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Americans Abroad And The Transition Tax – Leaves Taxpayers In Tough Situation



John Richardson - Transition Tax Leaves Taxpayers In Tough Situation

As 2018 comes to and end many individuals are still trying to decide how to respond to the Sec. 965 “transition tax” problem. The purpose of this post is to summarize what I believe is the universe of different ways that one can approach Sec. 965 transition tax compliance. These approaches have been considered at various times and in different posts over the last year.

As 2018 comes to an end the tax compliance industry is confused about what to do. The taxpayers are confused about what to do. For many individuals they must choose between: bad and uncertain compliance or no attempt at compliance. (I add that the same is true of the Sec. 951A GILTI provisions which took effect on January 1, 2018.)

But first – a reminder: This tax was NEVER intended to apply to Americans abroad!!!

A recent post by Dr. Karen Alpert – “Fixing the Transition Tax for Individual Shareholders” – includes:

There have been several international tax reform proposals in the past decade, some of which are variations on the final Tax Cuts and Jobs Act (TCJA) package. None of these proposals even considered the interaction of the proposed changes with taxing based on citizenship. One even suggested completely repealing the provision that eliminates US tax on dividends out of previously taxed income because corporate shareholders would no longer be paying US tax on those dividends anyway.

and later that …

One of the obstacles often mentioned when it comes to a legislative fix is the perceived requirement that any change be “revenue neutral”. While this is understandable given the current US budget deficit, it shouldn’t apply to this particular fix because the transition tax liability of individual US Shareholders of CFCs was not included in the original estimates of transition tax revenue.

The bottom line is:

Congress did not consider whether the transition tax would apply to Americans abroad and therefore did not intend for the transition tax to apply to them. Within hours of release of the legislation, the tax compliance industry, while paying no attention to the intent of the legislation, began a compliance campaign to assist owners of Canadian Controlled Private Corporations to turn their retirement savings over to the IRS. There was (in general) no “push back” from the compliance industry. There was little attempt on the part of the compliance industry to analyze the intent of the legislation. In general (there are always exceptions – many who I know personally – who have done excellent work), the compliance industry failed their clients. By not considering the intent of the legislation and not considering responses consistent with that intent, the compliance industry effectively created the “transition tax”.

In fairness to the industry, Treasury has given little guidance to practitioners and the guidance given came late in the year. In fairness to Treasury, by granting the two filing extensions, Treasury made some attempt to do, what they thought they could, within the parameters of the legislation.

The purpose of this post …

This post will summarize (but not discuss) the various options. There is no generally preferred option. This is not “one size fits all”. The response chosen will largely depend in the “stage in life” of the individual. Younger people can pay/absorb the “transition tax”. For people closer to retirement, for whom the retained earnings in their corporations are their pensions: compliance will result in the destruction of your retirement.

After summarizing the various options I will conclude by discussing the question of, how much of the foreign (Canadian) tax paid by the individual shareholder (on a 2017 distribution), is allowable as a FTC against Sec. 965 transition tax liability. This is a technical topic. I am discussing this to alert you to the issue. Obviously you would need to discuss this (and any of these options) with your favourite (if you have one) U.S. tax compliance specialist.

Here we go …

My impression is that people are utilizing a wide range of responses. Generally the responses fall into four categories:

Category 1 – Full Compliance And Full Payment Without Consideration of Foreign Tax Credits

– simply accepting the 965 transition tax and paying the full amount
– simply accepting the 965 transition tax and paying the full amount over the eight year period

Who are Category 1 Compliers? These are younger people with strong projected earnings who do NOT want to distribute the earnings in their corporations. Note that with strong earnings they will have to face the Sec. 951A GILTI problem which means they should renounce their U.S. citizenship quick time. I would also note that with full compliance with Sec. 965 (payment of the tax) they will receive a “bump up” in the adjusted cost basis of their shares in the corporation. (The “bump up” will help on the S. 877A Exit Tax issue should they renounce U.S. citizenship).

