Twelve % Tax on Deferred Earnings Likely to Apply ONLY to Larger/Multi-National Corporations

 
UPDATE November 6 2017 – see below
 


 
Since the new House GOP Tax Bill came out, many are looking beyond the obvious and trying to analyze what this might really mean in peoples’ lives. This post appeared on the Isaac Brock Society on Nov 2 by Stephen Kish. The following sections are excerpts from that post:

Here is the United States House “Tax Cuts and Jobs Act” bill of November 2, 2017.

This is a first pass proposed repeal/amendment etc. of the 1986 Internal Revenue Code of 1986 and is permanently stored here.

November 3 UPDATE:

I was just made aware of an article by Max Reed that apparently indicates that US persons overseas who own small business corporations might be harmed by the new tax legislation. In particular, the imposition of a one-time 12% tax on deferred earnings [THIS INCLUDES LOCAL EARNINGS] would hit not just the intended giant corporations overseas, but also the tiny incorporated businesses (e.g., family or one person farming or medical doctor “corporation”). This would include “U.S. Persons” who have no meaningful relationship with the U.S.

From the Max Reed article:

“… New punitive rules that apply to US citizens who own a business. Currently, most US citizens who own a Canadian corporation that is an active business don’t pay tax on the company’s profits until they take the money out. The House plan changes this. It imposes a new, very complicated, set of rules on US citizens that own the majority of a foreign corporation. The proposal would tax the US citizen owner personally on 50% of the entire income of the Canadian corporation that is above the amount set by an extremely complex formula. At best, this will make the compliance requirements for US citizens that own a business extremely complicated and expensive. At worst, this will cause double tax exposure for US citizens who own a Canadian business on 50% of the profits of that business.

Imposition of a 12% one-time tax on deferred profits. Under the new rules, the US corporate tax system is transitioning to a territorial model. As part of this transition, the new rules impose a one-time 12% tax on income that was deferred in a foreign corporation. Although perhaps unintentional, since US citizens will not benefit from a territorial model, the new rules impose a 12% tax on any cash that has been deferred since 1986. Take a simple example to illustrate the enormity of the problem. A US citizen doctor moved to Canada in 1987. She has been deferring income from personal tax in her medical corporation and investing it. Now, 12% of the total deferred income since 1986 would be subject to a one-time tax in the US. That may be a significant US tax bill…”

November 4 UPDATE:

Republicans Overseas responds to the above concern:

“Stephen Kish, Your comments were forwarded to a House Ways and Means Committee member’s office. His legislative counsel is looking into this. We will report once we receive their reply.

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Needless to say, while many hoped there would be improvements in our situation, virtually no one voiced concerns about something appearing that would make things worse. Imagine being an incorporated individual (such as a doctor, accountant, lawyer etc, in Canada) and suddenly being told any retained/deferred earnings left in the corporation since 1986 would be taxed at 12%! While there are no guarantees at the moment, before this idea takes firm hold, particularly in the minds of the tax compliance community, here is an analysis which suggests such a notion could most definitely seen as out-of-context if viewed as a standalone. It really only makes sense when applied to the corporations who moved overseas for whom the U.S. is trying to entice to come back.

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USCitizenAbroad says
November 5, 2017 at 9:29 pm

@Stephen Kish

You refer to the “frightening prospect” of the 12% tax on the retained earnings of Canadian Controlled Corporations suggested by Max Reed as follows:
 

Imposition of a 12% one-time tax on deferred profits. Under the new rules, the US corporate tax system is transitioning to a territorial model. As part of this transition, the new rules impose a one-time 12% tax on income that was deferred in a foreign corporation. Although perhaps unintentional, since US citizens will not benefit from a territorial model, the new rules impose a 12% tax on any cash that has been deferred since 1986. Take a simple example to illustrate the enormity of the problem. A US citizen doctor moved to Canada in 1987. She has been deferring income from personal tax in her medical corporation and investing it. Now, 12% of the total deferred income since 1986 would be subject to a one-time tax in the US. That may be a significant US tax bill…”

 
@Eric in a later comment confirms that Mr. Reed’s analysis comes from a reference to Sec. 4004 (the transition tax).
 

@Stephen Kish: Yes, he’s referring to Sec 4004 (the transition tax)

 
Although this is unclear and generally difficult to read, I believe that the 12% transition tax (dealing with past retained earnings) does NOT apply to the retained earnings of Canadian Controlled Private Corporations which are owned by INDIVIDUAL shareholders.
 
My reasoning follows …
 
Sections 4001 – 4004 are part of Subtitle A in the proposed bill which appears to deal specifically with the “foreign source” dividends received from certain specific 10-percent owned foreign corporations”. The point is that it deals with domestic corporations that are shareholders of “foreign corporations”.

If you analyze Sections 4001 – 4004, they appear to achieve their objective by amending two different Subchapters of the Internal Revenue Code.
 
Amendments to Sec. 245 which is in the Subchapter of the Internal Revenue Code that describes the computation of taxable income
 
Sec. 4001 is an amendment to the current Sec. 245 which deals very specifically with the deductions available to corporations in the computation of taxable income. Furthermore, by its plain terms Sec. 4001 describes domestic shareholders that are shareholders of foreign corporations. In general the section allows domestic corporations to deduct foreign dividends from the calculation of taxable income. This is the way the USA moves to “territorial taxation” for corporations ONLY.
 
