This is the fourth in my series of posts about the Sec. 965 Transition Tax and whether/how it applies to the small business corporations owned by tax paying residents of other countries (who may also have U.S. citizenship). These small business corporations are in no way “foreign”. They are certainly “local” to the resident of another country who just happens to have the misfortune of being a U.S. citizen.
Last night I was discussing the “transition tax” with an “individual” who is impacted by the tax AND is a Homeland American. He is a “tax resident” of ONLY the United States. For Homeland Americans who are subject to ONLY the U.S. tax system the “transition tax” is NOT a bad thing.
For “non-residents” it is a terrible thing, which may destroy their retirements. The reason is that “nonresidents” are subject to both U.S. taxation and taxation in their countries of residence. The “transition tax” is an extremely egregious example of the terrible effects of the U.S. practice of imposing “worldwide taxation” on the residents of other countries. I hope that “the transition tax” will be the “straw that breaks the Camel’s back” and ends the U.S. practice of imposing taxation on people who don’t live in the United States.
After the discussion, I summarized our conversation in the following letter to him. Here is the letter.
Thanks for the chat last night. Because there are so many moving parts to this “transition tax” issue, I wanted to summarize some of the points we discussed (both for me and for possible help to you). This discussion will focus only on how the “transition tax” impacts individuals. The primary purpose of this note is to compare the effects of the “transition tax” on individuals who are “U.S. residents” vs. individuals who are “Non-residents”. The comparison reveals the shocking conclusions that:
(1) the “transition tax may benefit “individuals” who live in the United States; and
(2) the “transition tax” may destroy the retirements and pensions of those who live outside the United States.
When it comes to U.S., there is a striking difference in how the same law affects Homeland Americans vs. the way the law affects “nonresidents”!
Let me begin by reiterating my long held view that: The United States must stop imposing “worldwide taxation” on people who are “tax residents” of other countries and do NOT live in the United States!
The possible impact of the “transition tax” on “non-residents” is a striking example, of why this uniquely U.S. tax policy MUST stop. I strongly suggest that your discussions include the reality that if:
The U.S. were to stop imposing “worldwide taxation” on “non-residents” problems inherent in the “transition tax” would not exist. That said, let me explain:
First – Comparing the effects of the “transition tax” on U.S. residents vs. Residents of other countries who, (because of U.S. citizenship) may be subject to the “transition tax”
The United States is the ONLY country in the world that imposes “worldwide taxation” on the residents of other countries. U.S. residents are NOT “tax residents” of other countries and will experience the “transition tax” ONLY in terms of the U.S. tax system. Furthermore, U.S. residents will certainly be “repatriating” (bringing the corporate retained earnings back to the United States) at some point.
As you point out, the “transition tax” is actually a “good deal” for U.S. residents. The reason is that although they incur the liability in 2017 (they have 8 years to pay the liability) they are incurring the liability at a lower rate than they would probably pay if they were to bring the money back (take distributions from the company) in “dribs and drabs”. To be taxed at the “transition tax” rate is simply a prepayment of U.S. tax at a lower rate. If I were a U.S. resident, I wouldn’t be overly upset by this. Remember that once the retained earnings are included in 2017 income, those earnings will NEVER be subject to U.S. tax again. (From a U.S. tax perspective, it’s just a question of taking the previously taxed distributions from the corporation whenever you want.) To put it simply: Individuals who are U.S. residents actually do receive a benefit by paying the “transition tax”. They are prepaying a future U.S. tax liability at a significantly lower rate. Once this tax has been paid, the earnings subject to the tax will NEVER be subject to U.S. taxation again.
Therefore, for U.S. residents, (given the 8 year payout period) I could imagine that the “transition tax” would be a “good deal”. It’s a “good deal” because:
“U.S. residents are NOT also “tax residents” of other countries! In other words, those corporate earnings when distributed to the U.S. residents will NOT also be subject to taxation by another country. From the perspective of a U.S. resident, the “transition tax” amounts to an “early distribution”, at a preferred tax rate, with generous payment options.
What’s there not to like (or at least tolerate)?
Residents of other countries who (because of U.S. citizenship) may be subject to the “transition tax”
For residents of other countries, NONE of these things is true. The “transition tax” is a disaster which results in a confiscation of retirement assets. Let me explain.
