Pursuant to the new Tax Cuts and Jobs Act, individuals that own at least 10% of the stock of a “specified foreign corporation” will need to include in their gross income their share of the foreign corporation’s deferred foreign income. Code §965(a). A specified foreign corporation is any controlled foreign corporation (“CFC”) or other foreign corporation that has at least one U.S. corporation as a 10% shareholder. Code §965(e)(1).
The deemed repatriation occurs by way of a Subpart F income inclusion for the last taxable year of the foreign corporation that begins before January 1, 2018. Thus, for a foreign corporation that has calendar year taxable year, the Subpart F income inclusion will occur on December 31, 2017. For foreign corporations that use a fiscal year, the Subpart F income inclusion will occur on the last day of the fiscal year ending in 2018.
The deemed repatriation is taxed at preferential rates in the U.S. U.S. corporations will generally be taxed at a 15.5% rate on their deferred earnings in the form of cash and other liquid assets. All other deferred earnings will be taxed at an 8% rate.
The “advertised” rates of 15.5% and 8% are reached by way of a deduction. The deduction is based on the highest corporate tax rate at the time of the inclusion. The highest corporate tax rate for 2017 is 35%, and for 2018 it is reduced to 21%. A corporation that has the inclusion in 2017 would calculate the deduction as [1-(15.5/35)] or 55.71% in the case of cash. Code §965(c)(2)(B). Thus, an inclusion of $100 would have a deduction of $55.71, leaving $44.29 to be taxed at a corporate tax rate of 35%. This makes the effective rate 15.5%.
Inclusion in 2017
Given that the rate equivalent percentages are keyed off of the maximum corporate tax rate, individuals may have effective tax rates on the repatriation that are lower or higher than the 15.5% and 8% advertised rates.
To illustrate, say that a U.S. resident individual owned 100% of a controlled foreign corporation that had $100 of deferred earnings, all in the form in cash. The controlled foreign corporation used the calendar year as its tax year. Consequently, the deemed repatriation / Subpart F inclusion would occur on December 31, 2017.
The individual is subject to the highest tax rate for individuals in 2017, 43.4% (39.6% + 3.8% (net investment income tax)). The individual would have a $100 Subpart F income inclusion and a deduction of [1-(15.5/35)] or 55.71%. Thus, $44.29 of income would be subject to a tax rate of 43.4%, resulting in $19.22 of tax due. The individual’s effective tax rate on the deemed repatriation is 19.22%, which is higher than the “advertised” rate on cash of 15.5%.
Inclusion in 2018
Now assume that the U.S. resident individual’s controlled foreign corporation did not use the calendar year as its tax year. Instead, the controlled foreign corporation uses a fiscal year of March 31. In this case, the deemed repatriation would occur on March 31, 2018, which is the last day of the foreign corporation’s tax year that begins before January 1, 2018. The individual would then include the repatriation inclusion on his 2018 tax return. We will assume that yet again the individual is subject to the highest rate of tax for individuals in 2018, which is 40.8% (37% + 3.8% (net investment income tax)).
As in the above example, the individual’s Subpart F income inclusion would be $100. However, the deduction will be much smaller in 2018. This is because the deduction is based on the highest corporate tax rate in 2018, which is 21%, and our individual is subject to tax at a 40.8% rate. Our deduction would be expressed as [1-(15.5/21)] or 26.19%. The individual’s net inclusion would be $73.81, which would be subject to the rate of 40.8%. This results in $30.11 of tax being due and is a 30.11% effective tax rate.
It is clear that the individual in our examples is significantly better off if he can recognize the deemed repatriation income in 2017 rather than 2018. In fact, he can save nearly 10 percentage points on his effective tax rate by recognizing the repatriation income in 2017.
Achieving the Lower 2017 Rate
The significant difference in effective tax rates for individuals is present at all income levels. The balance of the foreign corporation’s cash and residual earnings does not matter; any individual that owns a controlled foreign corporation with a fiscal year should consider taking steps to cause the deemed repatriation inclusion to occur in 2017 instead of 2018. The tax savings can be substantial. Contact us today to understand your options for accelerating the income and deduction into 2017.