Patrick J. McCormick, JD, a partner with Culhane Meadows, is a leading guest for CPA Conversations when it comes to international tax issues. We have relied on his expertise many times in the past. For this podcast, he discusses U.S. taxpayers who engage in foreign investments and maintain foreign holdings, and highlights threshold considerations, determining if a foreign entity is a trust, and much more.

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By: Jim DeLuccia, Manager, Learning Content

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Podcast Transcript

Patrick J. McCormick, JD has returned to the show today to talk again about international taxation. This time Patrick is here to talk about us taxpayers who engage in foreign investments and maintain foreign holdings. We'll discuss threshold considerations, determining if a foreign entity is a trust, and the ramifications of that decision, and some of the overall considerations of the taxation of foreign corporations. Patrick is a partner with Culhane Meadows.

Patrick, thanks again for stopping by. We always seem to do these interviews in person, which I guess is a good thing.

[McCormick] It's certainly cool by me, Jim. It's always a pleasure to be here. I'm out in the suburbs now, so it gives me an excuse to stretch my legs a little bit and come back into the city. It's my pleasure.

There you go. It's always good to get some city time.

[McCormick] Yes, sir.

To set up this conversation, can you tell me if this is a growing trend, and what I'm referring to there is U.S. taxpayers engaging in foreign investments? If so, what do you think is contributing to that?

[McCormick] Absolutely. Look, I'm coming from a biased perspective. It's a bit of background from the audience, my entire practice is based in international tax, both in the inbound realm, which is foreign taxpayers entering the United States market, and the outbound realm, which is what we're going to be talking about today, United States taxpayers entering foreign markets.

It’s really they're both growing areas in the outbound realm. Just based on globalization generally, there are so many new opportunities that are presented to the United States taxpayers overseas. When those opportunities present themselves. When the United States taxpayers by circumstance have, say close family members, have business partners who move overseas, who then start to explore foreign business ventures and start holding foreign assets. All of these questions need to be considered and I definitely think it's a growing area as the world becomes increasingly borderless, especially from the economic perspective.

I was just going to follow up with by saying that, that I guess the world just seems to be getting smaller and smaller.

[McCormick] Absolutely, which is certainly a good thing because it gets everybody closer together. Everybody in better communication and lets everybody grow together, which it's always a good thing.

Why does classification matter and what are some threshold considerations for CPAs practicing in this space?

[McCormick] Classification is really critical in so far as it affects how the foreign interest is reported and ultimately how it's taxed as well when you're talking about something say as straightforward as a foreign bank account, you're not really looking at tax per se unless the account's earning interest. If there's dividends, if it's some sort of investment account, something like that.

If you're talking though about some sort of asset that could be classified as a business entity, as some sort of an organizational structure, then it's really the threshold consideration that you're looking at is whether a foreign entity can be found. What you need there is some sort of organizational structure that's foreign in its nature.

The organization will be found if you have an undertaking by multiple parties. It's really, really critical at the outset to note for the sake of the audience, for the sake of practitioners generally who weren't concentrating in the international area, one of the things you want to be cognizant of is that presuppositions in this area can be incredibly harmful.

You have things like foreign bank accounts, say a straightforward cash account that's going to be, you knew that that's not in organization. It's not the type of organizational structure that can be classified as an entity. When you're looking at something even say like foreign mutual funds are a phenomenal example of this because they're so indicative of the issues that arise in the US tax area.

A foreign mutual fund under the U.S. classification rules for foreign entities. First things first, the foreign mutual fund based on how it's formed is classified as an organization and entity. It's then classified as a business entity, a foreign corporation ultimately, under the rules that apply for Section 1291 as to PFIC, the income of any foreign mutual funds realistically is going to make it a PFIC, which is why all of the tremendously onerous and punitive PFIC rules come into play is based on how that foreign mutual fund is classified.

What you find here is that you wouldn't necessarily make that connection per se, or usually if you have a mutual fund to think about it as, "Hey, this is going to be a foreign corporation." It's an area that's indicative of the complications that can arise when you're classifying things from a foreign perspective and how you really need to take a step by step approach.

So moving on, how can someone determine whether a foreign entity is a trust and how does that decision affect the taxation?

[McCormick] Absolutely. Once you get past the threshold consideration that an entity exists, once again, is for the benefit of the audience, is an undertaking by multiple parties. Once you have a foreign organization, a foreign entity, the question that flows from that is whether it's a trust or whether it's a business entity.

