In each of the past two years, a new reporting law for foreign corporations has created additional work, stress, confusion, and in some cases taxes. Although some taxpayers may want to ignore these changes, the problem with not addressing these two laws is that on a properly filed tax return the IRS has all the information it needs to not only determine the reporting should have been done but also to make an assessment. Furthermore, there have been discussions that the IRS is beginning to target these exact situations. Therefore, it is imperative to know if these laws apply to you so they can be addressed and the effects mitigated as much as possible.
The two laws are known as “GILTI” and the “Transition Tax”. GILTI (Global Intangible Low Taxed Income) is a tax on income earned by a foreign subsidiary which is considered intangible income in a low tax jurisdiction. The Transition Tax was a one-time tax on all of the past, undistributed earnings of a foreign subsidiary. On their face, these both appear straightforward but they both have issues in their application that cause problems.
Policy Goals and Problems
The policy goals behind the laws make sense in theory, but the application was flawed. This was possibly the consequences of rushing through the Tax Cuts and Jobs Act. Regardless of the cause, these problems in application create effects that are not intuitive, therefore, taxpayers cannot assume the laws do not apply to their situation.
GILTI
GILTI attempts to tax intangible income in a low tax jurisdiction. The thinking behind taxing this income is because the IRS feels the only reason to hold an intangible asset generating income in a low tax jurisdiction is for tax purposes. Since it is an intangible asset, there is no reason it could not be held within the U.S. While this may be true, it ignores possible legitimate reason to have IP outside of the U.S., but that is not the major issue. The problem is that GILTI does not actually tax intangible income. Instead, the calculation allows for a 10% return on a fixed asset base, anything above this return is deemed “intangible” income. The flaws with this are obvious. First, a 10% return is relatively low for some assets, and this would seem to penalize anyone making productive use of their fixed assets. Next, not all businesses use fixed assets, such as a sales entity or consulting company. Also, the fixed asset base is calculated after depreciation and many assets could have a useful life well after their depreciable life. These are only some of the most potential issues. Overall, a tax on intangible income that does not have intangible income anywhere in the calculation is bound to have its problems in application.
Transition Tax
To fully understand the policy behind the Transition Tax it is necessary to consider the Participation Exemption. The Participation Exemption was a new law that allows U.S. corporations to repatriate earnings from certain foreign-owned subsidiaries tax free. The idea is that this will encourage the money to come back to the U.S. to create jobs and help the economy. However, the government did not want to reward the corporations that had been keeping earnings offshore for years. The answer was the Transition Tax, a one-time tax on the accumulated earnings at the end of 2017.[1] This interaction between the Transition Tax and Participation Exemption would make it clear going forward that dividends paid back from these foreign subsidiaries would all be tax free – previous earnings were already taxed and new earnings were tax exempt. The problem is that the Participation Exemption only applies to corporate shareholders, but the Transition Tax applies to both corporate and individual shareholders. This means that individual shareholders had to pay the Transition Tax but do not have consistency in distributions going forward. Previous earnings have been taxed and can be distributed tax free, but new earnings are taxable since they are not eligible for the Participation Exemption. The tracking of this inconsistency also changed a simple one page form to a complicated two page form. This inconsistency and problem are well known, but in the end, Treasury and the IRS chose not to address the problem.
Application
First, it must be determined if the law applies to you. For both laws, the key terms are “U.S. shareholders” and “controlled foreign corporations (CFC).” A “U.S. shareholder” is a U.S. person for tax purposes who owns at least 10% of the stock for a foreign corporation. A business is a U.S. person for tax purposes by being incorporated in the U.S., while an individual is a U.S. person for tax purposes by either citizenship, permanent resident status (green card), or substantial presence. A “CFC” is a foreign corporation that is controlled (greater than 50%) by “U.S. shareholders.”
Both GILTI and the Transition Tax apply to U.S. shareholders of CFCs, and the Transition Tax also applies to corporate U.S. shareholders of a foreign corporation even if it is not a CFC. This means, both laws apply to foreign corporations which have U.S. taxpayers who own at least 10% of the stock (vote or value) owning collectively more than 50%. Also, the Transition Tax applies to foreign corporations that have at least one U.S. corporate shareholder owning 10% of the corporation. However, even this analysis is not quite that simple. When considering ownership there are rules that can apply constructive and indirect ownership through other investments or attribution from family members. These rules themselves have been recently changed and are too complex to summarize here.
