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Tax Reform for individuals with foreign corporations - Extended effect of Sec 962 Election

Tax Reform for individuals with foreign corporations - Extended effect of Sec 962 Election
Ines Zemelman, EA
01 October 2018

What does Sec 962 mean for U.S. owners of foreign-controlled corporations (CFC)?

The cornerstone of Tax Reform 2017 in the area of international taxes is the imposition of Transition tax on accumulated earnings and profits of the foreign corporation.

The owner of CFC with accumulated untaxed earnings and profits must pay Transition tax (Sec 965) on deemed repatriation of those profits. Corporate taxes previously paid in the foreign country cannot be taken as a foreign tax credit on the individual tax return.

Sec.962 is the election to treat that income for this particular year as corporate income reported on the personal tax return. It will be taxed at the corporate rate of 21%, and the individual U.S. shareholder will be allowed to take an indirect credit for foreign taxes the CFC paid on that income in the past. Sounds like a great deal.

Not so good if we look past the one-year horizon

Taking or not taking Sec 962 election is the choice between "pay less now" and "pay more later". In the year where Sec 962 election was taken to eliminate the Transition tax, the CFC owner may end up paying zero tax on those profits upon applying the foreign credit. However, the profits will still remain untaxed for the purpose of IRS personal taxation. When the shareholder decides to take distribution he will have to pay personal income tax on that very income  that he thought was already taxed (this is the nature of corporate double taxation of dividends).

Residents of high-tax countries assume they will pay sufficient foreign tax when they take distributions, and that will offset US tax. Their goal is to postpone taxation of profits to the time when they become eligible for personal foreign tax credit.

Unfortunately, tax on distributions post Sec 962 election cannot be easily offset by Foreign Tax Credit, which is why Sec 962 is hardly ever used with Sec 965 tax.

The interplay of Sec 965 and Sec 962 is full of multiple inconsistencies as described in  nysba.org

While a section 962 election may have seemed a simpler way to create parity between corporations and individuals, it was not designed for the provisions of section 965.

In particular, the article points out to Sec  1.962-3, which dictates the order of distributions for post Sec 962 election. It is not a matter of free choice of the shareholder. Any distribution will be first applied to the current year earnings. Only after all current earnings were distributed, the US owner may start taking distributions from post Sec 962 income.

What happens the following year

Further, GILTI tax provisions make virtually all corporate profits (qualified business income for the year) taxable to the shareholder to the extent of his pro rata

share. This is manageable when the balance of previously unpaid earnings and profits is zero (post Sec 965 tax payment). Conversely, it is not so easy post Sec 962 election, with the burden of previously untaxed Earnings and Profits (E&P).

All distributions must first be applied to the current year earnings. The CFC owner will have to take full distribution of annual corporate profits in their home country in order to generate sufficient foreign tax for credit against US tax - before he can even touch post Sec 962 income.

Meanwhile, the balance of previously untaxed Sec 962 E&P will remain undistributed. In order to take distributions from Sec 962 income, the taxpayer may have to withdraw more than the company’s annual profits - only then he will be able to take distribution from Sec 962 income.

No ability to accumulate earnings in the corporation

Taking this election will also limit the option of accumulating earnings in the corporation. The taxpayer would have to withdraw more than the corporation earns - otherwise, they would pay tax in the US without having enough foreign tax credit to offset it.

Section 962 can be taken for any year and it is effective only for one year. The taxpayer may continue taking Sec 962 election in the future years  - to avoid GILTI tax - this will only make the situation worse because the balance of untaxed E&P will keep growing. GILTI income taxed under Sec 962 election will be considered untaxed at the personal level and will increment the balance of untaxed E&P.

Sec 962 income is akin to a balloon mortgage - you enjoy interest-free life in your house until it is time to pay it all and you realize that you can't handle the debt.

Ines Zemelman, EA
founder of Taxes for Expats