Residents of other countries (including those who identify as Americans abroad) ARE “tax residents” of other countries and therefore those future distributions WILL be taxed by their country of residence. (For example, a Canadian will be taxed on those same future distributions by the Government of Canada.) Furthermore, because they are largely citizen/residents of those countries there is NO PRESUMPTION that these corporate earnings are to be repatriated to the United States. In fact, for many people these retained corporate earnings actually function as their private pension plans. The earnings will stay in the country where they were earned.
To put it simply, for “non-residents”, the “transition tax demand” means that they must simply turn over a portion of their pension plans to the IRS. There is no “realization event”. This means that there is no actual distribution. There is no actual taxable event. It’s pure confiscation. It is the U.S. Government simply forcing them to “turn over” this money to the United States. Sure, they get an 8 year payout. But, for people who are also subject to a second tax system, the “transition tax” will operate as follows:
1. Although the full amount is included in their U.S. taxes for 2017, there is no actual distribution. This means that when there is an actual distribution, it will be taxed a second time in their country of residence. Again, first they pay (what it likely to be at least 20% of the value of the company* – I will explain this calculation below) they are then required to pay tax a second time, to their country of residence, when the money is actually distributed. At a bare minimum this makes double taxation the rule.
2. One might ask: Well, why not take an actual distribution (dividend or salary) in their country of residence and then use the tax paid in the country of residence as a credit against the U.S. “transition tax”? Even if this had been an option, it forces the person to basically liquidate the company. In other words, “bye bye” pension plan.
3. I do acknowledge (and have participated in numerous discussions) about how the technicalities of this “transition tax” would interact with Canada’s tax system, for Canadian residents “All Roads Lead To The Effective Confiscation” of a portion of their assets!
For “residents of other countries” the “transition tax” is NOT the benefit that it is for Homeland Americans. For “residents of other countries”:
- the transition tax is likely to result in double taxation
- the preferred tax rate is of no value because the tax obligation in the country of residence continues to exist
- any attempt to generate foreign tax credits (by taking early distributions) will significantly erode the value of the company and therefore the value of what is (in effect) a private pension.
- They are subject to an impossible compliance obligation (technically difficult and financially costly) that was NEVER intended to apply to them.
To illustrate the effects of this, I would like to reference a recent blog post I wrote on this topic which includes:
Food for thought – distinguishing the literal language from what this actually means in the lives of people affected
The more that a Canadian Controlled Private Corporation functions as a “private pension plan” the more punitively the Sec. 965 “Transition Tax” would impose taxation on the shareholder. The more the assets of the corporation are in “fixed assets” (for example land), the less the rate of taxation. (For individuals in the top tax rate, it’s a rate of 17.54% for “cash and liquid assets” and approximately 9% for “fixed assets”).
The way that this affects a life depends on (1) what the corporation really is (active business or “pension” plan and (2) the age of the individual (do they have enough years to recoup the “transition tax hit”?
Imagine the following two scenarios which illustrate the significance of “age” and “where” the retained earnings have been invested
Scenario 1: A Canadian resident is 65 years old. He has been carrying on his business through a Canadian Controlled Private Corporation since 1986. He has saved assiduously and has accumulated (through frugal living) three million dollars which his retirement pension. Because it his his “retirement pension”, the three million dollars is invested in cash/liquid assets. Under the “transition tax” rules he would be “taxed” at the highest rate. He is now required to turn a significant portion of this over to the U.S. Government. At the age of 65 he has no way of making this up. It’s “bye bye” retirement!
This is made even more offensive and unreasonable because the Sec. 965 “transition tax” is a “retroactive tax” on income that was NOT subject to U.S. taxation at the time that it was earned! And hey, the idea is that is to be applied to people who don’t even live in the United States!
Scenario 2: A Canadian resident is 45 years old. He has had the Canadian Controlled Private Corporation for only 5 years. Because he has had the corporation for only 5 years, he has only one million in retained earnings. Most of that one million is invested in an office building that he uses to run his law practice. Because the one million is invested in a fixed asset, the “transition tax” is payable at the lower rate. Think of it! He pays the lower rate because of the way in which the one million dollars has been invested. But, the real point is that the 45 year old lawyer is young enough to “make up” the loss.
Finally: This is made even more offensive and unreasonable because the Sec. 965 “transition tax” is a “retroactive tax” on income that was NOT subject to U.S. taxation at the time that it was earned! And hey, the idea is that is to be applied to people who don’t even live in the United States!