What’s Next – Taxpayers
When deciding how to address this issue, taxpayers fall into two categories, those that have filed a Form 5471 and those that haven’t. A Form 5471 is required for several situations regarding foreign corporations, but always required for a CFC. If a Form 5471 has not been filed, the compliance options need to be analyzed for penalty exposure. Failure to file a Form 5471 carries a $10,000/year penalty, and depending on foreign account and asset values a Form 8938 could be required which also has a $10,000/year penalty. Additionally, if the taxpayer has signature authority on the business bank accounts, or is deemed to have a direct financial interest because they own greater than 50%, an FBAR (foreign bank account report) might be needed. Generally, the minimum penalty for not filing an FBAR is $10,000/year but could be as high as $10,000/account/year for a non-willful violation, and up to 100% of the account balance if the non-filing is deemed willful. Assuming there is not any criminal exposure, which requires analysis with a qualified tax attorney, taxpayers would most likely use either the streamlined program or file under reasonable cause to get into compliance. Both of these methods have pros and cons which require examination to pick the best option. While these are the main choices, there may be other unique paths to compliance that could be taken making it very important that each case has a detailed analysis of the risks, exposure, and options. If there is criminal exposure, the Voluntary Disclose Program should be considered. This program is less defined than the former Offshore Voluntary Disclosure Program, and will very likely come with the highest penalties, but it will give criminal protection.
If the Form 5471 has been filed, this is a good news – bad news situation. The good news is that you may not have to be concerned about the non-filing penalty. “May” not need to be concerned because the IRS can still give this penalty if a Form 5471 is “substantially incomplete.” What it takes for a form to be substantially incomplete is not well defined but missing the GILTI or Transition Tax forms might get you there. However, the problem is an accurate Form 5471 gives the IRS information needed to make an assessment of the potential GILTI or Transition Tax – an assessment that is likely to be unfavorable. Also, it would not allow for any mitigation planning such as a possible Section 962 election allowing for foreign taxes paid to be used as a credit.
Overall, if GILTI or the Transition Tax have not been addressed, it is very clear it needs to be done as soon as possible, the only decision is what path to choose to get there.
What’s Next – IRS
On the enforcement side, the IRS is likely to have this as a point of emphasis as it hits several key points. First, the IRS has been big on international enforcement and these are two new international laws. Next, offenders are either giving the IRS all the info they need to make an assessment, or haven’t even filed the form which could lead to more penalties. Lastly, coming off from the coronavirus stimulus package, the government will be looking for revenue and these new laws would seem to be low hanging fruit.
What should be next is to fix the error in application of both of these laws. Unfortunately, it is probably too late to remedy the inconsistency of the Transition Tax. However, GILTI could be made much more effective and less burdensome with two changes, a small one and a big one. First, GILTI should actually apply to intangible income. After all, that is the intent, it’s in the actual name. This would stop businesses with fully depreciated assets, sales/service businesses, businesses that are able to generate large profits from fixed assets, and any other entity that doesn’t actually generate intangible income to avoid having GILTI. There are other areas of foreign earnings under the Subpart F rules (foreign anti-deferral regime) where we look at the actual type of income without using an abstract formula, it would seem possible to do that here as well. Next, there should be a threshold, most likely based on income. There are many foreign businesses where the GILTI calculation is extremely burdensome when compared to overall income and operations. We have even seen taxpayers where the fee to calculate GILTI is more than the actual GILTI tax. Surely these small businesses were not the focus of this new law, and the larger businesses have the bandwidth and professionals needed to get all this extra work completed. If there is no exemption, the IRS is going to have its hands full with audits, and many of these audits won’t lead to much revenue. However, if they back off enforcement of GILTI on small businesses due to cost v. reward what is the point? The IRS might as well exempt these taxpayers so neither the IRS or the taxpayer have to lose sleep over the issue.
Between FATCA, IRS international enforcement increasing, and new, complex laws such as GILTI and the Transition Tax, it has become a difficult time for international taxpayers and the professionals who prepare their returns. Additionally, the non-filing penalties are severe and the IRS is pushing the envelope on maximizing those penalties. The only thing that is clear is that ignoring the problem is not an option as it will only make things worse. Taxpayers are not the IRS, they do not have the luxury of overlooking their mistakes and continuing forward.
Notes
[1] The measurement date is either November 2, 2017 or December 31, 2017, whichever date has a higher accumulated earnings. The contingent measurement date is to avoid accumulated earnings manipulation after it became public this law was being considered.
Josh Maxwell
Tax Attorney, CPA, MPG
For more information on MPG advisory services relating to GILTI and The Transition Tax, contact [email protected]