If it's not a trust, then usually it's going to be a business entity under most circumstances. What you're looking at with a trust is an agreement, and the regulations are really great. They give a very strong definition of a trust, or they give the word by word rather, definition of a trust is, "A structure under which a trustee holds title to assets, has title invested in her for the benefit of beneficiaries."

The really critical part there is that the beneficiaries do not take part in the substantive decisions related to the trust corpus. They're not bearing the responsibility of generating income, of the daily caretaking of the assets themselves. What you look at that's very important in this structure, if you have things like business trust that are oftentimes you see it overseas.

It's a bit of background just from more the academic perspective I guess for the audience, the United States is what's called a common law jurisdiction. The majority of other jurisdictions are civil law. In civil law jurisdictions you don't see the same type of trust structures, where you're really seeing trust typically as we conceptualize them are in common law jurisdictions which are United States, Canada, UK, Australia, New Zealand, places like that.

I've seen clients with New Zealand interest in trust, Australian ones as well that are called trusts, for New Zealand and Australian purposes, but when you're classifying them on the United States side there's sufficient interest in the, "Beneficiaries," that they often need to be reclassed, or they often need to be classified from the United States perspective as business entities instead.

Let's keep talking here about foreign business entities and what do CPAs need to know about these, especially as it relates to relevance determination?

[McCormick] Absolutely, and this is really the area where there is most meat to the bone. I would say once you get past the initial steps of determining whether there is a ... once you go through the threshold considerations in determining whether there is a foreign business entity. Once you're there you have to make a determination as to how that entity is going to be classified for United States tax purposes.

The United States rules are actually very friendly in this regard. What the United States rules say is that you have a list in the regulations. I believe it's the B28-301.7071-B28, I believe regulations give an alphabetical listing country by country of each country, and then it's usually one entity in each country that is classified as what is called a per se corporation. if you have that sort of entity that entity's automatically classified as a corporate entity for United States tax purposes.

If you have any other type of entity, you have a non-listed, non per se corporation, you are able to elect classification of that entity for United States tax purposes. The two general scopes for taxation are flow- through and pass-through entities, that can be either a disregarded entity or a partnership with that classification solely depending on whether there's a single owner or multiple owners.

The second general structure you can have is corporations, which are as most are aware, separately taxed, treated as separate taxpayers for United States tax purposes. The differentiation between the two, especially after the Tax Cuts and Jobs Act, is enormous or it's very, very ... I would say, if we can call it that portion, the differentiation between the two is absolutely critical because it's affecting how the United States stakeholder's ultimately taxed.

If you have a flow-through entity, all of the income is immediately attributable or immediately reportable by the United States stakeholder. If you have a corporate entity, you're able to, at least historically, you were able to delay taxation on that income.

When you're looking at from a relevance perspective, Jim, like you mentioned, that's really a very, very critical consideration here. Relevance is the time you have to make the election, the initial classification election for a foreign entity within 75 days of the entity becoming what is called, relevant for United States tax purposes.

Relevance is the date on which the entity either has itself an income tax filing ... it creates an income tax filing obligation with the United States or that the entity itself has an information reporting requirement associated with it by United States stakeholders.

What you're often looking at for the latter is things like a 5471 requirement for 10% or greater U.S. shareholders who acquire in that year, 8865 is the matching form in that regard for foreign partnerships. You can also have circumstances where you have a 5471 reportable interest for officers and directors, things like that.

One of the things to mention there is that you get 75 days from the date of relevance to make the initial classification election. There is limited election relief that's available that basically gives you until the filing deadline for the first tax return that would be owed after the date of relevance.

That's under Revenue Procedure 2009-41, macro-level though, which are really functionally looking at is wanting to ideally make the election within 75 days, but certainly once you get past that initial period where you can get even the 2009-41 relief, then you're in a situation where you're stuck with whatever the default classification would be at least until you make a prospective election.

The default classification that applies here is based on the limited liability of the stakeholders in the foreign entity, and that really hinges on the local law. So say if you're forming an entity in let's say Mexico, you form an entity there, and for the entity that you form, all of the owners of the entity under Mexican law have limited liability, then that entity is going to be classified as a corporation if one or more of the owners have non-limited liability of unlimited liability, then that entity is going to be classified as a pass-through for U.S. purposes, either as a disregarded entity or a partnership as the case may be.

One of the things that does get very tricky there and can be counter to expectations is when you're talking about, as you'd expect, foreign jurisdictions don't have the same classification rules that the United States do, but you can see similar concepts. Very often, what you're seeing in foreign jurisdictions, and it's something tantamount to a United States limited liability company, as we're all familiar with the LLCs being taxed as a pass-through under default rules for United States purposes, but all of the owners get limited liability.

