In December 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA) into law. The TCJA made significant amendments to the Internal Revenue Code (IRC). Among them was the introduction of a transition tax under IRC section 965—a tax on accumulated earnings of certain foreign corporations in the hands of U.S. shareholders. This new tax marked a transition to taxing the active income of foreign corporations.
Following the transition tax, active income of foreign corporations may be taxed each year on a shareholder basis under the GILTI1 regime. During the 2021 calendar year, those years began to fall outside of the standard reporting window of a particular voluntary disclosure program. Consequently, without a change to the reporting period, a taxpayer could become compliant and potentially avoid transition tax and some GILTI.
The particular voluntary disclosure program is referred to as the Streamlined Filing Compliance Procedures (streamlined procedures) and requires the most recent three years of income tax filings in order for one to become compliant with one’s federal income tax filing requirements. Once the 2020 income tax returns became overdue in 2021, one might, under existing rules, be able to become compliant by filing the 2018-2020 income tax returns and avoid the transition tax altogether. As a result, the deadline for the 2020 income tax returns was seen by many in the tax community as a hard deadline for the IRS to close the streamlined procedures.
Perhaps that was the plan, until the COVID19 pandemic arrived. Governments and tax agencies the world over faced unprecedented challenges in 2020 during the pandemic. Both Canada and the U.S. gave one-time extensions in 2020 for 2019 income tax filings. To date, processing delays still remain. Perhaps in light of this, the streamlined procedures have endured throughout the 2021 year, when 2017 would not typically be a required income tax filing.
The result would have been too good to be true, and the IRS responded by updating the streamlined procedures rules. On this specific issue, the IRS has stated:
Since the disclosure scope for a submission to the Streamlined Filing Compliance Procedures with a SFC2 will include tax years 2017 and/or 2018 and forward, noncompliant years prior to the submission scope may have previously untaxed Subpart F income or section 9563 amounts. Absent the Subpart F income or section 956 amounts being reported by the taxpayer, making a submission to the Streamlined Filing Compliance Procedures does not constructively provide the taxpayer with Previously Taxed Earnings & Profits (PTEP) for pre-disclosure years. In other words, a taxpayer using the Streamlined Filing Compliance Procedures must strictly comply with the Internal Revenue Code for purposes of section 965 and computing PTEP. Taxpayers must properly account for and report Subpart F income and section 956 amounts in their submission, and only amounts included in income by the taxpayer prior to the submission period and amounts included as part of the submission will constitute PTEP.4
The IRS commentary means that, indeed, the number of returns required may extend beyond three. If the streamlined procedures remain open in coming years, taxpayers to whom the transition tax applies will have an increasing number of returns required. The total tax bill may increase with each year under GILTI. With limited and often time-sensitive relief options, time becomes more of the essence.
Streamlined Foreign Offshore Procedures
One particularly unique feature of the U.S. individual income tax regime is that it treats a broad class of U.S. non-residents as residents—thus, they are taxed on their worldwide income. This broad class includes U.S. citizens and permanent legal residents.5 One set of streamlined procedures exists to encourage non-residents, including this class, to become compliant: the Streamlined Foreign Offshore Procedures (SFOP).
In order to qualify for the SFOP, taxpayers must:
- certify that conduct was not willful and include a completed and signed certification statement (Form 14653);
- not have had a civil examination of returns for any taxable year by the IRS;
- meet the non-residency requirements;
- file each of the most recent three years of late U.S. income tax returns with “Streamlined Foreign Offshore” written on the first page of each return;
- file each of the most recent six years of late Foreign Bank and Financial Accounts (FBAR) returns with a statement noting they are being filled as part of the SFOP;
- include the full amount of tax and interest due in connection with these filings;
- include an application for an Individual Tax Identification Number, if necessary;6 and,
- include statements pertaining to timely election of income deferral from certain retirement or savings plans, if necessary.
Taxpayers who meet the eligibility criteria and comply with the procedure will not be subject to several different penalties and will be deemed to be compliant with their federal income tax obligations.
The SFOP does not have an unlimited life. Previous voluntary disclosure programs have come and gone. The IRS has not given any indication yet when the procedures will end, but the end could come with little notice. The Offshore Voluntary Disclosure Program ended in 2018 with roughly six months of notice provided by the IRS.
For the 2017 year,7 a transition tax applied on U.S. shareholders on their pro-rated share of accumulated post-1986 deferred foreign income. In many cases, this situation will be similar to the retained earnings of a corporation (however, calculated under U.S. income tax rules). The general mechanics aim8 to split the accumulated income into two categories:
- cash position,9 which is taxed at 15.5 per cent; and
- the remainder, which is taxed at 8 per cent.
When a foreign corporation is taxed in the hands of a U.S. shareholder, the income generally falls under a category of previously taxed earnings and profits (PTEP). The maintenance of the different PTEP categories works similar to the Canadian taxable surplus rules, such that:
- ongoing balances are kept in separate accounts;
- accounts are increased by income and dividends received into the account;
- accounts are decreased by losses and dividends paid out of the account; and,
- dividends paid from the account receive special treatment.10
Transition tax does not apply based on all U.S. shareholder holdings. Both the transition tax and GILTI have sets of rules that determine whether a particular set of shareholdings falls within these tax regimes.11
For U.S. individuals, foreign tax credit carryovers available on the individual side may provide relief under the U.S. “pool” system of foreign tax credits, and carryovers may be used for the purposes of the transition tax. However, it may also be the case that other income would have drained the pool. In such a case, or if the carryovers are insufficient, an election under IRC section 962 may provide relief. For foreign corporations that have built up substantial assets, this situation can create expensive tax bills for U.S. individual taxpayers.
