Investments by U.S. Investors in Non-U.S. Businesses – Tax Planning and Effective Structuring

By:
Gerard O’Beirne, CPA, and Harold Adrion, JD, LLM
Published Date:
Jun 1, 2017

Planning and effective structuring for U.S. investors investing in non-U.S. businesses can only be accomplished with an understanding of the various rules that impact cross-border transactions. Tax advisors must, in particular, be familiar with the following sections of the IRC and Income Tax Regulations:

  • Income Tax Regulation section 301.7701-1 to 301.7701-3: Choice of Entity
  • IRC sections 951-964: Controlled Foreign Corporations and Subpart F Income
  • IRC sections 1291-1298: Passive Foreign Investment Companies
  • IRC section 367: Transfer of U.S. Assets to Foreign Corporations
  • IRC section 901(m): Covered Asset Acquisitions

The United States has a vast network of income tax and estate tax treaties, and tax advisors will also need to address the relevant treaties for the country into which the U.S. investor is investing.  Further, in 2016, the Organization for Economic Cooperation and Development recommended that countries adopt certain action plans put forth in its base erosion and profit-shifting (“BEPS”) project, which addresses tax avoidance strategies and techniques employed by multinational businesses to reduce their overall tax burden. Over 100 countries adhere to or are considering adopting one or more of the recommendations. Accordingly, international tax advisors must take these concepts into account as well.

Overview of U.S. Taxation

Unlike most countries that only tax their residents on income arising within its borders, the United States taxes its citizens, residents, and domestic corporations on worldwide income. This system creates a risk of double taxation because a foreign country may also tax the same income arising within its borders. The United States therefore provides relief—or at least mitigation of double taxation—through foreign tax credits and special exclusions, such as the foreign earned income exclusion, which is contained in IRC section 911.

When a U.S. person invests in a foreign corporation, the United States will only tax that foreign corporation on its income from U.S. sources or income that is effectively connected with a U.S. trade or business. This might allow a U.S. taxpayer to defer the U.S. tax on income generated in a foreign corporation until the income is repatriated to the United States.  

As with any investment, a U.S. investor considering investing in a foreign enterprise must consider the choice of entity. This requires the investor to analyze whether the income will be of the type that allows for deferral of U.S. tax—and, if it is, whether the U.S. investor wants to defer the tax. Deferring the tax will generally be advantageous if the income being generated outside the United States is in a low- or no-tax jurisdiction.  If earnings and profits are needed to expand that business overseas, deferral might be desired. If, however, the income is in a high-tax jurisdiction, foreign tax credits will generally alleviate the burden of U.S. tax, and the need for deferral might be less—apart, perhaps, from state and local tax implications.

On the other hand, even in a low- or no-tax jurisdiction, if cash generated overseas will be needed to fund other obligations back in the United States, deferral might not be warranted because the administrative costs associated with deferral—for example, reporting requirements and calculating and tracking foreign corporate earnings and profits, among others—might outweigh the benefits.

Under IRC section 902, a domestic “C” corporation owning 10% or more of a foreign corporation is deemed to have paid its proportionate share of the foreign entity's foreign taxes upon distribution of the foreign corporation’s earnings and profits. Accordingly, a domestic C corporation can defer U.S. tax on the foreign corporation’s earnings and profits and still get the benefit of the foreign tax credits paid by the foreign corporation upon repatriation of the foreign corporation’s earnings and profits. 

An individual or businesses entity other than a C corporation owning 10% or more of a foreign corporation will not be deemed to have paid its proportionate share of the foreign corporation’s foreign taxes. Accordingly, if that person or entity wants to utilize the foreign business’s foreign tax as foreign tax credits, such person or entity will have to invest in a transparent entity or elect to treat the foreign corporation as transparent. 

An eligible entity uses Form 8832 to elect how it will be taxed under the IRC: as a corporation, partnership, or disregarded entity, depending on the particular facts. The procedure is generally referred to as a “check-the-box” election. The election has effect for only U.S. tax purposes—it has no effect, for example, on the entity’s legal classification or its non-U.S. tax classification.

Once a U.S. investor determines the type of entity it will invest through, the investment needs to be capitalized as debt, equity, or a combination of both. Many foreign jurisdictions require a minimum amount of equity in order for the entity to retain legal standing. Many foreign jurisdictions also have strict debt-to-equity ratio rules and limitations on interest expense. 

