Editor’s note: The February issue of Advisor’s Edge reviews other ways the U.S. tax changes affect cross-border clients.
The recently passed U.S. tax law makes it more complicated for American citizens outside the United States to run businesses. The new Tax Cuts and Jobs Act (TJCA) contains two complex tax regimes to consider: the one-time mandatory repatriation tax and the annual GILTI rules. Their one-two punch may drive U.S. citizens to renounce their citizenship. Here’s why.
1. The one-time mandatory repatriation tax
The new U.S. tax law transitions the U.S. corporate tax system from a worldwide model to a territorial model. The worldwide system had incentivized large companies to keep profits offshore in foreign subsidiaries. Apple, for instance, currently has more than US$200 billion offshore being deferred from U.S. corporate taxation.
To pay for the corporate tax system transition, the TCJA imposes a tax on all offshore profits deferred from U.S. tax since 1986. This tax is known informally as the “one-time tax.” Companies like Apple will benefit significantly from the new corporate tax system, so it is logical to impose a one-time tax on deferred profits to pay for the transition.
The one-time tax also extends to U.S. citizens who own foreign corporations. Simply put, the one-time tax is integrated into the existing controlled foreign corporation (CFC) regime. This regime applies to U.S. citizens who own 10% of a CFC. Without going into technical detail, the one-time tax taxes all profits of the CFC that have been previously deferred from personal tax since 1986. The one-time tax has two tax rates: 15.5% for cash and investments, and 8% for illiquid investments.
A simple example illustrates the severity of this tax. Dr. Jones is a U.S. citizen in Canada who practices medicine through a Canadian corporation that she wholly owns. If her medical corporation has US$1 million in investments that come from deferred profits, the one-time tax would cost her US$155,000 (15.5% of her corporately owned investments that have been deferred from personal tax since 1986).
Renouncing cannot negate the impact of the one-time tax. It does, however, alleviate the burden of the GILTI regime, to which Dr. Jones is also subject.
2. The GILTI regime
GILTI is an acronym for “Global Intangible Low-Taxed Income.” Under the new U.S. corporate tax system, U.S. corporations are now generally only taxed on the income of the U.S. company itself; dividends received from a foreign subsidiary are tax-free. GILTI was enacted to ensure that companies do not then try to shift all profits to foreign subsidiaries in low-tax countries to then be repatriated tax-free. That’s a laudable goal as applied to large multinationals, but U.S. taxpayers living abroad are also caught up in these complicated rules.
Here is a simplified summary of the GILTI regime. Profits earned through a CFC owned by a U.S. citizen must be classified as GILTI or not. Profits are deemed GILTI if they exceed a 10% return on depreciable tangible assets owned by the corporation. Many professional corporations don’t require a lot of tangible property like equipment. For instance, an incorporated doctor who is a Canadian-resident U.S. citizen may only own computers and medical equipment. Yet the profits of the doctor’s corporation will be deemed GILTI income to the extent they exceed 10% of the corporation’s investment in depreciable tangible assets.
GILTI income is undesirable because it is taxed to the U.S. taxpayer personally, even if it is not distributed to the U.S. taxpayer personally. Worse, the ability to offset the GILTI inclusion with Canadian tax paid is limited.
As a result:
- because the GILTI rules are so complicated, the annual accounting costs associated with determining whether profits are GILTI or not will be high;
- for U.S. citizens who perform services through foreign corporations, the ability to defer income from personal tax will be limited; and
- the limitation on the foreign tax credits creates a significant double tax risk.
To illustrate these consequences, let’s look at the case of Dr. Jones again. Let’s say she earns profits of CA$500,000 but only takes a salary from the corporation of CA$100,000. Prior to the new U.S. tax law, she could have deferred the remaining CA$400,000 from personal tax until she needed the money. However, because she is a doctor working in a hospital, her company’s only tangible asset is a laptop worth CA$3,000. Under the new GILTI rules, all profits earned by the company (CA$400,000) in excess of a 10% return on her laptop (CA$300) would be taxed to her personally in the U.S. That would significantly limit her ability to defer her medical income from personal tax, dramatically increasing the amount of tax she pays annually; she will pay personal tax on almost the full CA$500,000 she earns. Her annual U.S. tax accounting bill will also increase dramatically.
The end result is that Dr. Jones will be substantially worse off. If Dr. Jones attaches little value to her U.S. citizenship, the one-two punch of the one-time tax and the GILTI rules may encourage her to renounce.
Renouncing U.S. citizenship
A full discussion of the pros and cons, as well as tax and immigration implications of renouncing U.S. citizenship, can be found here. The rules on renunciation are largely unchanged under U.S. tax reform, but the TJCA does allow more people to renounce without paying taxes. In order to renounce without tax exposure, a U.S. citizen’s net worth has to be less than US$2 million. It is now possible to make gifts of up to US$11 million (up from US$5.5 million under the prior law) to reduce a citizen’s worth below the threshold.
With proper advice, it should be possible for Dr. Jones to renounce her American citizenship without paying any taxes to renounce and without any border risk. If the practical and emotional value of the citizenship is not worth the tax headaches caused by the one-time tax and the GILTI regime, then that may be a wise decision.
Either way, the new U.S. tax rules make life far more complex and expensive for U.S. citizens abroad who own foreign corporations.
Max Reed and Charmaine Ko are U.S. tax lawyers at SKL Tax in Vancouver. Max can be reached at firstname.lastname@example.org