Category 2 – Full Compliance Utilizing Foreign Tax Credits to pay the Sec. 965 transition tax liability

– making use of FTC carry forwards as a mechanism to pay the Sec. 965 transition tax liability

– making use of the Section 962 election which allows the use of taxes paid inside the corporation to offset/reduce the Section 965 transition tax liability. Any remaining transition tax liability would be paid. Note that (contrary to the “compliance party line”) this may not actually result in double taxation. Full Canadian tax credits should be available to offset U.S. tax due on – post 2017 distributions (I think).

– using distributions in 2017* and 2018 (with a one year carry back) from PTI (Previously Taxed Income) to generate FTCs on the individual side to offset Section 965 transition tax liability. This will LIKELY result in the erosion/liquidation of the corporation.

Who are Category 2 Compliers? This is a much more complicated way of dealing with this situation. There are people (except for the FTC carry forward people) who must use the retained earnings in the corporation to pay the transition tax. Note also that the use of the Sec. 962 election will NOT provide the “bump up” in the adjusted cost basis of the shares (which may or may not be a problem on the subsequent renunciation).

Category 3 – Treaty Response: Arguing generally that the Sec. 965 transition tax (1) results in double taxation (which certainly occurs when there are timing mismatches between the 2017 inclusion and later distributions) or (2) results in the taxation of undistributed earnings of a non-U.S. corporation

These arguments have not received enthusiastic support from the tax compliance industry because:

– the tax compliance industry is about compliance and not about generating and supporting arguments for why there should be no compliance; and

– backstopping their propensity to compliance by arguing that the “savings clause” allows the United States to do anything it wants to a U.S. citizen (which doesn’t get the benefit of the tax treaty). That said, the prohibition against double taxation is an exclusion from the “savings clause”

Who are Category 3 Compliers? They are people who want no part of this. They are simply not participating in the Sec. 965 transition tax confiscation of their assets. They will file and take the position that the “transition tax” doesn’t apply because it violates the tax treaty.

Category 4 – Treaty Response: Arguing that any disallowance of FULL CREDIT for foreign tax paid on 2017 distributions violates the tax treaty

Now on to the primary addition to my previous posts. I will first define the issue. I will then suggest both (1) an Internal Revenue Code response to the issue and then (2) A tax treaty response to the issue. This will be brief. My purpose is to make you aware of this and not explore the technicalities.

The issue …

Section 965 requires a 2017 income inclusion for a percentage of the undistributed earnings accumulated in the corporation since 1986. For many shareholders this will be an inclusion of approximately 50% of the earnings. Well, if only 50% of the earnings are included in the income, then shouldn’t one be able to use only 50% of the foreign tax paid on those earnings an offsetting foreign tax credit? Maybe yes. Maybe no. But, Section 965 requires those taxpayers who make use of FTCs, arriving at the appropriate FTC, to reduce the actual amount of taxes paid by the same percentage as the reduction of income.

For example (a very general example):

Imagine corporate income of $1000 Imagine that the corporation had paid $300 of foreign tax on that $1000.00. Imagine that only $500 of that $1000 (50%) is included in income. Then shouldn’t the corporation (in determining the applicable FTC) be required to reduce the $300 tax paid by 50%? Shouldn’t the FTCs allowed be ONLY the proportion of tax paid on the amount of the income actually included in income? How does Sec. 965 achieve this result?

Internal Revenue Code Sec. 965 includes:

(g) Disallowance of foreign tax credit, etc.

(1) In general

No credit shall be allowed under section 901 for the applicable percentage of any taxes paid or accrued (or treated as paid or accrued) with respect to any amount for which a deduction is allowed under this section.

Okay, so far so good. But, what happens in the following situation (using the same set of facts):

1. The income inclusion to the individual shareholder is $500. Let’s imagine that the U.S. tax payable by the individual is $100.