If you have that sort of entity, a matching entity overseas, very often under the foreign jurisdiction, let's say here in Mexico, under hypothetically here, Mexican rules, if that entity is taxed as a pass-through, that entity by default is going to be taxed as a corporation in the United States, which creates a mismatch between how it's taxed for United States purposes and how it's taxed from Mexican purposes, which creates a multitude of issues from a foreign tax credit perspective is one that very often comes up as to whether taxes are creditable by the, "U.S. taxpayer." There's a multitude of concerns that could arise there.

What do listeners need to know about foreign corporations and Subpart F income?

[McCormick] It's like I've referenced briefly before, when you have a pass-through entity overseas all of the income, the pro rata share of that pass-through entity's income that's attributable to the United States stakeholder will be reportable in her annual income return with no deferral based on the pass- through structure, everything is immediately flowing through to her from a United States reporting perspective.

If she instead forms a foreign corporation or has an interest in a foreign corporation, she gets deferral on recognition of income. The foreign corporation is respected as a separate taxpayer, and as so, as a result, the foreign taxpayer, historically there's been no direct attribution to the United States shareholder until there's a dividend that's paid out, and there are special rules. These are always convoluted.

Generally speaking, under the macro-level, the historical U.S. system, unless a special rule like Subpart F applied, there was no immediate taxation on a foreign corporation's income. That allowed the foreign corporation for say, a U.S. shareholder who's conducting operations overseas, who has non U.S. sourced income, that U.S. stakeholder can then form a foreign corporation, have all the income instead of going directly to her, it goes to the foreign corporation.

The United States, if it's foreign sourced, is going to have no jurisdiction to tax that income because it's being earned by a foreign taxpayer and it's foreign sourced. No U.S. tax hits that income until it gets repatriated to the U.S. shareholder under the macro-level U.S. system. that's a huge incentive. That's historically been a huge incentive for U.S. business people to form operations overseas, defer U.S. income tax, deferred dilution of business profits by U.S. income tax, reinvest it as business profits for the sake of the business, be able to go that route.

The United States, cognizant of that deferral opportunity that's out there, and the United States wanting to disincentivize deferral in that regard, created the Subpart F rules as the historical primary anti-deferral approach.

What Subpart F says is essentially that for certain categories of income specified United States shareholders are going to be treated as if they earned that income directly, or more appropriately from a mechanical perspective, as if that income had been repatriated to them, as if dividends had been paid out to them, they have to report on those income amounts.

Subpart F is fairly extensive as to its scope. You're usually targeting macro-level, the two biggest areas you most often see are passive income, dividends, interest, rents depending on the facts. Royalties, net gains from the disposition of properties that produce passive income or that produced no income at all are categorized as Subpart F income for the foreign corporation, which is then reportable by the U.S. shareholder.

You also have Subpart F categorization of related party transactions that occur outside of the controlled foreign corporation's country of incorporation. The really big thing to note from a Subpart F perspective, and I know we'll be talking about GILTI momentarily, and it's very important there as well, so it's a great segue. In order for the Subpart F rules to apply, you have to have both a United States shareholder and what is called, a controlled foreign corporation.

Subpart F, what it mechanically does, like I've referenced, is it treats the U.S. shareholder as directly earning the foreign corporation's ... the U.S. shareholders pro rata share of the foreign corporation's Subpart F income. For these purposes, the United States shareholder is any United States taxpayer who by vote or value owns 10% or greater of the stock of a foreign corporation.

That's a change under the Tax Cut and Jobs Act. It used to be by just vote. Now it's vote or value, which creates an expansion as to who's treated as a U.S. shareholder. Controlled foreign corporation is any foreign corporation and again, that's important that that's where the entity rules become the classification rules become critical. These rules aren't applying unless you have a foreign corporation.

Subpart F applies if you have a foreign corporation where U.S. shareholders, that is 10% or greater U.S. stakeholders in the foreign corporation, where U.S. shareholders own greater than 50% of the vote or value of a foreign corporation.

So the macro-level idea, Jim, is they're targeting foreign entities where the ability to repatriate earnings, the ability to source income overseas is largely controlled, is primarily controlled from the United States perspective. Obviously, it's not always this simple but from the United States, and fairly much to date, the United States stakeholders have the ability to direct how the income is being earned, who's earning the income, whether it's earned from a foreign corporation or from domestic sources.

