Trump’s Tax Cut and Jobs Act: what’s all the buzz about?
So, you probably remember all the news around the new Trump tax cuts that were passed in December, and how it would massively reduce corporate taxes to encourage companies to bring business to the US? If you’re an Amazon, Google, Goldman Sachs or Exxon of the world, it’s a huge saving and effectively allows major global companies to repatriate trillions of dollars for little to no Federal tax cost. Amazon is reported to have saved $800 million in the first year alone. But what if you’re not a Google of the world? What if you’re a small business owner who has operations outside the US? Well, in some ways, you and your foreign business are the unintended dolphins getting caught in this tuna net of tax.
Does the new tax law apply to me and my foreign business?
One of the major components of this new tax law are changes to how controlled foreign companies are taxed by the US Federal government. There are several changes that apply to controlled foreign companies, but for the purposes of this discussion we’re going to focus just on the one-time deemed repatriation of earnings. A controlled foreign company (CFC) is essentially a non-US entity that is controlled by US taxpayers. For instance, if you are a US citizen that sets up and owns a business in Mexico manufacturing construction supplies, this business would be considered a CFC.
However, many companies are ensnared by the CFC definition unintentionally by the owner. This can potentially be a difficult situation to find yourself in, as the taxation of CFCs by the US can be arduous and burdensome. Unintentional CFCs happen more often than you may think. Let’s say you’re British, living in London, and you start a company with your business partner producing films. Your business is so successful it’s decided you will move your family to Los Angeles to expand the business in the US. You move to LA, establish residence, incorporate the US company, and get to work. You continue to own 50% of your British film company and can make management decisions for the business, but your business partner is running the London company while you focus on LA. Congratulations. Your British production company, which has nothing to do with the US whatsoever other than the fact that you’re living in LA, just became a controlled foreign company and is now subject to US tax laws and the necessary reporting. Your share of the accumulated earnings and profits of the CFC is now subject to the same deemed repatriation tax law as Amazon.
What is the new law and what does it change?
The new law changes the way CFCs are taxed. Typically, the earnings of CFCs were only subject to US tax to the extent that the earnings were repatriated or brought into the United States. This could include a dividend paid to a US taxpayer, earnings used to purchase a building in the US, monies loaned for below market rate to a US company, etc. This largely remains true and continues to be the way CFCs are taxed by the US. However, the new tax law created a one-time deemed tax event that taxes CFCs as if all the accumulated earnings as of December 31, 2017 were distributed and repatriated to the US on that date. It doesn’t matter whether or not these accumulated earnings are actually brought to the US, they are deemed to have been, and this ‘income’ is included in the US shareholders’ tax returns.
Using the example of the British production company, your 50% share of the accumulated earnings of the company as of December 31, 2017 are to be included in your individual tax return as income. The term ‘accumulated earnings’ refers to the aggregate of annual net profits (before corporate tax) of the CFC. The earnings are aggregated just for the period that the non-US business is considered a CFC under US tax law. For instance, you started your British film business on 1 January 2014 and moved to LA starting your US business on 1 January 2016. This means that the British company is considered a CFC for 2016 and 2017 tax years, but not for the years prior to that. The earnings for just the years 2016 and 2017 are analyzed and aggregated for deemed repatriation income purposes.
What does this mean for my bank account balance; what’s the damage in tax costs?!
It seems strange that so many global corporations like Amazon and Google were excited by being forced to recognize income on their US tax returns that otherwise may not have been taxed. The cause for excitement was over how low the new law set the Federal tax rate on this one-off income inclusion. The December 2017 deemed repatriation of CFC accumulated earnings are taxed at 15.5% for the cash earnings and at 8% for any earnings that have been converted into immoveable property like foreign real estate. This also means that if these companies want to repatriate all their overseas earnings that were earned up to December 31, 2017, they are now able to do so without additional tax cost because it’s already been taxed in this one-time event. Earnings that would have cost about 35% in corporate taxes to make available for repatriation to the US are now being freed up for US use for the low price of 15.5% in tax.
Let’s look at how this would work in practice. Your British production company earns net profits of $50,000 and $75,000 before UK corporate taxes in 2016 and 2017, respectively. The accumulated earnings of your CFC for deemed repatriation purposes is $125,000. You would report your 50% ownership of these earnings of $62,500 on your personal US tax return and pay tax at a rate of 15.5%, which is $9,688 in Federal tax due. This means you can distribute up to $62,500 to yourself from the UK business that would have otherwise been taxed at a much higher tax rate under regular CFC tax rules.
Perhaps you and your business partner have been considering buying some new equipment for the LA studio but didn’t want to use earnings from the UK business because of the high tax cost to do so? Well, now you’re able to put your hard-earned profits to good use to expand the US operations for little cost.
There are other considerations with this income inclusion such as the State tax treatment, the complex method of reporting the tax due on the return, identifying and making use of available foreign tax credits, etc. However, the bottom line is that earnings that were previously trapped overseas can cheaply be brought to the US in this one-time deal.
If you think you may have controlled foreign company issues or would like further information about the new tax law, please contact Gareth Jones at Kingston Smith Barlevi.