From a U.S. perspective, a U.S. shareholder in a foreign corporation might want to fund the foreign corporation with debt. The repayment of the principal by the foreign corporation will not result in U.S. tax, whereas the payment of a dividend will generate U.S. tax. The interest paid by the foreign entity will also generally be deductible in the foreign jurisdiction, reducing foreign taxes. The interest would be taxable in the United States at ordinary rates, unless a hybrid instrument—treated as equity in the United States—is created. If treated as equity, the dividend might be taxed more favorably in the United States. Another consideration is foreign withholding taxes. Many jurisdictions will not impose a withholding tax on interest payments (either through internal laws or treaties), whereas a dividend will generally be subject to foreign withholding tax.  This is obviously a country-by-country analysis.

To prevent abusive deferral of U.S. taxation on income generated in a foreign corporation, the United States has adopted several anti-deferral tax regimes. These anti-deferral regimes include controlled foreign corporations (“CFCs”) and passive foreign investment companies (“PFICs”).

Controlled Foreign Corporations

Under IRC section 957(a), a CFC is a foreign (non-U.S.) corporation where more than 50% of the total combined voting power of all classes of stock entitled to vote or more than 50% of the total value of the corporation is owned by “United States shareholders.” For this purpose, the definition of a United States shareholder under IRC section 951(b) is a U.S. person owning (directly, indirectly, or constructively) 10% or more of the total combined voting power of all classes of stock entitled to vote. Accordingly, if non-U.S. shareholders own 50% or more of the voting power and value of the corporation, the corporation will not be a CFC. Detailed rules describing direct, indirect, and constructive ownership for this purpose are provided in IRC section 958 and the income tax regulations thereunder.

Under IRC section 951(a), if a corporation is a CFC, certain income—known as “subpart F income”—will be taxable to U.S. shareholders whether or not it is distributed to the shareholder. Under IRC section 952(a), there are generally five types of subpart F income: (1) insurance income, (2) “foreign base company income,” (3) international boycott income, (4) illegal bribes, and (5) income from countries that sponsor terrorism or are otherwise not recognized by the United States.

The most common type of subpart F income encountered by U.S. investors is foreign base company income. Foreign base company income includes the following.

  • Foreign personal holding company income: passive investment income, such as dividends, interest, rents, royalties, capital gains, foreign currency gains, and personal service contracts.    
  • Foreign base company sales income: income from the purchase or sale (including profits and commissions) of personal property. This item is generally limited to purchases and sales between related parties, where the property is resold without any appreciable value being added by the seller. This provision applies if the property is manufactured, produced, grown, or extracted outside the country in which the CFC is organized and is sold or bought for use outside such foreign country.
  • Foreign base company services income: fees for certain services performed outside the CFC’s country of incorporation for or on behalf of a related person. These fees can be in the form of commissions, fees, compensation, or other income.
  • Foreign base company oil-related income: Foreign oil-related income other than (1) income derived from a source within a foreign country in connection with oil or gas which was extracted from an oil or gas well located in such foreign country or (2) oil, gas, or a primary product of oil or gas which is sold by the foreign corporation or a related person for use or consumption within such country or is loaded in such country on a vessel or aircraft as fuel for such vessel or aircraft.

These types of income generally could have been earned—either directly or through a U.S. corporation—by the U.S. shareholder and been subject to current U.S. taxation. To remove the incentive to defer taxation, subpart F subjects the U.S. shareholder of the CFC to current U.S. taxation on this income. While there are various exceptions, limitations, and exclusion rules that might apply, they are beyond the scope of this article.

Passive Foreign Investment Companies

Unlike the CFC rules, the PFIC rules look to the assets and income of the foreign corporation, not the shareholdings in the foreign corporation. A PFIC is a foreign corporation where (1) more than 50% of the corporation’s assets are passive assets (assets that generate passive income, such as interest, dividends, rents, and royalties) or (2) more than 75% of the corporation’s income is passive income. It does not matter how much of the PFIC is owned by U.S. persons. The PFIC regime only applies to U.S. persons owning shares in a PFIC.

Barring any tax elections that a PFIC shareholder can make, the PFIC rules apply a punitive tax regime on the shareholder known as the “excess distribution” regime. Where a PFIC makes an excess distribution, the shareholder is deemed to have earned that excess distribution over his or her holding period of the PFIC, and it is taxed at the highest marginal ordinary income tax rates—with an additional interest charge—as though it had been earned in each of those years.

Under IRC section 1291, an excess distribution is defined as: (1) the amount of the distribution that is in excess of 125% of the average distributions over the preceding 3 years and (2) gain on sale of stock in the PFIC. Accordingly, the sale of a PFIC will not be taxed at the favorable long-term capital gains rate—but rather at the highest marginal ordinary tax rates spread over the shareholder’s holding period, with an interest charge applied.