Here when you're talking about things like passive income, related party transactions that are outside the foreign corporation's country of incorporation, these are what are deemed moveable income items. The ones that United States views as not needing a foreign jurisdiction in order to earn that income where you're essentially trying to shift the foreign income to the foreign jurisdiction for tax purposes.

What the United States is saying, historically has been, "Hey, for that specific type of income, we're treating it as if you earned it directly, so you're going to be taxable on that. We're not going to let you shift it overseas when there's no real business purpose for doing that."

So it seems like we can't have too many tax conversations, no matter what the tax item is, without not mentioning the Tax Cuts and Jobs Act. Right?

[McCormick] Certainly. Yes, sir.

It's that gift that keeps on giving.

[McCormick] Yes.

And so, how have the Tax Cuts and Jobs Act changes altered how foreign corporations are taxed?

[McCormick] It's really absolutely drastic. Here from a macro-level, as a bit of background, Tax Cuts and Jobs Act from the international perspective, if you wanted one big takeaway, and what you're seeing is the incentivization of United States shareholders to incorporate their interest in foreign corporations, in particular, because what you're looking at is very beneficial provisions under the Tax Cuts and Jobs Act in the international context that apply to United States C corporations. They're not going to apply to United States, non C corporation shareholders really under in terms of the foreign corporate income tax structure.

Certainly worthy of note are provisions like section 245A which allows a United States shareholder of a foreign corporation, a full 100% deduction for the foreign sourced portion of any dividend from that foreign corporation.

Importantly, that applies only to C corporations, not to non-C corporate shareholders. That was really the headline grabber when the Tax Cuts and Jobs Act came out. Very, very quickly, I think after people really started to flush through the act, flush through the international provisions, there was much, much more concentration on GILTI, and I think much of the audience is familiar at least from an awareness perspective of GILTI. GILTI is the Global Intangible Low-Taxed Income Provisions, Section 951A of the code newly enacted under the Tax Cuts and Jobs Act.

That is background for the audience, Subpart F is Section 951. The interplay is strong between the two. There's a number of provisions. Section 951, one that immediately comes to mind where the Subpart F and GILTI redeems mirror each other. Section 951 for the benefit of the audience, when you have inclusion of income as Subpart F or now as GILTI as well, if you have that inclusion as a U.S. shareholder on actual repatriation of those funds, on actual dividend payment, you're not subject to tax again.

The real primary exception of that being Section 962, electing a non-C corporate shareholder, which is into the woods of certainly that's something we need to cover today, but from a GILTI perspective, what you're really looking at macro-level, you still need the same rules as to U.S. shareholders, controlled foreign corporations as Subpart F, those need to apply for GILTI to be applicable.

However, if you have U.S. shareholders, if you have controlled foreign corporations, the way that they're taxed now is vastly different. Before they would just be subject to immediate tax on Subpart F income, moveable income specified categories.

Now with the United States is saying under GILTI, is functionally, and obviously there's minutia on this, essentially what you're looking at is you take a base number, which is a foreign corporation's income that's not already subject to United States tax, whether by virtue of being associated with the U.S. trade or business, U.S. permanent establishment, whether it's Subpart F income, what have you, any income that's not already subject to United States tax is falling under the GILTI umbrella.

You get a 10% rate of return as a reduction on that amount on your tangible business assets, so you're basically taking all of the income that's earned by the foreign corporation that's not already subject to United States tax.

You get a 10% rate of return on your tangible or depreciable business assets. Then from there, the entire rest of that amount is your GILTI inclusion, and you're being taxed on that immediately from a United States perspective. If you're a U.S. shareholder of a controlled foreign corporation, your rate of tax, that's another area where the C corporation approach is beneficial. C corporations under section 250 get a 50% deduction on their GILTI inclusion.

That means their effective rate of tax is 10.5%, for non-C corporate U.S. shareholders, they're taxed at ordinary rate, so it can be as high as 37%. There's one important caveat that may be forthcoming, which is in regards to the high tax exclusion under the GILTI provisions they're in ...

I should give a bit of background for the audience's sake, and this is prospective. It's in the proposed regulations now and it looks much more promising than people expect it, and under Subpart F there was always a high tax exclusion for income that basically was subject to a rate of tax that was 90% of the U.S., I believe it was built off the corporate rate of tax, but it was somehow, it was essentially the idea was if the foreign income was subject to 90% of the rate of tax of either the U.S. shareholder or a U.S. corporation, then that income was not going to be subject to a Subpart F inclusion.