Amendments to the subpart F rules which are found in Subchapter N and used to attribute the income of controlled foreign corporations to U.S. shareholders (Sec. 956, Sec. 961 and Sec. 965)
 
Sec. 4002 is an amendment to the current Sec. 956 which speaks only to the application (or non application) of the section to corporations. In other words, Sec. 4002 applies only to corporations.
 
Sec. 4003 is an amendment to the current Sec. 961 which applies ONLY to corporate shareholders of foreign corporations.
 
Sec. 4004 replaces Sec. 965 which is a section that deals specifically with “the case of a corporation which is a United States shareholder”. I agree that Sec. 4004 (if read outside the context of Subtitle A) could be interpreted to apply to individual shareholders. That said:
 
1. Sec. 4004 replaces a section that deals specifically with corporations; and

2. For Sec. 4004 to apply to individuals would make it the “odd man out” in Subtitle A (in the proposed bill) which is clearly descriptive of how corporations would transition to “territorial taxation”.
 
For these reasons I don’t see how the 12% “transition tax” would apply to individual shareholders.
 
But, Mr. Reed also describes a “prospective tax” (found in Sec. 4301) of the proposed bill on the U.S. citizen shareholders of Canadian Controlled Private Corporations as follows (which I think may be accurate):
 

It imposes a new, very complicated, set of rules on US citizens that own the majority of a foreign corporation. The proposal would tax the US citizen owner personally on 50% of the entire income of the Canadian corporation that is above the amount set by an extremely complex formula. At best, this will make the compliance requirements for US citizens that own a business extremely complicated and expensive. At worst, this will cause double tax exposure for US citizens who own a Canadian business on 50% of the profits of that business.

 
Renounce & Rejoice!

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UPDATE November 6 2017

Stephen wrote to Max, asking him to explain his conclusion and why it differed from USCitizenAbroad’s. Unfortunately for us, he is sticking to his initial analysis. Let us hope this gets clarified ASAP.

 

Max Reed has just reviewed USCA’s analysis for me but still feels that, irrespective of intent of the drafters, the proposed tax reform bill, as stated, captures ALL owners of foreign corporations (bad news for us if true).

I am passing this analysis on to Republicans Overseas hoping that it will be passed on to the mark-up folks.

 

Max’s November 6, 2017 response sent to me:

“The purpose of the two sections 4004 and 4301 are to transition the US federal corporate tax regime from a global model to a territorial model. To accomplish this, they create new categories of Subpart F” income that relies in large part on the existing controlled foreign corporation US citizens abroad are already familiar with these rules as they apply to those who own foreign corporations.

As a result, the way the sections are drafted provides for a broader application than the drafters may have intended (I’m not sure).

The technical reasons for this result are briefly summarized as follows. Both sections 4004 and 4301 apply to “United States Shareholders”.

That term is currently defined in Code section 951(b) to mean a US person defined in 957(c) who owns 10% or more of the voting stock of a foreign corporation. Section 957(c) essentially adopts the definitions 7701(a)(30) including US citizen.

There is no change to either Code section 951(b) or Code section 957(c) in the House bill that would alter this. Consequently, 4004 and 4301 apply to “US Shareholders” including all US citizens, US green card holders, US trusts as well as US corporations who own 10% or more of the voting stock of a foreign corporation.

There is no carve out elsewhere in the bill.

The fact that other provisions in the same section only apply to corporate shareholders does not affect the reading of 4004 and 4301. Those sections specifically note the limited application of those provisions whereas 4004 and 4301 do not. Further, the fact that existing section 965 only applied to corporate shareholders also does not matter as it is being replaced in its entirety by new section 965.

In short, the purpose of the provisions may be to assist in the transition to a territorial corporate tax system.

But, as drafted, from a technical perspective the legal effect of them will be so much broader. It will apply this 12% one-time tax to US citizens who own an interest in CFCs [e.g., an incorporated medical doctor’s clinic].

It will further apply an ongoing complex new tax regime to US citizens that own a foreign business that earns active business income. These provisions may not be passed in their current state. I certainly hope not. But if they are the effects on US citizens outside the US will be significant.”

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a response from USCitizenAbroad

@Stephen Kish

Re: The Max Reed response to you vis-a-vis my suggestion that that the proposed should NOT be read to include the Canadian Controlled Private Corporations for the “one off 12% tax”.

Mr. Reed’s interpretation is characterized by a the notion that one section of the IRC can/should be divorced from the context in which it appears. Perhaps he is right. Perhaps not. But interestingly the IRS specifically warns that the individual sections of the IRC should be read in the context of the entire code (and therefore obviously the individual subtitles).

Specifically note IRS Official Guidance:

Finally, the IRC is complex and its sections must be read in the context of the entire Code and the court decisions that interpret it. At a minimum, please do not be misled by the false interpretations of the IRC promoted by the purveyors of anti-tax law evasion schemes.

The idea that a a move to territorial taxation for corporations (who have the opportunity to repatriate their earnings at a discount) should be applied to the individual shareholders of Canadian Controlled Private Corporations, is absurd.

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