2 The shareholder pays a dividend to himself of $200. Let’s imagine that the CDN (or other foreign tax) is $100.

Can the full $100 be used as an FTC to offset the U.S. tax? Must the $100 of tax be reduced by 50% to only $50. As you can see this is a major issue. I believe there are strong arguments supporting the conclusion that the FULL $100 availability to use as an FTC.

If this is not clear, let’s get some help from Professor Allison Christians who explains the issue as follows:

As explained by Professor Allison Christians in Tax Notes:

But the shareholder immediately faces a conundrum if section 965(g) is read to impose a limitation on the U.S. creditability of this foreign tax. This section states that if foreign taxes are paid on an amount of income that is subject to reduction by section 965(b), no credit shall be allowed under section 901 for the “applicable percentage” portion. This is colloquially referred to as a “grind-down.” Accordingly, when an amount of income is or would be ground down for calculating the section 965 transition tax, as in the example above, the question is whether, as the proposed regulations suggest, the foreign taxes paid on actual cash distributions must also be ground down in applying the FTC limitation. GILTI accomplishes a similar result more directly, by expressly limiting creditability to 80 percent of the foreign tax.

The implication of this interpretation is that the foreign tax on amounts distributed to U.S. shareholders of specified foreign corporations would be eligible for only a partial credit. This potentially leaves an uncredited amount of foreign tax paid on cash distributions made to U.S. shareholders of foreign corporations on foreign-source income. Yet the relevant statutes and regulations are silent regarding the current and future treatment of the portion of foreign taxes that would be thus denied creditability.

The IRS position in the August 1, 2018 Regulations …

The August 1, 2018 regulations which were announced here here and may be found here.

reg-104226-18

It appears that the position in the Treasury Regulations is that the $100 tax paid by the individual shareholder to Canada WOULD be subject to the 50% “grind down”. As per one commentator put it:

Foreign tax paid on a distribution of PTI is subject to the “grind down” – 1.965-5(b) – p 197 of the pdf document – also described on page 67 of the explanation portion.

As you can see, this is a BIG problem because it means that far more retained earnings are required to be distributed in order to generate enough Canadian tax to offset the transition tax liability. The only way to generate more tax credit is to generate more distributions.

This Treasury interpretation does NOT allow full FTCs on distributions received by the shareholder and does NOT appear to be consistent with either the text of Section 965 or with the Canada U.S. Tax Treaty. Each of these will be considered in turn.

Disallowing full FTCs and the contextual reading of Internal Revenue Code Section 965

You will recall that Section 965 includes:

(g) Disallowance of foreign tax credit, etc.

(1) In general

No credit shall be allowed under section 901 for the applicable percentage of any taxes paid or accrued (or treated as paid or accrued) with respect to any amount for which a deduction is allowed under this section.

To put it simply (or as simply as it can be put):

The whole of Section 965 deals within the context of Sec. 965. It does not address what happens to the income after it leaves the corporation as a distribution. The significance of this is developed in a very technical article (written before the August 1, 2018 regulations) by Max Reed and Charmaine Ko appropriately titled – “The Grind down of Foreign Tax Credits and the Code Section 965 Inclusion” – which is available here. The article is quite technical, written for tax professionals and does not constitute legal advice. The authors summarize their conclusions based on a reading of Section 965 of the Internal Revenue Code as follows:

Above, the order of the 2017 tax inclusions is set out. Notice 2017-8 makes clear that a dividend or bonus paid by a Canadian company effective as at 12/31/2017 would not be US taxable, because it would be considered previously tax income under Code section 959. This is because the Code section 965 inclusion is taken into account prior to the dividend. Recall that the foreign tax credit grind down under Code section 965(g) applies “with respect to any amount for which a deduction is allowed under this section.” The plain meaning of this phrase suggests that a dividend paid out by the Canadian company effective 12/31/2017 would not be caught. An individual Canadian shareholder who owns a CFC does not generate any Canadian tax with respect to the 965 inclusion itself so there is no US FTC generated because of that. Instead, the individual CFC owner gets a deduction as computed under the general principles of Code section 965. According to Notice Notice 2017-8, a dividend or bonus paid on 12/31/2017 would occur after the 965 inclusion has already been taking into income. Thus, any US FTC generated by the Canadian tax owed as a result of the dividend or bonus payment on 12/31/2017 is not “in respect of an amount for which a deduction is allowed” because the Canadian tax owing is not generated by the same item which is subject to the 965 inclusion, i.e. the CFC’s post-1986 accumulated E&P, but rather, the FTC is generated by the later-in-time dividend. Put differently, the US FTC generated by the Canadian tax on the dividend or bonus payment comes from a different tax event of income than the 965 inclusion. The deduction only applies to income generated by the 965 inclusion. Because the dividend is a different tax event, it cannot be said to be “in respect of an amount for which a deduction is allowed” under section 965. Thus, on the plain meaning of Code section 965(g) the grind down does not apply to the FTC generated by the dividend.

To be clear, the authors reason that under the text of Internal Revenue Code Sec. 965 that there is NO GRIND DOWN of the tax paid at the individual shareholder level for the purposes of determining any FTC to offset the transition tax.

Although not central to their argument, the authors do comment on the applicability of the Canada U.S. Tax Treaty as follows:

The Canada-US Tax Treaty offers a backstop to this position

The Canada-US Tax Treaty offers a backstop (an alternate route to arrive at the same conclusion) that there should be no grind down in the FTC related to a dividend subsequently paid. That argument runs as follows. Under Treaty Article XXIV, the dividend income is Canadian source income when received by a Canadian resident US citizen. Under Treaty Article XXIV(1), the US has to give a credit for Canadian tax paid on that dividend unless there is a limit under US domestic law. Our general view is that the Treaty credit generally exceeds that available under US domestic law (consider the credit available under Treaty Article XXIV(5)). Regardless, any limitation under US domestic law would have to expressly limit the Treaty benefit. Code section 965(g) is silent as to the application of the Treaty. Thus, it cannot be said that there is a limitation as to the Treaty credit. Although the US generally has a later-in-time rule under which the Code can be used to override the Treaty, such Treaty overrides are generally explicit. Compare this to Code section 7874 or Code section 884(e) or where the override of treaty benefits is explicit. Where possible, a Treaty and the Code are meant to be read harmoniously (see Haver v. Commissioner, No. 05-1269 (D.C. Circuit 2006)). Even if an override is implied, in instances of inconsistency, the Treaty prevails (Protocol 3 Amending the 1980 Canada-US Tax Treaty (April 24, 1995).)

In short, there is a reasonable position under the Treaty that the Code section 965(g) grind down would not apply to FTCs generated by Canadian tax paid on a subsequent dividend.

Kudos to Charmaine Ko and Max Reed for a superb analysis!

Disallowing full FTCs under Sec. 965 and the Canada U.S. Tax Treaty

On October 8, 2018 (after the release of the Sec. 965 regulations) Professor Christians published an insightful article in Tax Notes (referenced above) titled: “Limiting Foreign Tax Credits: Not So Easy”

Professor Christians supports the view that applying the “grind down” to the Canadian/foreign tax paid on the distribution to the shareholder DOES violate the tax treaty. The relevant excerpt is as follows:

It therefore seems necessary to interpret sections 951A and 965 to exclude from the FTC haircut any foreign tax paid on cash distributions made to U.S. shareholders who are eligible for the benefits of the treaty. The logic of the FTC haircut is preserved when a country (with a treaty or not) imposes no tax on such distributions, because in those cases there is no double taxation and therefore no cause to provide U.S. tax relief. The same result would be created by a per-country credit limitation, as it would if Congress created a separate basket for section 965 income as it did for section 951A. However, the haircut creates, rather than relieves, double taxation when it applies to a taxpayer that faces foreign tax on distributions it makes from the same income subject to deemed distribution by the United States.