So if you have a C corporation, historically with 35% rate of tax, it was 31.5 was the breakthrough level. Now with the new tax rate, it's a 18.9%. The GILTI rules contained in the statute, there's portions referencing the high tax exclusion.

What most practitioners, myself certainly included amongst them, assumed for the GILTI purposes, is that the provisions would apply only if you were getting a Subpart F ... those exclusions were applicable only if the income was Subpart F income that you weren't getting say a high tax exclusion on your GILTI for any foreign sourced income that was already subject to 90% of the U.S. rate of tax, that it had to be foreign income that was subject to the 90% rate of U.S. tax that was also Subpart F income.

What the proposed regulations say, and this is only prospective, the regulations as they're currently constituted say they are only applying after the date final regulations are enacted. Proposed regulations say that the high tax exclusion applies to everything, not just Subpart F income, to everything that's out there, which would be a hugely beneficial provision for taxpayers who are already subject to significant foreign tax in their foreign corporation's jurisdiction. That being said though, I mean GILTI is really a seismic shift in how the United States taxes foreign corporations, and one that really can't be understated.

I can tell you that that acronym of GILTI-

[McCormick] Yeah, certainly.

... it's certainly something that is easy to remember, I think, but you mentioned something about some things that are proposed in that area. I just want to mention to the audience that we're recording this on Dec. 6, 2019. How soon do you see something happening on that?

[McCormick] What I recall, and it's always possible in say like the last week or so that something has come out or something like that, and I don't think that there has been. From my recollection was that it was June when the proposed regulations click in. It was sometime mid-year. Ideally there'd be something out before the 2019 reporting year. I don't think that's particularly promising, I'd be hopeful. I haven't seen anything out there on that.

I have seen people ... there's question as to whether the high tax exclusion would apply retroactively. The regulations, the proposed regulations say they'll only apply prospectively there's an addition that's out there they might apply retroactively. So it’s certainly an open issue to look at. But in terms of actual enactment, hopefully sometime in 2020.

If it happens sometime in 2020 I'll be happy.

You and many others.

[McCormick] Yes, sir. Me and many clients will be very happy then.

So to wrap this up, Patrick, what ultimately is the best structure for a US taxpayer with foreign assets?

[McCormick] Yeah, really the thing to keep in mind is that when you're talking about the GILTI provisions, the Subpart F provisions and how difficult ... and the real difficulties both in complying with them and how they've changed the U.S. tax system, how they've made things worse for covered United States shareholders of controlled foreign corporations. The big thing to emphasize is that when you're talking, these rules are applying to foreign corporate entities.

Getting back to the entity classification, you're either classifying yourself as a corporate entity or a pass-through. If you're classifying as a pass-through or a flow-through entity, you're immediately giving up any type of deferral opportunity that you'd have.

You're treated as earning the income all directly. You still have some reporting requirements either in 8865, and depending on the circumstances, if you have a requisite level of interest, you either have an 8865 requirement or an 8858 requirement, in the case of a U.S. tax earner of a disregarded entity.

What you're really looking at, though, with a pass-through entity is any opportunity to defer. If you're talking about a foreign corporate structure, you're still retaining some level of deferral ability. A lot of that, the level you can get has been greatly reduced by GILTI. The high tax exclusion could give a little bit back in some circumstances, but macro-level, if you're a U.S. shareholder in a controlled foreign corporation, GILTI makes your deferral ability much less, but you're taking old deferral ability away by having a flow-through structure.

That doesn't automatically mean that you should always go corporate, with any foreign entity the reporting requirements from a GILTI perspective, 5471 controlled foreign corporations, even if you don't have a controlled foreign corporation, the PFIC rules that come into play can create draconian requirements both from the compliance side and from the tax amount owed side as well.

There's no one clean best structure because you do have to factor in those compliance costs as well, and the compliance headaches that are associated with that too. So there's not necessarily one great structure. Oh, there's not one perfect structure, there's considerations to taking of that.

I've heard other members say that with taxation, sometimes, or oftentimes. the answer is, "It depends," right?

[McCormick] The best answer very often is, "It depends." Yes, sir.

Well, Patrick international taxation, right? You live it, you breathe it, you do it.

[McCormick] It's what I do. I was telling somebody the other day, two days ago, I was on the phone at 1:00 a.m. with one of my Indian based clients, so it's I keep myself open, I keep myself ... It's a fun area to work in, but you got to be a little bit flexible at times.

I would say so, 1:00 a.m. phone call with a client, definitely. But Patrick, thanks again for stopping by our offices today.

[McCormick] Absolutely love it.