In event, payment of this tax may be simply impossible. Where would people get the money?”
I emphasize also that these “undistributed earnings” were NEVER subject to U.S. taxation in the past. For all individuals (whether in the United States or outside the United States) the “transition tax” imposes retrospective taxation on income that was NOT subject to taxation when it was earned. For many “non-residents”, the result is: “Bye bye retirement!”
It is critical that this issue be taken seriously, that there be relief and that there be QUICK relief! The tax compliance community has been generally unhelpful and is pressuring people to pay the “transition tax” – by making a first “transition tax” payment by April 15, 2018. (Those electing the 8 year payout option are required to make the first payment by that date). Tax professionals don’t understand this tax. Individuals don’t understand this tax. Fear and confusion reign!
Lobbying and education aimed at securing relief for “non-resident” individuals
As Karen Alpert notes at her Fix The Tax Treaty blog, various individuals and groups have “come together” for the purpose of educating Congress and Treasury and attempting to secure “relief” for “non-residents”. This is an unprecedented alliance of various groups including: ACA, AARO, RO, DA and various individuals. I fully support all of these efforts. In addition, I urge you to support Attorney Monte Silvers’s petition.
But, I am very concerned about: because the “transition tax” is not well understood, some of the objection to the “transition tax” is based on the fact that “individuals” impacted by the tax do NOT get the same benefits as corporations impacted by the tax. The discrepancies between the treatment of individuals and corporations are real and unjust. For example individuals do not get the benefits of any move to partial “territorial taxation”. But, the real issue is NOT how “individuals” are treated relative to “corporations” under the “transition tax”. The real issue is that “non-residents” individuals are subjected to this tax at all!!!!!!!
Therefore, I believe that it is CRITICAL that the objections to the “transition tax” be clearly stated. It’s important to explain that the objection is the application of this tax to “non-resident” individuals! To ask for a “fix” that ONLY ensures that “individuals” are treated the same way as “corporations” will make things much worse for the “non-resident” individuals who need relief!!!!!!
Possible legislative solutions
- tie an exemption for “non-resident individuals” to the residential requirements needed to satisfy eligibility to make the Sec. 911 election (Foreign Earned Income Exclusion). Those who would eligible for the FEIE would be eligible for an exemption from the “transition tax”
- amend the legislation to exclude “non-resident” shareholders of CFCs
Possible administrative solutions
- it is not clear to me what is the scope of Treasury’s authority to make regulations that would exclude “non-residents” from the application of this tax. But, this needs to be considered
- ask that Treasury/IRS simply suspend enforcement of the “transition tax” on “non-resident” individuals
Possible Tax treaty solutions (on a country by country basis)
- I note that the Canada/U.S. tax treaty includes a provision that would prevent the United States from imposing taxes on the undistributed earnings of Canadian Corporations (and vice-versa). I have raised this question in the following post:
- It’s quite obvious that the “transition tax” is an attempt to impose taxation on the undistributed earnings of certain Canadian corporations. This is being achieved indirectly by attributing the income of the corporation to the income of certain “non-residents” who are individuals
- At a bare minimum, it seems to me that the “transition tax” imposes taxation on corporations over which other countries have primary taxing rights. It is a pre-emptive tax strike on the earnings of Canadian corporations before the income has been distributed (and therefore subject to taxation in Canada)
Practical compliance or non-compliance for “non-resident” individuals
- compliance with the “transition tax” is somewhere between very difficult and impossible
- people can’t afford the professional fees
- for many payment of the tax will effectively “end their possibilities of retirement” in the way they planned
The “transition tax” affects “U.S. resident” individuals very differently from the way it affects “non-resident individuals”! For “U.S. residents” the tax is NOT a terrible thing. For “non-resident” individuals it can (and will for many) be a life destroying thing! What I am saying is that:
The United States through its tax policies is destroying the lives of people who do NOT live in the United States? How more unjust can this get?
In the short term, please let’s figure out how to fix the issue of “non-residents” and the “transition tax”!
In the medium run, let’s implement the obvious solution to these problems, which is to achieve a change where:
The Unites States does not impose “worldwide taxation” on people who are “tax residents” of other countries and do NO live in the United States!
Attorney Monte Silver has organized a worldwide petition to prevent the application of the “transition tax” and GILTI to “tax residents” of other countries. Please support him by participating. You will find his petition and further information here: https://www.democratsabroad.org/remedy_repatriation_gilti_taxes