corporation X’s minimum BEAT liability is equal to $30 million. Thus, because Corporation X’s normal tax liability of $42 million is in excess of its minimum BEAT liability of $30 million, Corporation X will not be required to pay any additional tax due to the imposition of the BEAT.

This is a very high-level and general explanation of this anti-deferral, anti-base shifting provision. Please note that there are many nuances and rules to this provision that are beyond the scope of this article. If your company is potentially subject to the BEAT and would like to better understand your risk, please contact our team to assist you with understanding your obligations and how to best plan around the provisions of BEAT.