Example: U.S. Investor holds PFIC stock for 10 years. There are no distributions made by the PFIC during that 10-year period. After 10 years, U.S. Investor sells the stock and generates a $100,000 capital gain. Under the PFIC rules, the $100,000 of gain is deemed to be earned over 10 years at $10,000 for each. The highest rate of tax for each of those years applies to the $10,000. An interest charge is then applied to the tax so that there will be 9 years of interest charged on the tax in Year 1, 8 in Year 2, and so on.

If either of the CFC or PFIC rules applies, there are certain U.S. tax elections that can be made to mitigate the consequences, but these elections will generally eliminate the ability to defer U.S. tax on the income. 

IRC section 367: Transfer of U.S. Assets to Foreign Corporations

IRC section 367(a) is intended to prevent U.S. persons from avoiding U.S. tax by transferring appreciated property, including stock, to a foreign corporation in a tax-free organization or reorganization and then selling the appreciated property outside the tax jurisdiction of the United States. Such a transfer of property—called an “outbound” transfer—is treated as a taxable exchange unless the transfer qualifies for an exception to the general rule.

IRC section 901(m): Covered Asset Acquisition

IRC section 901(m), which was enacted in 2010, disallows a foreign tax credit but permits a deduction for foreign taxes on income attributable to "basis differences" arising from covered asset acquisitions (“CAAs”). In general, a CAA is an asset purchase or deemed asset purchase for U.S. purposes—but is treated differently in the relevant foreign jurisdiction, resulting in a step-up in basis of an entity’s assets for U.S. tax purposes, but not for foreign tax purposes. In such cases, the taxpayer's foreign income (and therefore its foreign tax) is relatively greater than the income that is recognized for U.S. tax purposes, due to enhanced depreciation deductions attributable to the step-up in the basis of the acquired assets. IRC section 901(m) is intended to deny the enhanced foreign tax credits that would otherwise result from this basis disparity.

Conclusion

The above discussion is not intended to be all inclusive, but rather to give the reader a basic understanding of the obstacles and opportunities that one might encounter when advising a U.S.-based taxpayer on investing in businesses outside the country. Each case an advisor encounters will be fact specific. Certain rules will apply or not apply depending on the nature of the income, the nature of the business, the specific countries in which the U.S. shareholder invests, whether the shareholder is an individual or an entity, and whether that entity is transparent or opaque.

As of the date of this article, several proposals have been presented in Congress and by the Trump administration to completely overhaul the U.S. tax code, including its international tax provisions. Although tax professionals can only advise their clients based on current law, it would certainly be prudent for advisors to carefully monitor the status of changes under consideration, as well as their potential impact.


Gerard_O'BeirneGerard O’Beirne, CPA, is a tax partner with more than 20 years of experience. He focuses on corporate (federal, state and local) taxation and providing tax compliance, tax planning, tax advisory and various regulatory consulting services to the corporate sector, including representing corporations before regulatory bodies. His clients span public, private, multistate and multinational entities. Gerry’s practice has involved serving clients with operations in Western Europe and Asia, including the United Kingdom, Spain, Greece, Russia, Australia, South Africa, Singapore and China. Gerry’s expertise includes advising the CFOs of both inbound and outbound international businesses on tax compliance, tax planning and tax advisory issues. This includes tax services to foreign entities operating in the U.S., as well as U.S. corporations doing business overseas. He also works with expatriates on their financial management and tax issues, including pre-departure and subsequent return tax planning and compliance. Gerry regularly speaks on international tax matters at conferences. He can be reached at GERARD.OBEIRNE@EISNERAMPER.COM or 212-891-4056.

 

Adrion_HaroldHarold Adrion, JD, LLM, is a counsel specializing in international tax. He has advised U.S. and foreign-based multinational publicly and privately held enterprises and individuals on domestic and international tax issues for more than 30 years. He is recognized as a leading tax practitioner on cross-border and international transactions and tax planning, including advising on cross-border mergers and acquisitions, financings, and other business arrangements and relationships including joint ventures, partnerships and business trusts. Harold also devotes much of his time to individual international tax issues, including personal investments, employment and immigration matters. He has advised significant investment bankers with respect to corporate finance arrangements, and international private equity funds. Harold advises a number of multinational companies on intercompany pricing issues, including preparing transfer pricing reports, and obtaining advance pricing agreements. He has worked extensively with the Treasury and IRS on tax treaty issues and has obtained a number of competent authority rulings regarding treaty issues. Harold is a frequent and popular speaker before professional groups. He is a regular contributor to Tax Notes, Tax Notes International and Tax Management International Journal. He can be reached at HAROLD.ADRION@EISNERAMPER.COM or 212-891-4082.

 
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