GILTI may apply for each year after the year of the transition tax. Prior to the TCJA, foreign income earned by a foreign corporation with U.S. shareholders generally would be taxable only when it was passive (under Subpart F rules)—similar to foreign accrual property income under the Canadian Income Tax Act—or when it was distributed to the U.S. shareholder in the form of dividends. The introduction of GILTI in the TCJA now includes foreign active business income earned by a foreign corporation as income that may be taxed to U.S. persons.
The calculation of GILTI begins with the net income of each particular applicable corporation and excludes certain amounts that may be taxed under another provision (such as Subpart F) or are a dividend from a related person, to arrive at an amount called “tested income” (or loss, as the case may be). The aggregate of the pro-rated share of tested income and loss in the hands of a particular U.S. shareholder is then the “net tested income.”
The GILTI rules calculate an amount that is deemed to be the part of net tested income that is tangible. This amount generally is 10 per cent of the amount, if any, that the average carrying value of tangible capital property exceeds the net, if any, of interest expense exceeds interest income.
Further, any amount that is deemed “high-taxed income” is not included in net tested income.
Generally, U.S. individuals do not have the ability to use foreign tax credit carryovers for an inclusion of GILTI. However, like the transition tax, there may be some relief with an IRC section 962 election.13
Other common strategies for reducing or eliminating GILTI for U.S. individuals include:
- increasing the amount of tangible capital assets to increase deemed tangible income;14
- triggering the high-tax exception with a reallocation of the Canadian small-business deduction;15
- converting the corporation to an unlimited liability corporation;16
- paying a payroll bonus to the shareholder to decrease tested income; and,
- gifting half the votes and value of the corporation to a non-U.S. spouse.17
Many of these steps are time sensitive and, in the context of an SFOP that is filed years after the fact, may not be available.
- Global Intangible Low-Taxed Income.
- An SFC is a specified foreign corporation, which is defined in IRC s. 965(e) as any controlled foreign corporation or any foreign corporation with respect to which one or more domestic corporations is a U.S. shareholder.
- IRC section 956 refers to amounts that are earned by a controlled foreign corporation based on U.S. property. Similar to the Subpart F rules, the amounts may be taxed on a pro-rated basis on the U.S. shareholder. In many cases, this may not be a common occurrence but would fall within the scope of the update nonetheless.
- Streamlined Filing Compliance Procedures and Section 965 | Internal Revenue Service (irs.gov).
- Commonly known as “green-card holders.”
- It is very likely that this will not be required; U.S. citizens are not eligible for these to begin with.
- This may generally mean the calendar year for U.S. individuals, but for either U.S. corporate filers or individuals filing with an IRC section 962 election, it may be a fiscal year beginning in 2017. This election allows an individual taxpayer to be treated as a corporation for specific areas of the IRC.
- The rates are achieved by use of rate equivalents, which are based on the corporate tax rate of 35 per cent, as it was at the time. Part of the TCJA was a lowering of the general corporate income tax rate from 35 per cent to 21 per cent beginning in 2018. The use of an IRC section 962 election may thus result in using a blended rate in calculating the rate equivalents of 15.5 per cent and 8 per cent.
- This includes not just cash and cash equivalents but also other current assets, such as the net of accounts receivable less accounts payable (if applicable).
- Under subsection 113(1) of the Canadian Income Tax Act, a foreign tax credit may be deducted by the recipient after applying the relevant tax factor. Under IRC s. 959(a), the dividends from PTEP are simply not included in the income of the recipient at all.
- Different rules around constructive and indirect ownership may apply. Even some parts of the reporting of Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, use a different set of rules than other parts of the same form.
- This is income taxed at 90 per cent of the corporate rate, which is currently 21 per cent. Thus, income in which the tax rate is over 18.9 per cent would be excluded from the GILTI regime.
- The 962 election allows the use of foreign tax credits and the section 250 deduction which, after grossing up the full foreign tax credit, reduces the income inclusion to half.
- This would be less effective if financing is used since interest expense reduces the calculation of tangible income.
- The combined income tax rate for active business income in British Columbia is 11 per cent with the small business deduction and 27 per cent without the deduction.
- For U.S. tax purposes, a Canadian unlimited liability corporation is treated as a disregarded entity (much like a sole proprietorship) or a partnership. Though income would flow through for income tax purposes on the U.S. income tax return, so too would the foreign tax that would be available as a foreign tax credit.
- GILTI does not apply to corporations that are not controlled by U.S. persons. For the purposes of a controlled foreign corporation, ownership by a non-U.S. spouse is not attributed as constructive ownership by a U.S. shareholder spouse. The prudent tax planner would note the U.S. gift-tax return filing and consider the Canadian income attribution implications.