Treaties are with countries with which the United States is determined to solve issues of double taxation for their mutual advantage. Since curtailing the U.S. tax credit for creditability of foreign-source taxes is not compatible with these U.S. treaties, is not in line with the general principles of how the United States relieves double taxation, and is accompanied by no express intent to override, it is reasonable to conclude that existing treaty provisions that provide relief of double taxation must remain in effect.

What Will Treaty Partners Do?
Even if the above argument for the treaty-based applicability of full creditability holds, it is not clear whether treaty partner jurisdictions ought to fight Treasury on the strength of U.S. constitutional jurisprudence regarding treaty override — and not only because such a fight is hard to win. Instead, at least in the case of section 965, foreign jurisdictions might not want to fight because the limit on creditability paradoxically presents U.S. shareholders an incentive to accelerate source-country taxation where the transition tax will be imposed.

To avoid potentially permanent double taxation created by a reduction of the creditable foreign tax base, U.S. shareholders might well choose to increase their foreign distributions until they generate sufficient tax at source to absorb the U.S. tax, even if this is in the gross amount of the U.S. deemed distribution rather than the ground-down amount. Perhaps foreign countries ought to object that as the residence country in this scenario, the United States is supposed to collect its residual tax only after the source country takes its bite. On the other hand, perhaps they will accept the incentive the United States is creating for U.S.-controlled companies to disgorge their profits. This is an odd incentive to construct with a provision meant to mitigate against U.S. tax base erosion.

Given the lack of an express intent to override and the fact that at the end of the day, taxpayers can and likely will eliminate U.S. tax wherever an equivalent source-based tax would eventually apply, it seems that both U.S. courts and Treasury in its role as treaty competent authority ought to reconcile U.S. tax treaties with the TCJA provisions in favor of unreduced source tax creditability. In the meantime, taxpayers face uncertainty and expense in trying to arrange their affairs to prevent clear instances of double taxation.

Conclusion And Summary …

This post has been to canvass some responses to the Section 965 Transition Tax available to shareholders of Canadian Controlled Private Corporations (and presumably shareholders of other non-U.S. corporations). All of these responses (with the exception of the applicability of the “grind down” to FTCs) have been discussed in previous posts.

The “transition tax” is nothing more and nothing less than:

The retroactive taxation of the undistributed profits of a non-U.S. corporation,that were never subject to U.S. taxation, based on NO REAlIZATION EVENT – but rather on a purely fictitious tax event.

It has left many Americans abroad in an untenable situation. Some can comply. Come can’t comply. Some will comply. Some won’t comply. It is very difficult (and impossible for most) to obtain competent and affordable professional help.

For many, transition tax compliance means turning their pensions over to the IRS. I urge you to support Monte Silver’s transition tax lawsuit.

 

View John Richardson’s Series of Posts on Transition Tax.

 

 

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The Reality of U.S. Citizenship Abroad

My name is John Richardson. I am a dual citizen. I am a lawyer – member of the Bar of Ontario. This means that, any counselling session you have with me will be governed by the rules of “lawyer client” privilege. This means that:

“What’s said in my office, stays in my office.”

I am also a member of the American Citizens Abroad Professional Tax Advisory Council (PTAC). This is an advisory panel focused on assisting American Citizens Abroad in an FBAR and FATCA world.

The U.S. imposes complex rules and life restrictions on its citizens wherever they live. These restrictions are becoming more and more difficult for those U.S. citizens who choose to live outside the United States.

FATCA is the mechanism to enforce those “complex rules and life restrictions” on Americans abroad. As a result, many U.S. citizens abroad are renouncing their U.S. citizenship. Although this is very sad. It is also the reality.